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2010 Tax Preparation

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2010 Tax Preparation

2010 tax preparation 2. 2010 tax preparation   Depreciation of Rental Property Table of Contents The BasicsWhat Rental Property Can Be Depreciated? When Does Depreciation Begin and End? Depreciation Methods Basis of Depreciable Property Claiming the Special Depreciation Allowance MACRS DepreciationDepreciation Systems Property Classes Under GDS Recovery Periods Under GDS Conventions Figuring Your Depreciation Deduction Figuring MACRS Depreciation Under ADS Claiming the Correct Amount of Depreciation You recover the cost of income producing property through yearly tax deductions. 2010 tax preparation You do this by depreciating the property; that is, by deducting some of the cost each year on your tax return. 2010 tax preparation Three factors determine how much depreciation you can deduct each year: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used. 2010 tax preparation You cannot simply deduct your mortgage or principal payments, or the cost of furniture, fixtures and equipment, as an expense. 2010 tax preparation You can deduct depreciation only on the part of your property used for rental purposes. 2010 tax preparation Depreciation reduces your basis for figuring gain or loss on a later sale or exchange. 2010 tax preparation You may have to use Form 4562 to figure and report your depreciation. 2010 tax preparation See Which Forms To Use in chapter 3. 2010 tax preparation Also see Publication 946. 2010 tax preparation Section 179 deduction. 2010 tax preparation   The section 179 deduction is a means of recovering part or all of the cost of certain qualifying property in the year you place the property in service. 2010 tax preparation This deduction is not allowed for property used in connection with residential rental property. 2010 tax preparation See chapter 2 of Publication 946. 2010 tax preparation Alternative minimum tax (AMT). 2010 tax preparation   If you use accelerated depreciation, you may be subject to the AMT. 2010 tax preparation Accelerated depreciation allows you to deduct more depreciation earlier in the recovery period than you could deduct using a straight line method (same deduction each year). 2010 tax preparation   The prescribed depreciation methods for rental real estate are not accelerated, so the depreciation deduction is not adjusted for the AMT. 2010 tax preparation However, accelerated methods are generally used for other property connected with rental activities (for example, appliances and wall-to-wall carpeting). 2010 tax preparation   To find out if you are subject to the AMT, see the Instructions for Form 6251. 2010 tax preparation The Basics The following section discusses the information you will need to have about the rental property and the decisions to be made before figuring your depreciation deduction. 2010 tax preparation What Rental Property Can Be Depreciated? You can depreciate your property if it meets all the following requirements. 2010 tax preparation You own the property. 2010 tax preparation You use the property in your business or income-producing activity (such as rental property). 2010 tax preparation The property has a determinable useful life. 2010 tax preparation The property is expected to last more than one year. 2010 tax preparation Property you own. 2010 tax preparation   To claim depreciation, you usually must be the owner of the property. 2010 tax preparation You are considered as owning property even if it is subject to a debt. 2010 tax preparation Rented property. 2010 tax preparation   Generally, if you pay rent for property, you cannot depreciate that property. 2010 tax preparation Usually, only the owner can depreciate it. 2010 tax preparation However, if you make permanent improvements to leased property, you may be able to depreciate the improvements. 2010 tax preparation See Additions or improvements to property , later in this chapter, under Recovery Periods Under GDS. 2010 tax preparation Cooperative apartments. 2010 tax preparation   If you are a tenant-stockholder in a cooperative housing corporation and rent your cooperative apartment to others, you can deduct depreciation on your stock in the corporation. 2010 tax preparation See chapter 4, Special Situations. 2010 tax preparation Property having a determinable useful life. 2010 tax preparation   To be depreciable, your property must have a determinable useful life. 2010 tax preparation This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes. 2010 tax preparation What Rental Property Cannot Be Depreciated? Certain property cannot be depreciated. 2010 tax preparation This includes land and certain excepted property. 2010 tax preparation Land. 2010 tax preparation   You cannot depreciate the cost of land because land generally does not wear out, become obsolete, or get used up. 2010 tax preparation But if it does, the loss is accounted for upon disposition. 2010 tax preparation The costs of clearing, grading, planting, and landscaping are usually all part of the cost of land and cannot be depreciated. 2010 tax preparation   Although you cannot depreciate land, you can depreciate certain land preparation costs, such as landscaping costs, incurred in preparing land for business use. 2010 tax preparation These costs must be so closely associated with other depreciable property that you can determine a life for them along with the life of the associated property. 2010 tax preparation Example. 2010 tax preparation You built a new house to use as a rental and paid for grading, clearing, seeding, and planting bushes and trees. 2010 tax preparation Some of the bushes and trees were planted right next to the house, while others were planted around the outer border of the lot. 2010 tax preparation If you replace the house, you would have to destroy the bushes and trees right next to it. 2010 tax preparation These bushes and trees are closely associated with the house, so they have a determinable useful life. 2010 tax preparation Therefore, you can depreciate them. 2010 tax preparation Add your other land preparation costs to the basis of your land because they have no determinable life and you cannot depreciate them. 2010 tax preparation Excepted property. 2010 tax preparation   Even if the property meets all the requirements listed earlier under What Rental Property Can Be Depreciated , you cannot depreciate the following property. 2010 tax preparation Property placed in service and disposed of (or taken out of business use) in the same year. 2010 tax preparation Equipment used to build capital improvements. 2010 tax preparation You must add otherwise allowable depreciation on the equipment during the period of construction to the basis of your improvements. 2010 tax preparation For more information, see chapter 1 of Publication 946. 2010 tax preparation When Does Depreciation Begin and End? You begin to depreciate your rental property when you place it in service for the production of income. 2010 tax preparation You stop depreciating it either when you have fully recovered your cost or other basis, or when you retire it from service, whichever happens first. 2010 tax preparation Placed in Service You place property in service in a rental activity when it is ready and available for a specific use in that activity. 2010 tax preparation Even if you are not using the property, it is in service when it is ready and available for its specific use. 2010 tax preparation Example 1. 2010 tax preparation On November 22 of last year, you purchased a dishwasher for your rental property. 2010 tax preparation The appliance was delivered on December 7, but was not installed and ready for use until January 3 of this year. 2010 tax preparation Because the dishwasher was not ready for use last year, it is not considered placed in service until this year. 2010 tax preparation If the appliance had been installed and ready for use when it was delivered in December of last year, it would have been considered placed in service in December, even if it was not actually used until this year. 2010 tax preparation Example 2. 2010 tax preparation On April 6, you purchased a house to use as residential rental property. 2010 tax preparation You made extensive repairs to the house and had it ready for rent on July 5. 2010 tax preparation You began to advertise the house for rent in July and actually rented it beginning September 1. 2010 tax preparation The house is considered placed in service in July when it was ready and available for rent. 2010 tax preparation You can begin to depreciate the house in July. 2010 tax preparation Example 3. 2010 tax preparation You moved from your home in July. 2010 tax preparation During August and September you made several repairs to the house. 2010 tax preparation On October 1, you listed the property for rent with a real estate company, which rented it on December 1. 2010 tax preparation The property is considered placed in service on October 1, the date when it was available for rent. 2010 tax preparation Conversion to business use. 2010 tax preparation   If you place property in service in a personal activity, you cannot claim depreciation. 2010 tax preparation However, if you change the property's use to business or the production of income, you can begin to depreciate it at the time of the change. 2010 tax preparation You place the property in service for business or income-producing use on the date of the change. 2010 tax preparation Example. 2010 tax preparation You bought a house and used it as your personal home several years before you converted it to rental property. 2010 tax preparation Although its specific use was personal and no depreciation was allowable, you placed the home in service when you began using it as your home. 2010 tax preparation You can begin to claim depreciation in the year you converted it to rental property because at that time its use changed to the production of income. 2010 tax preparation Idle Property Continue to claim a deduction for depreciation on property used in your rental activity even if it is temporarily idle (not in use). 