Mike and Melissa form the equal MM Partnership. Mike contributes cash of $40,000 and land (fair market value of $100,000, adjusted basis of $136,000), and Melissa contributes the assets of her sole proprietorship (value of $140,000, adjusted basis of $115,000). What are the tax issues that should be considered by Mike, Melissa, and MM on the formation of the partnership? What are the tax consequences of these issues?
Continue with the facts presented in Problem 31. Mike purchased the land (value of $100,000; adjusted basis of $136,000) several years ago as an investment (capital) asset. Mike and MM LLC are trying to decide between two alternatives.
In Alternative 1, Mike will contribute the land to the LLC. MM will use the property as a § 1231 asset (a parking lot) and then sell it in six years at an estimated $100,000 price. (Disregard any potential improvements to the land.)
In Alternative 2, Mike will sell the land immediately to a third party and contribute to MM the $100,000 cash proceeds from the sale. MM will use that cash to purchase similar land for $100,000.
Use the following additional assumptions: (1) neither Mike nor MM will realize other capital or § 1231 gains or losses now or in the future, (2) Mike’s marginal tax rate is 35%, (3) a reasonable annual discount rate is 3%, and (4) the tax treatment of capital and § 1231 gains and losses does not change in the foreseeable future.
For each alternative, when would the $36,000 loss be recognized, to whom would the loss be allocated, what is the character of the loss, and over what time period can the loss be deducted?
In these two alternatives, calculate Mike’s tax savings each year from deducting his share of any loss allocated to him that year. Use the tables in Appendix G (or Microsoft Excel) to calculate the present value of these savings. Considering only tax savings, as Mike’s tax adviser, would you recommend Alternative 1 or Alternative 2? Why? What other issues should Mike consider?
How would the results in parts (a) and (b) change if MM were to sell the property in Alternative 1 after only four years? Answer conceptually; do not make calculations.
- Alternative 1
- The 36,000 loss would be recognized in 6 years upon its sale.
- The loss would be allocated 50-50 between Mike and Melissa.
- This is a Section 1231 loss.
- The loss can be deducted after sale, so in 6 yrs.
- The 36,000 loss would be recognized immediately upon sale.
- The loss would be allocated 100% to Mike.
- This is a capital loss.
- The loss can be deducted after sale, so immediately.
- The PV of Mike’s tax savings is 36,000*.35*.5*0.8375[Appendix G] = 5276.25
- The PV of Mike’s tax savings is the full 36,000*.35 = 12,600 due to the full deduction for the loss.
Recommend Alternative 2, Mike should consider Alternative 2 because he can claim the full deduction. Whereas in Alternative 1, he has to share the deduction.
- New Alternative 1
- The 36,000 loss would be recognized in 4 years upon its sale.
- The loss would be allocated to Mike 100%.
- This is a Section 1231 loss.
- The loss can be deducted after sale, so in 4 yrs
- Still Recommend Alternative 2, Mike should consider Alternative 2 because he can claim the full deduction. Whereas in Alternative 1 he has to share the deduction. Even though the PV deduction would be more than the original alternative 1 deduction, it is still not greater than the full deduction.