Understanding the mechanics of minimum gain.

• Author: Ellentuck, Albert B.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide-Partnerships," 18th Edition, by James A. Keller, William D. Klein, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, TX, 2004 ((800) 323-8724; www.ppcnet.com)

Minimum gain is the amount by which a partnership's nonrecourse liabilities exceed the book basis of the property securing the liability. According to Regs. Sec. 1.704-2(d)(1), a partnership's minimum gain is the total minimum gain for all partnership property subject to nonrecourse liabilities. If a property is subject to two or more liabilities of equal security priority, the property's basis is allocated among the liabilities in proportion to their outstanding balances. Otherwise, the property's basis is allocated first to liabilities of superior security priority. Basis is allocated to an inferior liability only when it exceeds the principal amount of superior liabilities. Under Regs. Sec. 1.704-2(d)(2), only the portion of the basis allocated to a nonrecourse liability is used in determining minimum gain.

Sources of Minimum Gain

Minimum gain usually arises in one of two ways:

1. The depreciation or amortization of property causes the book basis to fall below the nonrecourse liability secured by the property.

2. The partnership refinances the property, (or obtains a second mortgage) and, as a result, the nonrecourse liability exceeds the book basis of the property securing it.

   Minimum gain can decrease in a number of ways, including:

1. The nonrecourse liability's principal is paid down.

2. A previously nonrecourse liability is converted into a recourse one.

3. The property securing the nonrecourse debt is revalued in a mandatory or optional bookup.

   Example

   Fats and Waller are equal general partners in Music Partners, to which they each contributed $10,000. On January 1 of year 1, they acquired a concert hall for $390,000 (on leased land). The partnership paid $20,000; the seller fully financed the purchase via a nonrecourse loan secured by the building. The loan required payments of interest only for five years, then was payable in full.

   In each of the first three years, the partnership's net loss was $10,000, resulting completely from depreciation. The partnership agreement complies with the safe-harbor allocation rules; each partner is obligated to restore his negative capital account on liquidation. The agreement also has a minimum-gain charge back...