2010 tax preparation For example, if you must make repairs after a tenant moves out, you still depreciate the rental property during the time it is not available for rent. 2010 tax preparation Cost or Other Basis Fully Recovered You must stop depreciating property when the total of your yearly depreciation deductions equals your cost or other basis of your property. 2010 tax preparation For this purpose, your yearly depreciation deductions include any depreciation that you were allowed to claim, even if you did not claim it. 2010 tax preparation See Basis of Depreciable Property , later. 2010 tax preparation Retired From Service You stop depreciating property when you retire it from service, even if you have not fully recovered its cost or other basis. 2010 tax preparation You retire property from service when you permanently withdraw it from use in a trade or business or from use in the production of income because of any of the following events. 2010 tax preparation You sell or exchange the property. 2010 tax preparation You convert the property to personal use. 2010 tax preparation You abandon the property. 2010 tax preparation The property is destroyed. 2010 tax preparation Depreciation Methods Generally, you must use the Modified Accelerated Cost Recovery System (MACRS) to depreciate residential rental property placed in service after 1986. 2010 tax preparation If you placed rental property in service before 1987, you are using one of the following methods. 2010 tax preparation ACRS (Accelerated Cost Recovery System) for property placed in service after 1980 but before 1987. 2010 tax preparation Straight line or declining balance method over the useful life of property placed in service before 1981. 2010 tax preparation See MACRS Depreciation , later, for more information. 2010 tax preparation Rental property placed in service before 2013. 2010 tax preparation   Continue to use the same method of figuring depreciation that you used in the past. 2010 tax preparation Use of real property changed. 2010 tax preparation   Generally, you must use MACRS to depreciate real property that you acquired for personal use before 1987 and changed to business or income-producing use after 1986. 2010 tax preparation This includes your residence that you changed to rental use. 2010 tax preparation See Property Owned or Used in 1986 in Publication 946, chapter 1, for those situations in which MACRS is not allowed. 2010 tax preparation Improvements made after 1986. 2010 tax preparation   Treat an improvement made after 1986 to property you placed in service before 1987 as separate depreciable property. 2010 tax preparation As a result, you can depreciate that improvement as separate property under MACRS if it is the type of property that otherwise qualifies for MACRS depreciation. 2010 tax preparation For more information about improvements, see Additions or improvements to property , later in this chapter under Recovery Periods Under GDS. 2010 tax preparation This publication discusses MACRS depreciation only. 2010 tax preparation If you need information about depreciating property placed in service before 1987, see Publication 534. 2010 tax preparation Basis of Depreciable Property The basis of property used in a rental activity is generally its adjusted basis when you place it in service in that activity. 2010 tax preparation This is its cost or other basis when you acquired it, adjusted for certain items occurring before you place it in service in the rental activity. 2010 tax preparation If you depreciate your property under MACRS, you may also have to reduce your basis by certain deductions and credits with respect to the property. 2010 tax preparation Basis and adjusted basis are explained in the following discussions. 2010 tax preparation If you used the property for personal purposes before changing it to rental use, its basis for depreciation is the lesser of its adjusted basis or its fair market value when you change it to rental use. 2010 tax preparation See Basis of Property Changed to Rental Use in chapter 4. 2010 tax preparation Cost Basis The basis of property you buy is usually its cost. 2010 tax preparation The cost is the amount you pay for it in cash, in debt obligation, in other property, or in services. 2010 tax preparation Your cost also includes amounts you pay for: Sales tax charged on the purchase (but see Exception next), Freight charges to obtain the property, and Installation and testing charges. 2010 tax preparation Exception. 2010 tax preparation   If you deducted state and local general sales taxes as an itemized deduction on Schedule A (Form 1040), do not include those sales taxes as part of your cost basis. 2010 tax preparation Such taxes were deductible before 1987 and after 2003. 2010 tax preparation Loans with low or no interest. 2010 tax preparation   If you buy property on any time-payment plan that charges little or no interest, the basis of your property is your stated purchase price, less the amount considered to be unstated interest. 2010 tax preparation See Unstated Interest and Original Issue Discount (OID) in Publication 537, Installment Sales. 2010 tax preparation Real property. 2010 tax preparation   If you buy real property, such as a building and land, certain fees and other expenses you pay are part of your cost basis in the property. 2010 tax preparation Real estate taxes. 2010 tax preparation   If you buy real property and agree to pay real estate taxes on it that were owed by the seller and the seller does not reimburse you, the taxes you pay are treated as part of your basis in the property. 2010 tax preparation You cannot deduct them as taxes paid. 2010 tax preparation   If you reimburse the seller for real estate taxes the seller paid for you, you can usually deduct that amount. 2010 tax preparation Do not include that amount in your basis in the property. 2010 tax preparation Settlement fees and other costs. 2010 tax preparation   The following settlement fees and closing costs for buying the property are part of your basis in the property. 2010 tax preparation Abstract fees. 2010 tax preparation Charges for installing utility services. 2010 tax preparation Legal fees. 2010 tax preparation Recording fees. 2010 tax preparation Surveys. 2010 tax preparation Transfer taxes. 2010 tax preparation Title insurance. 2010 tax preparation Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions. 2010 tax preparation   The following are settlement fees and closing costs you cannot include in your basis in the property. 2010 tax preparation Fire insurance premiums. 2010 tax preparation Rent or other charges relating to occupancy of the property before closing. 2010 tax preparation Charges connected with getting or refinancing a loan, such as: Points (discount points, loan origination fees), Mortgage insurance premiums, Loan assumption fees, Cost of a credit report, and Fees for an appraisal required by a lender. 2010 tax preparation   Also, do not include amounts placed in escrow for the future payment of items such as taxes and insurance. 2010 tax preparation Assumption of a mortgage. 2010 tax preparation   If you buy property and become liable for an existing mortgage on the property, your basis is the amount you pay for the property plus the amount remaining to be paid on the mortgage. 2010 tax preparation Example. 2010 tax preparation You buy a building for $60,000 cash and assume a mortgage of $240,000 on it. 2010 tax preparation Your basis is $300,000. 2010 tax preparation Separating cost of land and buildings. 2010 tax preparation   If you buy buildings and your cost includes the cost of the land on which they stand, you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings. 2010 tax preparation The part of the cost that you allocate to each asset is the ratio of the fair market value of that asset to the fair market value of the whole property at the time you buy it. 2010 tax preparation   If you are not certain of the fair market values of the land and the buildings, you can divide the cost between them based on their assessed values for real estate tax purposes. 2010 tax preparation Example. 2010 tax preparation You buy a house and land for $200,000. 2010 tax preparation The purchase contract does not specify how much of the purchase price is for the house and how much is for the land. 2010 tax preparation The latest real estate tax assessment on the property was based on an assessed value of $160,000, of which $136,000 was for the house and $24,000 was for the land. 2010 tax preparation You can allocate 85% ($136,000 ÷ $160,000) of the purchase price to the house and 15% ($24,000 ÷ $160,000) of the purchase price to the land. 2010 tax preparation Your basis in the house is $170,000 (85% of $200,000) and your basis in the land is $30,000 (15% of $200,000). 2010 tax preparation Basis Other Than Cost You cannot use cost as a basis for property that you received: In return for services you performed; In an exchange for other property; As a gift; From your spouse, or from your former spouse as the result of a divorce; or As an inheritance. 2010 tax preparation If you received property in one of these ways, see Publication 551 for information on how to figure your basis. 2010 tax preparation Adjusted Basis To figure your property's basis for depreciation, you may have to make certain adjustments (increases and decreases) to the basis of the property for events occurring between the time you acquired the property and the time you placed it in service for business or the production of income. 2010 tax preparation The result of these adjustments to the basis is the adjusted basis. 2010 tax preparation Increases to basis. 2010 tax preparation   You must increase the basis of any property by the cost of all items properly added to a capital account. 2010 tax preparation These include the following. 2010 tax preparation The cost of any additions or improvements made before placing your property into service as a rental that have a useful life of more than 1 year. 2010 tax preparation Amounts spent after a casualty to restore the damaged property. 