When an asset declines in value thought should be given to the timing and character of the loss for tax purposes. One method to potentially accelerate a tax loss and, more importantly, claim an ordinary loss as opposed to a capital loss is to abandon the investment rather than selling it. For a brief period, it looked as if the IRS and Tax Court had foreclosed the abandonment technique (see here), but the beneficial tax treatment has been revived.
Earlier this year the Fifth Circuit Court of Appeals reversed the 2013 Tax Court decision in Pilgrim’s Pride Corp. v. Commissioner, 141 T.C. No. 17 (2013). The continuing validity of the abandonment technique is particularly important for investors in alternative investment funds, real estate and other alternative asset classes. In 1997, Treasury and the IRS issued regulations that eliminated the abandonment technique for “securities” so losses on stocks and bonds can no longer benefit from the abandonment technique. However, partnership interests, real estate, intangibles, etc… can still benefit.
The Fifth Circuit opinion is also valuable in that the court did not attempt to characterize the abandonment technique as lacking economic substance. Any abandonment transaction is, by definition, tax motivated. There is no profit potential in walking away from an investment for no consideration. Nevertheless, the Fifth Circuit did not raise the economic substance doctrine and the IRS did not attempt to attack the transaction on those grounds. Further, the court clarified that Section 1234A is only applicable to derivative interests in capital property and not the capital property itself. The Tax Court had relied on Section 1234A in finding for the government originally. That code section treats a termination of rights in capital property as a capital gain / loss.
The key takeaway here is that, until the IRS makes a regulatory change, abandoning partnership investments (as well as real estate, intangibles and other non “security” assets), should be considered in all loss scenarios to determine if the ordinary tax loss may be more valuable than an actual sale or redemption of the asset. However, beware if the partner is relieved of liabilities via the abandonment (e.g., liabilities of the partnership), the transaction will be recharacterized as a sale, resulting in a capital loss. The liabilities must be satisfied or otherwise relieved prior to abandonment to achieve an ordinary loss.
If you have questions related to abandonment tax losses or any other tax issues, please consult a member of the WithumSmith+Brown financial services group.