Proposal to Permit Liability Netting for Partnerships Subject to Involuntary Conversion¹

By Veronica Long²

EXECUTIVE SUMMARY

Internal Revenue Code ("IRC") section 1033 provides for the deferral of gain recognition where property is involuntarily converted and the taxpayer reinvests the conversion proceeds in similar replacement property. The purpose of section 1033 is to defer gain recognition when taxpayers use conversion proceeds to replace property, without subjecting them to unanticipated tax liability.

When a partnership uses conversion proceeds to purchase replacement property, there is no gain where the partnership pays off a liability on the converted property and takes out a similar liability on the replacement property. However, under the same facts, Revenue Ruling 81-242 requires partners to recognize gain in an involuntary conversion where their share of liability relief exceeds their basis in the partnership.³ Section 1033 is a gain deferral statute intended to allow taxpayers to put themselves in the same position as they were pre-involuntary conversion, but Revenue Ruling 81-242 conflicts with this purpose by requiring taxpayers to recognize gain and leaving taxpayers with less funds to purchase replacement property. This result is unique to partners because individual taxpayers are not required to recognize gain under the same facts. Additionally, sections 1033 and 1031 are very similar gain deferral provisions, with generally similar results. However, section 1031 allows taxpayers to defer gain under these circumstances while section 1033 does not.