2010 tax preparation The cost of extending utility service lines to the property. 2010 tax preparation Legal fees, such as the cost of defending and perfecting title, or settling zoning issues. 2010 tax preparation Additions or improvements. 2010 tax preparation   Add to the basis of your property the amount an addition or improvement actually cost you, including any amount you borrowed to make the addition or improvement. 2010 tax preparation This includes all direct costs, such as material and labor, but does not include your own labor. 2010 tax preparation It also includes all expenses related to the addition or improvement. 2010 tax preparation   For example, if you had an architect draw up plans for remodeling your property, the architect's fee is a part of the cost of the remodeling. 2010 tax preparation Or, if you had your lot surveyed to put up a fence, the cost of the survey is a part of the cost of the fence. 2010 tax preparation   Keep separate accounts for depreciable additions or improvements made after you place the property in service in your rental activity. 2010 tax preparation For information on depreciating additions or improvements, see Additions or improvements to property , later in this chapter, under Recovery Periods Under GDS. 2010 tax preparation    The cost of landscaping improvements is usually treated as an addition to the basis of the land, which is not depreciable. 2010 tax preparation However, see What Rental Property Cannot Be Depreciated, earlier. 2010 tax preparation Assessments for local improvements. 2010 tax preparation   Assessments for items which tend to increase the value of property, such as streets and sidewalks, must be added to the basis of the property. 2010 tax preparation For example, if your city installs curbing on the street in front of your house, and assesses you and your neighbors for its cost, you must add the assessment to the basis of your property. 2010 tax preparation Also add the cost of legal fees paid to obtain a decrease in an assessment levied against property to pay for local improvements. 2010 tax preparation You cannot deduct these items as taxes or depreciate them. 2010 tax preparation    However, you can deduct as taxes, charges or assessments for maintenance, repairs, or interest charges related to the improvements. 2010 tax preparation Do not add them to your basis in the property. 2010 tax preparation Deducting vs. 2010 tax preparation capitalizing costs. 2010 tax preparation   Do not add to your basis costs you can deduct as current expenses. 2010 tax preparation However, there are certain costs you can choose either to deduct or to capitalize. 2010 tax preparation If you capitalize these costs, include them in your basis. 2010 tax preparation If you deduct them, do not include them in your basis. 2010 tax preparation   The costs you may choose to deduct or capitalize include carrying charges, such as interest and taxes, that you must pay to own property. 2010 tax preparation   For more information about deducting or capitalizing costs and how to make the election, see Carrying Charges in Publication 535, chapter 7. 2010 tax preparation Decreases to basis. 2010 tax preparation   You must decrease the basis of your property by any items that represent a return of your cost. 2010 tax preparation These include the following. 2010 tax preparation Insurance or other payment you receive as the result of a casualty or theft loss. 2010 tax preparation Casualty loss not covered by insurance for which you took a deduction. 2010 tax preparation Amount(s) you receive for granting an easement. 2010 tax preparation Residential energy credits you were allowed before 1986, or after 2005, if you added the cost of the energy items to the basis of your home. 2010 tax preparation Exclusion from income of subsidies for energy conservation measures. 2010 tax preparation Special depreciation allowance claimed on qualified property. 2010 tax preparation Depreciation you deducted, or could have deducted, on your tax returns under the method of depreciation you chose. 2010 tax preparation If you did not deduct enough or deducted too much in any year, see Depreciation under Decreases to Basis in Publication 551. 2010 tax preparation   If your rental property was previously used as your main home, you must also decrease the basis by the following. 2010 tax preparation Gain you postponed from the sale of your main home before May 7, 1997, if the replacement home was converted to your rental property. 2010 tax preparation District of Columbia first-time homebuyer credit allowed on the purchase of your main home after August 4, 1997 and before January 1, 2012. 2010 tax preparation Amount of qualified principal residence indebtedness discharged on or after January 1, 2007. 2010 tax preparation Claiming the Special Depreciation Allowance For 2013, your residential rental property may qualify for a special depreciation allowance. 2010 tax preparation This allowance is figured before you figure your regular depreciation deduction. 2010 tax preparation See Publication 946, chapter 3, for details. 2010 tax preparation Also see the Instructions for Form 4562, Line 14. 2010 tax preparation If you qualify for, but choose not to take, a special depreciation allowance, you must attach a statement to your return. 2010 tax preparation The details of this election are in Publication 946, chapter 3, and the Instructions for Form 4562, Line 14. 2010 tax preparation MACRS Depreciation Most business and investment property placed in service after 1986 is depreciated using MACRS. 2010 tax preparation This section explains how to determine which MACRS depreciation system applies to your property. 2010 tax preparation It also discusses other information you need to know before you can figure depreciation under MACRS. 2010 tax preparation This information includes the property's: Recovery class, Applicable recovery period, Convention, Placed-in-service date, Basis for depreciation, and Depreciation method. 2010 tax preparation Depreciation Systems MACRS consists of two systems that determine how you depreciate your property—the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). 2010 tax preparation You must use GDS unless you are specifically required by law to use ADS or you elect to use ADS. 2010 tax preparation Excluded Property You cannot use MACRS for certain personal property (such as furniture or appliances) placed in service in your rental property in 2013 if it had been previously placed in service before 1987 when MACRS became effective. 2010 tax preparation In most cases, personal property is excluded from MACRS if you (or a person related to you) owned or used it in 1986 or if your tenant is a person (or someone related to the person) who owned or used it in 1986. 2010 tax preparation However, the property is not excluded if your 2013 deduction under MACRS (using a half-year convention) is less than the deduction you would have under ACRS. 2010 tax preparation For more information, see What Method Can You Use To Depreciate Your Property? in Publication 946, chapter 1. 2010 tax preparation Electing ADS If you choose, you can use the ADS method for most property. 2010 tax preparation Under ADS, you use the straight line method of depreciation. 2010 tax preparation The election of ADS for one item in a class of property generally applies to all property in that class that is placed in service during the tax year of the election. 2010 tax preparation However, the election applies on a property-by-property basis for residential rental property and nonresidential real property. 2010 tax preparation If you choose to use ADS for your residential rental property, the election must be made in the first year the property is placed in service. 2010 tax preparation Once you make this election, you can never revoke it. 2010 tax preparation For property placed in service during 2013, you make the election to use ADS by entering the depreciation on Form 4562, Part III, Section C, line 20c. 2010 tax preparation Property Classes Under GDS Each item of property that can be depreciated under MACRS is assigned to a property class, determined by its class life. 2010 tax preparation The property class generally determines the depreciation method, recovery period, and convention. 2010 tax preparation The property classes under GDS are: 3-year property, 5-year property, 7-year property, 10-year property, 15-year property, 20-year property, Nonresidential real property, and Residential rental property. 2010 tax preparation Under MACRS, property that you placed in service during 2013 in your rental activities generally falls into one of the following classes. 2010 tax preparation 5-year property. 2010 tax preparation This class includes computers and peripheral equipment, office machinery (typewriters, calculators, copiers, etc. 2010 tax preparation ), automobiles, and light trucks. 2010 tax preparation This class also includes appliances, carpeting, furniture, etc. 2010 tax preparation , used in a residential rental real estate activity. 2010 tax preparation Depreciation on automobiles, other property used for transportation, computers and related peripheral equipment, and property of a type generally used for entertainment, recreation, or amusement is limited. 2010 tax preparation See chapter 5 of Publication 946. 2010 tax preparation 7-year property. 2010 tax preparation This class includes office furniture and equipment (desks, file cabinets, etc. 2010 tax preparation ). 2010 tax preparation This class also includes any property that does not have a class life and that has not been designated by law as being in any other class. 2010 tax preparation 15-year property. 2010 tax preparation This class includes roads, fences, and shrubbery (if depreciable). 2010 tax preparation Residential rental property. 2010 tax preparation This class includes any real property that is a rental building or structure (including a mobile home) for which 80% or more of the gross rental income for the tax year is from dwelling units. 2010 tax preparation It does not include a unit in a hotel, motel, inn, or other establishment where more than half of the units are used on a transient basis. 