Joint Report on IRC Section 1031
Open Issues Involving Partnerships
February 8, 2001
Contents | Introduction | I | II | III | IV | V
Discussion of Partnership Section 1031 Open Issues: Questions and
Answers
Q-5: When a partnership engages in a Section 1031 deferred exchange,
does Section 465(e) trigger the realization of income because of a “gap” or
temporary reduction in the amount the taxpayer has at risk, if upon completion of the
deferred exchange the amount the taxpayer has at risk is equal to or greater than the
amount at risk immediately before the transfer of the relinquished property?
A-5: No. Section 465(e) requires the recapture of previously allowed
losses when the amount a taxpayer has at risk in an activity is reduced below zero. To the
extent the amount at risk is reduced below zero, the taxpayer recognizes income. However,
a temporary reduction in the amount at risk does not trigger income recognition under
Section 465(e) because a deferred exchange is treated as an integrated or single
transaction, notwithstanding the fact that the deferred exchange straddles two tax
periods.
Under Section 465, the amount at risk cannot be less than zero. Losses are
suspended after the amount at risk reaches zero. Distribution of cash, reductions in
liabilities and various other events that would otherwise result in a negative at risk
amount trigger income recognition under Section 465(c)(1)(B). This income recognition is
intended to recapture previously deducted losses.
The recapture of income under Section 465(e) generates a suspended loss in
the same amount, which has the effect of placing the taxpayer in the same place if the
losses had originally been suspended because the at risk amount had reached zero.
The at risk rules are applied to the separate "activities" of a
taxpayer. The general rule is that activities are not aggregated. However, if a taxpayer
actively participates in the management of a trade or business, then all activities
comprising the trade or business are aggregated for purposes of the at risk rules, as
provided by Section 465(c)(3)(B)(i), (2)(B)(ii).8
The determination of a taxpayer’s at risk amount on a separate
activity basis is not addressed under regulations in the context of an exchange. The
appropriate treatment should be that the replacement property should be considered the
continuation of the same activity, and a partnership level exchange should not be treated
as an event that triggers income under Section 465.
Contents | Introduction
| I | II | III | IV | V |