Loss on walkaway from partnership - is it ordinary or capital?

• Author: Williford, Jerry S.

If a taxpayer walks away from a partnership interest in which he has a positive capital account, is the loss capital or ordinary?

By walking away, it is assumed that the partner has either abandoned his interest or his interest has become worthless. Under Sec. 165, a taxpayer is allowed an abandonment or worthless loss. However, Sec. 165 does not determine the character of the loss. It may be either capital or ordinary, depending on whether or not there has been a sale or exchange. It will not necessarily depend on the nature of the property. Whether or not there has been a sale or exchange will generally depend on whether the taxpayer has received anything as a result of the walk-away.

Sec. 741 states that, in connection with the sale or exchange of a partnership interest, gain or loss will be considered as from the sale or exchange of a capital asset. (This rule applies when there are no gains or losses in connection with unrealized receivables, inventory or depreciation recapture.)

A partner may be deemed to have received something on walking away from a partnership if there are partnership liabilities. Sec. 752(b) states that there is a deemed distribution of cash to a partner when his share of partnership liabilities decreases. On the other hand, if the partner increases his share of liabilities or increases his individual liabilities by reason of assumption of partnership liabilities, under Sec. 752(a) there is a deemed contribution of cash to the partnership.

Therefore, in connection with the walkaway from a partnership interest, the partnership's liabilities must be examined.

If partnership liabilities are non-recourse, the partner's share of the nonrecourse liability is decreased. Thus, there is a deemed distribution of cash under Sec. 752(b) and the partner has received consideration. Accordingly, there is a sale or exchange and the resulting loss is a capital loss. (See Echols, 5th Cir., 1991 rev'g 93 TC 553 (1989); O'Brien, 77 TC 113 (1981); Arkin, 76 TC 1048 (1981); and Freeland, 74 TC 970 (1980).)

There same result will occur when the partnership liabilities are recourse and the partner is released from these debts when he leaves. However, this is not usually the case.

When the liabilities are recourse and the partner remains liable on these recourse liabilities after he walks away from his partnership interest, there is no sale or exchange and the loss is ordinary. See Hutchenson, 17 TC 14 (1951), and Gannon, 16 TC 1134...