2010 tax preparation If you live in any part of the building or structure, the gross rental income includes the fair rental value of the part you live in. 2010 tax preparation The other property classes do not generally apply to property used in rental activities. 2010 tax preparation These classes are not discussed in this publication. 2010 tax preparation See Publication 946 for more information. 2010 tax preparation Recovery Periods Under GDS The recovery period of property is the number of years over which you recover its cost or other basis. 2010 tax preparation The recovery periods are generally longer under ADS than GDS. 2010 tax preparation The recovery period of property depends on its property class. 2010 tax preparation Under GDS, the recovery period of an asset is generally the same as its property class. 2010 tax preparation Class lives and recovery periods for most assets are listed in Appendix B of Publication 946. 2010 tax preparation See Table 2-1 for recovery periods of property commonly used in residential rental activities. 2010 tax preparation Qualified Indian reservation property. 2010 tax preparation   Shorter recovery periods are provided under MACRS for qualified Indian reservation property placed in service on Indian reservations. 2010 tax preparation For more information, see chapter 4 of Publication 946. 2010 tax preparation Additions or improvements to property. 2010 tax preparation   Treat additions or improvements you make to your depreciable rental property as separate property items for depreciation purposes. 2010 tax preparation   The property class and recovery period of the addition or improvement is the one that would apply to the original property if you had placed it in service at the same time as the addition or improvement. 2010 tax preparation   The recovery period for an addition or improvement to property begins on the later of: The date the addition or improvement is placed in service, or The date the property to which the addition or improvement was made is placed in service. 2010 tax preparation Example. 2010 tax preparation You own a residential rental house that you have been renting since 1986 and depreciating under ACRS. 2010 tax preparation You built an addition onto the house and placed it in service in 2013. 2010 tax preparation You must use MACRS for the addition. 2010 tax preparation Under GDS, the addition is depreciated as residential rental property over 27. 2010 tax preparation 5 years. 2010 tax preparation Table 2-1. 2010 tax preparation MACRS Recovery Periods for Property Used in Rental Activities   MACRS Recovery Period   Type of Property General Depreciation System Alternative Depreciation System   Computers and their peripheral equipment 5 years 5 years   Office machinery, such as: Typewriters Calculators Copiers 5 years 6 years   Automobiles 5 years 5 years   Light trucks 5 years 5 years   Appliances, such as: Stoves Refrigerators 5 years 9 years   Carpets 5 years 9 years   Furniture used in rental property 5 years 9 years   Office furniture and equipment, such as: Desks Files 7 years 10 years   Any property that does not have a class life and that has not been designated by law as being in any other class 7 years 12 years   Roads 15 years 20 years   Shrubbery 15 years 20 years   Fences 15 years 20 years   Residential rental property (buildings or structures) and structural components such as furnaces, waterpipes, venting, etc. 2010 tax preparation 27. 2010 tax preparation 5 years 40 years   Additions and improvements, such as a new roof The same recovery period as that of the property to which the addition or improvement is made, determined as if the property were placed in service at the same time as the addition or improvement. 2010 tax preparation   Conventions A convention is a method established under MACRS to set the beginning and end of the recovery period. 2010 tax preparation The convention you use determines the number of months for which you can claim depreciation in the year you place property in service and in the year you dispose of the property. 2010 tax preparation Mid-month convention. 2010 tax preparation    A mid-month convention is used for all residential rental property and nonresidential real property. 2010 tax preparation Under this convention, you treat all property placed in service, or disposed of, during any month as placed in service, or disposed of, at the midpoint of that month. 2010 tax preparation Mid-quarter convention. 2010 tax preparation   A mid-quarter convention must be used if the mid-month convention does not apply and the total depreciable basis of MACRS property placed in service in the last 3 months of a tax year (excluding nonresidential real property, residential rental property, and property placed in service and disposed of in the same year) is more than 40% of the total basis of all such property you place in service during the year. 2010 tax preparation   Under this convention, you treat all property placed in service, or disposed of, during any quarter of a tax year as placed in service, or disposed of, at the midpoint of the quarter. 2010 tax preparation Example. 2010 tax preparation During the tax year, Tom Martin purchased the following items to use in his rental property. 2010 tax preparation He elects not to claim the special depreciation allowance discussed earlier. 2010 tax preparation A dishwasher for $400 that he placed in service in January. 2010 tax preparation Used furniture for $100 that he placed in service in September. 2010 tax preparation A refrigerator for $800 that he placed in service in October. 2010 tax preparation Tom uses the calendar year as his tax year. 2010 tax preparation The total basis of all property placed in service that year is $1,300. 2010 tax preparation The $800 basis of the refrigerator placed in service during the last 3 months of his tax year exceeds $520 (40% × $1,300). 2010 tax preparation Tom must use the mid-quarter convention instead of the half-year convention for all three items. 2010 tax preparation Half-year convention. 2010 tax preparation    The half-year convention is used if neither the mid-quarter convention nor the mid-month convention applies. 2010 tax preparation Under this convention, you treat all property placed in service, or disposed of, during a tax year as placed in service, or disposed of, at the midpoint of that tax year. 2010 tax preparation   If this convention applies, you deduct a half year of depreciation for the first year and the last year that you depreciate the property. 2010 tax preparation You deduct a full year of depreciation for any other year during the recovery period. 2010 tax preparation Figuring Your Depreciation Deduction You can figure your MACRS depreciation deduction in one of two ways. 2010 tax preparation The deduction is substantially the same both ways. 2010 tax preparation You can either: Actually compute the deduction using the depreciation method and convention that apply over the recovery period of the property, or Use the percentage from the MACRS percentage tables. 2010 tax preparation In this publication we will use the percentage tables. 2010 tax preparation For instructions on how to compute the deduction, see chapter 4 of Publication 946. 2010 tax preparation Residential rental property. 2010 tax preparation   You must use the straight line method and a mid-month convention for residential rental property. 2010 tax preparation In the first year that you claim depreciation for residential rental property, you can claim depreciation only for the number of months the property is in use, and you must use the mid-month convention (explained under Conventions , earlier). 2010 tax preparation 5-, 7-, or 15-year property. 2010 tax preparation   For property in the 5- or 7-year class, use the 200% declining balance method and a half-year convention. 2010 tax preparation However, in limited cases you must use the mid-quarter convention, if it applies. 2010 tax preparation For property in the 15-year class, use the 150% declining balance method and a half-year convention. 2010 tax preparation   You can also choose to use the 150% declining balance method for property in the 5- or 7-year class. 2010 tax preparation The choice to use the 150% method for one item in a class of property applies to all property in that class that is placed in service during the tax year of the election. 2010 tax preparation You make this election on Form 4562. 2010 tax preparation In Part III, column (f), enter “150 DB. 2010 tax preparation ” Once you make this election, you cannot change to another method. 2010 tax preparation   If you use either the 200% or 150% declining balance method, you figure your deduction using the straight line method in the first tax year that the straight line method gives you an equal or larger deduction. 2010 tax preparation   You can also choose to use the straight line method with a half-year or mid-quarter convention for 5-, 7-, or 15-year property. 2010 tax preparation The choice to use the straight line method for one item in a class of property applies to all property in that class that is placed in service during the tax year of the election. 2010 tax preparation You elect the straight line method on Form 4562. 2010 tax preparation In Part III, column (f), enter “S/L. 2010 tax preparation ” Once you make this election, you cannot change to another method. 2010 tax preparation MACRS Percentage Tables You can use the percentages in Table 2-2, earlier, to compute annual depreciation under MACRS. 2010 tax preparation The tables show the percentages for the first few years or until the change to the straight line method is made. 2010 tax preparation See Appendix A of Publication 946 for complete tables. 2010 tax preparation The percentages in Tables 2-2a, 2-2b, and 2-2c make the change from declining balance to straight line in the year that straight line will give a larger deduction. 2010 tax preparation If you elect to use the straight line method for 5-, 7-, or 15-year property, or the 150% declining balance method for 5- or 7-year property, use the tables in Appendix A of Publication 946. 