Timing a loss deduction.

• Author: Bier, Rivka

Many small real estate ventures are structured so that one partner provides the capital and the second partner provides operational experience. As illustrated in the example below, a key question that may arise in such an arrangement is how to treat the loss incurred by the "capital" partner in the event of operational failure and a personal bankruptcy filing by the "service" partner.

Example: In year 1, capital partner CP and service partner SP formed a joint real estate venture as a general partnership. CP invested $1 million along with mortgage financing of $7 million to purchase 12 properties. SP was responsible for leasing and other functions of property management. The partnership agreement for the joint venture specifically provided that all profits, losses, and capital items would be allocated equally between the two partners. In year 2, CP discovered that, despite SP's efforts to lease the properties, the real estate venture was running a cash flow deficit. Even with the financial shortfall, SP continued to collect his management fees, although he stopped paying the bills, including the mortgages, and failed to inform CP of the financial difficulties. One month after this discovery, CP filed suit against SP for CP's investment. Early in year 3, SP personally filed for bankruptcy. SP failed to appear in Bankruptcy Court, which resulted in the issuance of a bench warrant for SP's arrest. The court ruled that the bankruptcy was 50% nondischargeable as a result of SP's fraudulent activities. Since SP's assets are minimal (less than $40,000), CP's chances of recovery as an unsecured party are remote at best and amount to approximately 0.5% of the total claim. On his year 3 individual income tax return, CP claimed an ordinary business loss on his investment in the real estate. Secured lenders now own the various properties. According to Sec. 165 (a), a deduction is allowed for "any loss sustained during the taxable year and not compensated for by insurance or otherwise." Regs. Sec. 1.165-1 (b) provides that "[t]o be allowable as a deduction under section 165 (a), a loss must be evidenced by closed and completed transactions, fixed by identifiable events. ... Only a bona fide loss is allowable. Substance and not mere form shall govern in determining a deductible loss." The issues here are whether recovery is reasonably foreseeable and whether the transaction is closed and complete.

According to Regs. Sec. 1.165-1(d)(2)(i), if an event has...