2010 tax preparation How to use the percentage tables. 2010 tax preparation   You must apply the table rates to your property's unadjusted basis (defined below) each year of the recovery period. 2010 tax preparation   Once you begin using a percentage table to figure depreciation, you must continue to use it for the entire recovery period unless there is an adjustment to the basis of your property for a reason other than: Depreciation allowed or allowable, or An addition or improvement that is depreciated as a separate item of property. 2010 tax preparation   If there is an adjustment for any reason other than (1) or (2), for example, because of a deductible casualty loss, you can no longer use the table. 2010 tax preparation For the year of the adjustment and for the remaining recovery period, figure depreciation using the property's adjusted basis at the end of the year and the appropriate depreciation method, as explained earlier under Figuring Your Depreciation Deduction . 2010 tax preparation See Figuring the Deduction Without Using the Tables in Publication 946, chapter 4. 2010 tax preparation Unadjusted basis. 2010 tax preparation   This is the same basis you would use to figure gain on a sale (see Basis of Depreciable Property , earlier), but without reducing your original basis by any MACRS depreciation taken in earlier years. 2010 tax preparation   However, you do reduce your original basis by other amounts claimed on the property, including: Any amortization, Any section 179 deduction, and Any special depreciation allowance. 2010 tax preparation For more information, see chapter 4 of Publication 946. 2010 tax preparation Please click here for the text description of the image. 2010 tax preparation Table 2-2 Tables 2-2a, 2-2b, and 2-2c. 2010 tax preparation   The percentages in these tables take into account the half-year and mid-quarter conventions. 2010 tax preparation Use Table 2-2a for 5-year property, Table 2-2b for 7-year property, and Table 2-2c for 15-year property. 2010 tax preparation Use the percentage in the second column (half-year convention) unless you are required to use the mid-quarter convention (explained earlier). 2010 tax preparation If you must use the mid-quarter convention, use the column that corresponds to the calendar year quarter in which you placed the property in service. 2010 tax preparation Example 1. 2010 tax preparation You purchased a stove and refrigerator and placed them in service in June. 2010 tax preparation Your basis in the stove is $600 and your basis in the refrigerator is $1,000. 2010 tax preparation Both are 5-year property. 2010 tax preparation Using the half-year convention column in Table 2-2a, the depreciation percentage for Year 1 is 20%. 2010 tax preparation For that year your depreciation deduction is $120 ($600 × . 2010 tax preparation 20) for the stove and $200 ($1,000 × . 2010 tax preparation 20) for the refrigerator. 2010 tax preparation For Year 2, the depreciation percentage is 32%. 2010 tax preparation That year's depreciation deduction will be $192 ($600 × . 2010 tax preparation 32) for the stove and $320 ($1,000 × . 2010 tax preparation 32) for the refrigerator. 2010 tax preparation Example 2. 2010 tax preparation Assume the same facts as in Example 1, except you buy the refrigerator in October instead of June. 2010 tax preparation Since the refrigerator was placed in service in the last 3 months of the tax year, and its basis ($1,000) is more than 40% of the total basis of all property placed in service during the year ($1,600 × . 2010 tax preparation 40 = $640), you are required to use the mid-quarter convention to figure depreciation on both the stove and refrigerator. 2010 tax preparation Because you placed the refrigerator in service in October, you use the fourth quarter column of Table 2-2a and find the depreciation percentage for Year 1 is 5%. 2010 tax preparation Your depreciation deduction for the refrigerator is $50 ($1,000 x . 2010 tax preparation 05). 2010 tax preparation Because you placed the stove in service in June, you use the second quarter column of Table 2-2a and find the depreciation percentage for Year 1 is 25%. 2010 tax preparation For that year, your depreciation deduction for the stove is $150 ($600 x . 2010 tax preparation 25). 2010 tax preparation Table 2-2d. 2010 tax preparation    Use this table when you are using the GDS 27. 2010 tax preparation 5 year option for residential rental property. 2010 tax preparation Find the row for the month that you placed the property in service. 2010 tax preparation Use the percentages listed for that month to figure your depreciation deduction. 2010 tax preparation The mid-month convention is taken into account in the percentages shown in the table. 2010 tax preparation Continue to use the same row (month) under the column for the appropriate year. 2010 tax preparation Example. 2010 tax preparation You purchased a single family rental house for $185,000 and placed it in service on February 8. 2010 tax preparation The sales contract showed that the building cost $160,000 and the land cost $25,000. 2010 tax preparation Your basis for depreciation is its original cost, $160,000. 2010 tax preparation This is the first year of service for your residential rental property and you decide to use GDS which has a recovery period of 27. 2010 tax preparation 5 years. 2010 tax preparation Using Table 2-2d, you find that the percentage for property placed in service in February of Year 1 is 3. 2010 tax preparation 182%. 2010 tax preparation That year's depreciation deduction is $5,091 ($160,000 x . 2010 tax preparation 03182). 2010 tax preparation Figuring MACRS Depreciation Under ADS Table 2–1, earlier, shows the ADS recovery periods for property used in rental activities. 2010 tax preparation See Appendix B in Publication 946 for other property. 2010 tax preparation If your property is not listed in Appendix B, it is considered to have no class life. 2010 tax preparation Under ADS, personal property with no class life is depreciated using a recovery period of 12 years. 2010 tax preparation Use the mid-month convention for residential rental property and nonresidential real property. 2010 tax preparation For all other property, use the half-year or mid-quarter convention, as appropriate. 2010 tax preparation See Publication 946 for ADS depreciation tables. 2010 tax preparation Claiming the Correct Amount of Depreciation You should claim the correct amount of depreciation each tax year. 2010 tax preparation If you did not claim all the depreciation you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted. 2010 tax preparation For more information, see Depreciation under Decreases to Basis in Publication 551. 2010 tax preparation If you deducted an incorrect amount of depreciation for property in any year, you may be able to make a correction by filing Form 1040X, Amended U. 2010 tax preparation S. 2010 tax preparation Individual Income Tax Return. 2010 tax preparation If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. 2010 tax preparation Filing an amended return. 2010 tax preparation   You can file an amended return to correct the amount of depreciation claimed for any property in any of the following situations. 2010 tax preparation You claimed the incorrect amount because of a mathematical error made in any year. 2010 tax preparation You claimed the incorrect amount because of a posting error made in any year. 2010 tax preparation You have not adopted a method of accounting for property placed in service by you in tax years ending after December 29, 2003. 2010 tax preparation You claimed the incorrect amount on property placed in service by you in tax years ending before December 30, 2003. 2010 tax preparation   Generally, you adopt a method of accounting for depreciation by using a permissible method of determining depreciation when you file your first tax return for the property used in your rental activity. 2010 tax preparation This also occurs when you use the same impermissible method of determining depreciation (for example, using the wrong MACRS recovery period) in two or more consecutively filed tax returns. 2010 tax preparation   If an amended return is allowed, you must file it by the later of the following dates. 2010 tax preparation 3 years from the date you filed your original return for the year in which you did not deduct the correct amount. 2010 tax preparation A return filed before an unextended due date is considered filed on that due date. 2010 tax preparation 2 years from the time you paid your tax for that year. 2010 tax preparation Changing your accounting method. 2010 tax preparation   To change your accounting method, you generally must file Form 3115, Application for Change in Accounting Method, to get the consent of the IRS. 2010 tax preparation In some instances, that consent is automatic. 2010 tax preparation For more information, see Changing Your Accounting Method in Publication 946,  chapter 1. 2010 tax preparation Prev  Up  Next   Home   More Online Publications
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The 2010 Tax Preparation

2010 tax preparation Publication 541 - Main Content Table of Contents Forming a PartnershipOrganizations Classified as Partnerships Family Partnership Partnership Agreement Terminating a PartnershipIRS e-file (Electronic Filing) Exclusion From Partnership Rules Partnership Return (Form 1065) Partnership DistributionsSubstantially appreciated inventory items. 2010 tax preparation Partner's Gain or Loss Partner's Basis for Distributed Property Transactions Between Partnership and PartnersGuaranteed Payments Sale or Exchange of Property Contribution of Property Contribution of Services Basis of Partner's InterestAdjusted Basis Effect of Partnership Liabilities Disposition of Partner's InterestSale, Exchange, or Other Transfer Payments for Unrealized Receivables and Inventory Items Liquidation at Partner's Retirement or Death Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)Partnership Item. 2010 tax preparation Small Partnerships and the Small Partnership Exception Small Partnership TEFRA Election Role of Tax Matters Partner (TMP) in TEFRA Proceedings Statute of Limitations and TEFRA Amended Returns and Administrative Adjustment Requests (AARs) How To Get Tax Help Forming a Partnership The following sections contain general information about partnerships. 2010 tax preparation Organizations Classified as Partnerships An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members carry on a trade, business, financial operation, or venture and divide its profits. 2010 tax preparation However, a joint undertaking merely to share expenses is not a partnership. 2010 tax preparation For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants. 2010 tax preparation The rules you must use to determine whether an organization is classified as a partnership changed for organizations formed after 1996. 2010 tax preparation Organizations formed after 1996. 2010 tax preparation   An organization formed after 1996 is classified as a partnership for federal tax purposes if it has two or more members and it is none of the following. 2010 tax preparation An organization formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate, or body politic. 2010 tax preparation An organization formed under a state law that refers to it as a joint-stock company or joint-stock association. 2010 tax preparation An insurance company. 2010 tax preparation Certain banks. 2010 tax preparation An organization wholly owned by a state, local, or foreign government. 2010 tax preparation An organization specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly traded partnerships). 2010 tax preparation Certain foreign organizations identified in section 301. 2010 tax preparation 7701-2(b)(8) of the regulations. 2010 tax preparation A tax-exempt organization. 2010 tax preparation A real estate investment trust. 2010 tax preparation An organization classified as a trust under section 301. 2010 tax preparation 7701-4 of the regulations or otherwise subject to special treatment under the Internal Revenue Code. 2010 tax preparation Any other organization that elects to be classified as a corporation by filing Form 8832. 2010 tax preparation For more information, see the instructions for Form 8832. 2010 tax preparation Limited liability company. 2010 tax preparation   A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC. 2010 tax preparation Unlike a partnership, none of the members of an LLC are personally liable for its debts. 2010 tax preparation An LLC may be classified for federal income tax purposes as either a partnership, a corporation, or an entity disregarded as an entity separate from its owner by applying the rules in Regulations section 301. 2010 tax preparation 7701-3. 2010 tax preparation See Form 8832 and section 301. 2010 tax preparation 7701-3 of the regulations for more details. 2010 tax preparation A domestic LLC with at least two members that does not file Form 8832 is classified as a partnership for federal income tax purposes. 2010 tax preparation Organizations formed before 1997. 2010 tax preparation   An organization formed before 1997 and classified as a partnership under the old rules will generally continue to be classified as a partnership as long as the organization has at least two members and does not elect to be classified as a corporation by filing Form 8832. 2010 tax preparation Community property. 2010 tax preparation    Spouses who own a qualified entity (defined later) can choose to classify the entity as a partnership for federal tax purposes by filing the appropriate partnership tax returns. 2010 tax preparation They can choose to classify the entity as a sole proprietorship by filing a Schedule C (Form 1040) listing one spouse as the sole proprietor. 2010 tax preparation A change in reporting position will be treated for federal tax purposes as a conversion of the entity. 2010 tax preparation   A qualified entity is a business entity that meets all the following requirements. 2010 tax preparation The business entity is wholly owned by spouses as community property under the laws of a state, a foreign country, or a possession of the United States. 2010 tax preparation No person other than one or both spouses would be considered an owner for federal tax purposes. 2010 tax preparation The business entity is not treated as a corporation. 2010 tax preparation   For more information about community property, see Publication 555, Community Property. 2010 tax preparation Publication 555 discusses the community property laws of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. 2010 tax preparation Family Partnership Members of a family can be partners. 2010 tax preparation However, family members (or any other person) will be recognized as partners only if one of the following requirements is met. 2010 tax preparation If capital is a material income-producing factor, they acquired their capital interest in a bona fide transaction (even if by gift or purchase from another family member), actually own the partnership interest, and actually control the interest. 2010 tax preparation If capital is not a material income-producing factor, they joined together in good faith to conduct a business. 2010 tax preparation They agreed that contributions of each entitle them to a share in the profits, and some capital or service has been (or is) provided by each partner. 2010 tax preparation Capital is material. 2010 tax preparation   Capital is a material income-producing factor if a substantial part of the gross income of the business comes from the use of capital. 2010 tax preparation Capital is ordinarily an income-producing factor if the operation of the business requires substantial inventories or investments in plants, machinery, or equipment. 2010 tax preparation Capital is not material. 2010 tax preparation   In general, capital is not a material income-producing factor if the income of the business consists principally of fees, commissions, or other compensation for personal services performed by members or employees of the partnership. 2010 tax preparation Capital interest. 2010 tax preparation   A capital interest in a partnership is an interest in its assets that is distributable to the owner of the interest in either of the following situations. 2010 tax preparation The owner withdraws from the partnership. 2010 tax preparation The partnership liquidates. 2010 tax preparation   The mere right to share in earnings and profits is not a capital interest in the partnership. 2010 tax preparation Gift of capital interest. 2010 tax preparation   If a family member (or any other person) receives a gift of a capital interest in a partnership in which capital is a material income-producing factor, the donee's distributive share of partnership income is subject to both of the following restrictions. 2010 tax preparation It must be figured by reducing the partnership income by reasonable compensation for services the donor renders to the partnership. 2010 tax preparation The donee's distributive share of partnership income attributable to donated capital must not be proportionately greater than the donor's distributive share attributable to the donor's capital. 2010 tax preparation Purchase. 2010 tax preparation   For purposes of determining a partner's distributive share, an interest purchased by one family member from another family member is considered a gift from the seller. 2010 tax preparation The fair market value of the purchased interest is considered donated capital. 2010 tax preparation For this purpose, members of a family include only spouses, ancestors, and lineal descendants (or a trust for the primary benefit of those persons). 2010 tax preparation Example. 2010 tax preparation A father sold 50% of his business to his son. 2010 tax preparation The resulting partnership had a profit of $60,000. 2010 tax preparation Capital is a material income-producing factor. 2010 tax preparation The father performed services worth $24,000, which is reasonable compensation, and the son performed no services. 2010 tax preparation The $24,000 must be allocated to the father as compensation. 2010 tax preparation Of the remaining $36,000 of profit due to capital, at least 50%, or $18,000, must be allocated to the father since he owns a 50% capital interest. 2010 tax preparation The son's share of partnership profit cannot be more than $18,000. 2010 tax preparation Business owned and operated by spouses. 2010 tax preparation   If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. 2010 tax preparation If so, they should report income or loss from the business on Form 1065. 2010 tax preparation They should not report the income on a Schedule C (Form 1040) in the name of one spouse as a sole proprietor. 2010 tax preparation However, the spouses can elect not to treat the joint venture as a partnership by making a Qualified Joint Venture Election. 2010 tax preparation Qualified Joint Venture Election. 2010 tax preparation   A "qualified joint venture," whose only members are spouses filing a joint return, can elect not to be treated as a partnership for federal tax purposes. 2010 tax preparation A qualified joint venture conducts a trade or business where: the only members of the joint venture are spouses filing jointly; both spouses elect not to be treated as a partnership; both spouses materially participate in the trade or business (see Passive Activity Limitations in the Instructions for Form 1065 for a definition of material participation); and the business is co-owned by both spouses and is not held in the name of a state law entity such as a partnership or LLC. 2010 tax preparation   Under this election, a qualified joint venture conducted by spouses who file a joint return is not treated as a partnership for federal tax purposes and therefore does not have a Form 1065 filing requirement. 2010 tax preparation All items of income, gain, deduction, loss, and credit are divided between the spouses based on their respective interests in the venture. 2010 tax preparation Each spouse takes into account his or her respective share of these items as a sole proprietor. 2010 tax preparation Each spouse would account for his or her respective share on the appropriate form, such as Schedule C (Form 1040). 2010 tax preparation For purposes of determining net earnings from self-employment, each spouse's share of income or loss from a qualified joint venture is taken into account just as it is for federal income tax purposes (i. 2010 tax preparation e. 2010 tax preparation , based on their respective interests in the venture). 2010 tax preparation   If the spouses do not make the election to treat their respective interests in the joint venture as sole proprietorships, each spouse should carry his or her share of the partnership income or loss from Schedule K-1 (Form 1065) to their joint or separate Form(s) 1040. 2010 tax preparation Each spouse should include his or her respective share of self-employment income on a separate Schedule SE (Form 1040), Self-Employment Tax. 2010 tax preparation   This generally does not increase the total tax on the return, but it does give each spouse credit for social security earnings on which retirement benefits are based. 2010 tax preparation However, this may not be true if either spouse exceeds the social security tax limitation. 2010 tax preparation   For more information on qualified joint ventures, go to IRS. 2010 tax preparation gov, enter “Election for Qualified Joint Ventures” in the search box and select the link reading “Election for Husband and Wife Unincorporated Businesses. 2010 tax preparation ” Partnership Agreement The partnership agreement includes the original agreement and any modifications. 2010 tax preparation The modifications must be agreed to by all partners or adopted in any other manner provided by the partnership agreement. 2010 tax preparation The agreement or modifications can be oral or written. 2010 tax preparation Partners can modify the partnership agreement for a particular tax year after the close of the year but not later than the date for filing the partnership return for that year. 2010 tax preparation This filing date does not include any extension of time. 2010 tax preparation If the partnership agreement or any modification is silent on any matter, the provisions of local law are treated as part of the agreement. 2010 tax preparation Terminating a Partnership A partnership terminates when one of the following events takes place. 2010 tax preparation All its operations are discontinued and no part of any business, financial operation, or venture is continued by any of its partners in a partnership. 2010 tax preparation At least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period, including a sale or exchange to another partner. 2010 tax preparation Unlike other partnerships, an electing large partnership does not terminate on the sale or exchange of 50% or more of the partnership interests within a 12-month period. 2010 tax preparation See section 1. 2010 tax preparation 708-1(b) of the regulations for more information on the termination of a partnership. 2010 tax preparation For special rules that apply to a merger, consolidation, or division of a partnership, see sections 1. 2010 tax preparation 708-1(c) and 1. 2010 tax preparation 708-1(d) of the regulations. 2010 tax preparation Date of termination. 2010 tax preparation   The partnership's tax year ends on the date of termination. 2010 tax preparation For the event described in (1), above, the date of termination is the date the partnership completes the winding up of its affairs. 2010 tax preparation For the event described in (2), above, the date of termination is the date of the sale or exchange of a partnership interest that, by itself or together with other sales or exchanges in the preceding 12 months, transfers an interest of 50% or more in both capital and profits. 2010 tax preparation Short period return. 2010 tax preparation   If a partnership is terminated before the end of what would otherwise be its tax year, Form 1065 must be filed for the short period, which is the period from the beginning of the tax year through the date of termination. 2010 tax preparation The return is due the 15th day of the fourth month following the date of termination. 2010 tax preparation See Partnership Return (Form 1065), later, for information about filing Form 1065. 2010 tax preparation Conversion of partnership into limited liability company (LLC). 2010 tax preparation   The conversion of a partnership into an LLC classified as a partnership for federal tax purposes does not terminate the partnership. 2010 tax preparation The conversion is not a sale, exchange, or liquidation of any partnership interest; the partnership's tax year does not close; and the LLC can continue to use the partnership's taxpayer identification number. 2010 tax preparation   However, the conversion may change some of the partners' bases in their partnership interests if the partnership has recourse liabilities that become nonrecourse liabilities. 2010 tax preparation Because the partners share recourse and nonrecourse liabilities differently, their bases must be adjusted to reflect the new sharing ratios. 2010 tax preparation If a decrease in a partner's share of liabilities exceeds the partner's basis, he or she must recognize gain on the excess. 2010 tax preparation For more information, see Effect of Partnership Liabilities under Basis of Partner's Interest, later. 2010 tax preparation   The same rules apply if an LLC classified as a partnership is converted into a partnership. 2010 tax preparation IRS e-file (Electronic Filing) Please click here for the text description of the image. 2010 tax preparation e-file Certain partnerships with more than 100 partners are required to file Form 1065, Schedules K-1, and related forms and schedules electronically (e-file). 2010 tax preparation Other partnerships generally have the option to file electronically. 2010 tax preparation For details about IRS e-file, see the Form 1065 instructions. 2010 tax preparation Exclusion From Partnership Rules Certain partnerships that do not actively conduct a business can choose to be completely or partially excluded from being treated as partnerships for federal income tax purposes. 2010 tax preparation All the partners must agree to make the choice, and the partners must be able to compute their own taxable income without computing the partnership's income. 2010 tax preparation However, the partners are not exempt from the rule that limits a partner's distributive share of partnership loss to the adjusted basis of the partner's partnership interest. 2010 tax preparation Nor are they exempt from the requirement of a business purpose for adopting a tax year for the partnership that differs from its required tax year. 2010 tax preparation Investing partnership. 2010 tax preparation   An investing partnership can be excluded if the participants in the joint purchase, retention, sale, or exchange of investment property meet all the following requirements. 2010 tax preparation They own the property as co-owners. 2010 tax preparation They reserve the right separately to take or dispose of their shares of any property acquired or retained. 2010 tax preparation They do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase, sell, or exchange the investment property. 2010 tax preparation Each separate participant can delegate authority to purchase, sell, or exchange his or her share of the investment property for the time being for his or her account, but not for a period of more than a year. 2010 tax preparation Operating agreement partnership. 2010 tax preparation   An operating agreement partnership group can be excluded if the participants in the joint production, extraction, or use of property meet all the following requirements. 2010 tax preparation They own the property as co-owners, either in fee or under lease or other form of contract granting exclusive operating rights. 2010 tax preparation They reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used. 2010 tax preparation They do not jointly sell services or the property produced or extracted. 2010 tax preparation Each separate participant can delegate authority to sell his or her share of the property produced or extracted for the time being for his or her account, but not for a period of time in excess of the minimum needs of the industry, and in no event for more than one year. 2010 tax preparation However, this exclusion does not apply to an unincorporated organization one of whose principal purposes is cycling, manufacturing, or processing for persons who are not members of the organization. 2010 tax preparation Electing the exclusion. 2010 tax preparation   An eligible organization that wishes to be excluded from the partnership rules must make the election not later than the time for filing the partnership return for the first tax year for which exclusion is desired. 2010 tax preparation This filing date includes any extension of time. 2010 tax preparation See Regulations section 1. 2010 tax preparation 761-2(b) for the procedures to follow. 2010 tax preparation Partnership Return (Form 1065) Every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing its income, deductions, and other required information. 2010 tax preparation The partnership return must show the names and addresses of each partner and each partner's distributive share of taxable income. 2010 tax preparation The return must be signed by a general partner. 2010 tax preparation If a limited liability company is treated as a partnership, it must file Form 1065 and one of its members must sign the return. 2010 tax preparation A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year in which it neither receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes. 2010 tax preparation See the Instructions for Form 1065 for more information about who must file Form 1065. 2010 tax preparation Partnership Distributions Partnership distributions include the following. 2010 tax preparation A withdrawal by a partner in anticipation of the current year's earnings. 2010 tax preparation A distribution of the current year's or prior years' earnings not needed for working capital. 2010 tax preparation A complete or partial liquidation of a partner's interest. 2010 tax preparation A distribution to all partners in a complete liquidation of the partnership. 2010 tax preparation A partnership distribution is not taken into account in determining the partner's distributive share of partnership income or loss. 2010 tax preparation If any gain or loss from the distribution is recognized by the partner, it must be reported on his or her return for the tax year in which the distribution is received. 2010 tax preparation Money or property withdrawn by a partner in anticipation of the current year's earnings is treated as a distribution received on the last day of the partnership's tax year. 2010 tax preparation Effect on partner's basis. 2010 tax preparation   A partner's adjusted basis in his or her partnership interest is decreased (but not below zero) by the money and adjusted basis of property distributed to the partner. 2010 tax preparation See Adjusted Basis under Basis of Partner's Interest, later. 2010 tax preparation Effect on partnership. 2010 tax preparation   A partnership generally does not recognize any gain or loss because of distributions it makes to partners. 2010 tax preparation The partnership may be able to elect to adjust the basis of its undistributed property. 2010 tax preparation Certain distributions treated as a sale or exchange. 2010 tax preparation   When a partnership distributes the following items, the distribution may be treated as a sale or exchange of property rather than a distribution. 2010 tax preparation Unrealized receivables or substantially appreciated inventory items distributed in exchange for any part of the partner's interest in other partnership property, including money. 2010 tax preparation Other property (including money) distributed in exchange for any part of a partner's interest in unrealized receivables or substantially appreciated inventory items. 2010 tax preparation   See Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later. 2010 tax preparation   This treatment does not apply to the following distributions. 2010 tax preparation A distribution of property to the partner who contributed the property to the partnership. 2010 tax preparation Payments made to a retiring partner or successor in interest of a deceased partner that are the partner's distributive share of partnership income or guaranteed payments. 2010 tax preparation Substantially appreciated inventory items. 2010 tax preparation   Inventory items of the partnership are considered to have appreciated substantially in value if, at the time of the distribution, their total fair market value is more than 120% of the partnership's adjusted basis for the property. 2010 tax preparation However, if a principal purpose for acquiring inventory property is to avoid ordinary income treatment by reducing the appreciation to less than 120%, that property is excluded. 2010 tax preparation Partner's Gain or Loss A partner generally recognizes gain on a partnership distribution only to the extent any money (and marketable securities treated as money) included in the distribution exceeds the adjusted basis of the partner's interest in the partnership. 2010 tax preparation Any gain recognized is generally treated as capital gain from the sale of the partnership interest on the date of the distribution. 2010 tax preparation If partnership property (other than marketable securities treated as money) is distributed to a partner, he or she generally does not recognize any gain until the sale or other disposition of the property. 2010 tax preparation For exceptions to these rules, see Distribution of partner's debt and Net precontribution gain, later. 2010 tax preparation Also, see Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later. 2010 tax preparation Example. 2010 tax preparation The adjusted basis of Jo's partnership interest is $14,000. 2010 tax preparation She receives a distribution of $8,000 cash and land that has an adjusted basis of $2,000 and a fair market value of $3,000. 2010 tax preparation Because the cash received does not exceed the basis of her partnership interest, Jo does not recognize any gain on the distribution. 2010 tax preparation Any gain on the land will be recognized when she sells or otherwise disposes of it. 2010 tax preparation The distribution decreases the adjusted basis of Jo's partnership interest to $4,000 [$14,000 − ($8,000 + $2,000)]. 2010 tax preparation Marketable securities treated as money. 2010 tax preparation   Generally, a marketable security distributed to a partner is treated as money in determining whether gain is recognized on the distribution. 2010 tax preparation This treatment, however, does not generally apply if that partner contributed the security to the partnership or an investment partnership made the distribution to an eligible partner. 2010 tax preparation   The amount treated as money is the security's fair market value when distributed, reduced (but not below zero) by the excess (if any) of: The partner's distributive share of the gain that would be recognized had the partnership sold all its marketable securities at their fair market value immediately before the transaction resulting in the distribution, over The partner's distributive share of the gain that would be recognized had the partnership sold all such securities it still held after the distribution at the fair market value in (1). 2010 tax preparation   For more information, including the definition of marketable securities, see section 731(c) of the Internal Revenue Code. 2010 tax preparation Loss on distribution. 2010 tax preparation   A partner does not recognize loss on a partnership distribution unless all the following requirements are met. 2010 tax preparation The adjusted basis of the partner's interest in the partnership exceeds the distribution. 2010 tax preparation The partner's entire interest in the partnership is liquidated. 2010 tax preparation The distribution is in money, unrealized receivables, or inventory items. 2010 tax preparation   There are exceptions to these general rules. 2010 tax preparation See the following discussions. 2010 tax preparation Also, see Liquidation at Partner's Retirement or Death under Disposition of Partner's Interest, later. 2010 tax preparation Distribution of partner's debt. 2010 tax preparation   If a partnership acquires a partner's debt and extinguishes the debt by distributing it to the partner, the partner will recognize capital gain or loss to the extent the fair market value of the debt differs from the basis of the debt (determined under the rules discussed in Partner's Basis for Distributed Property, later). 2010 tax preparation   The partner is treated as having satisfied the debt for its fair market value. 2010 tax preparation If the issue price (adjusted for any premium or discount) of the debt exceeds its fair market value when distributed, the partner may have to include the excess amount in income as canceled debt. 2010 tax preparation   Similarly, a deduction may be available to a corporate partner if the fair market value of the debt at the time of distribution exceeds its adjusted issue price. 2010 tax preparation Net precontribution gain. 2010 tax preparation   A partner generally must recognize gain on the distribution of property (other than money) if the partner contributed appreciated property to the partnership during the 7-year period before the distribution. 2010 tax preparation   The gain recognized is the lesser of the following amounts. 2010 tax preparation The excess of: The fair market value of the property received in the distribution, over The adjusted basis of the partner's interest in the partnership immediately before the distribution, reduced (but not below zero) by any money received in the distribution. 2010 tax preparation The “net precontribution gain” of the partner. 2010 tax preparation This is the net gain the partner would recognize if all the property contributed by the partner within 7 years of the distribution, and held by the partnership immediately before the distribution, were distributed to another partner, other than a partner who owns more than 50% of the partnership. 2010 tax preparation For information about the distribution of contributed property to another partner, see Contribution of Property , under Transactions Between Partnership and Partners, later. 2010 tax preparation   The character of the gain is determined by reference to the character of the net precontribution gain. 2010 tax preparation This gain is in addition to any gain the partner must recognize if the money distributed is more than his or her basis in the partnership. 2010 tax preparation For these rules, the term “money” includes marketable securities treated as money, as discussed earlier. 2010 tax preparation Effect on basis. 2010 tax preparation   The adjusted basis of the partner's interest in the partnership is increased by any net precontribution gain recognized by the partner. 2010 tax preparation Other than for purposes of determining the gain, the increase is treated as occurring immediately before the distribution. 2010 tax preparation See Basis of Partner's Interest , later. 2010 tax preparation   The partnership must adjust its basis in any property the partner contributed within 7 years of the distribution to reflect any gain that partner recognizes under this rule. 2010 tax preparation Exceptions. 2010 tax preparation   Any part of a distribution that is property the partner previously contributed to the partnership is not taken into account in determining the amount of the excess distribution or the partner's net precontribution gain. 2010 tax preparation For this purpose, the partner's previously contributed property does not include a contributed interest in an entity to the extent its value is due to property contributed to the entity after the interest was contributed to the partnership. 2010 tax preparation   Recognition of gain under this rule also does not apply to a distribution of unrealized receivables or substantially appreciated inventory items if the distribution is treated as a sale or exchange, as discussed earlier. 2010 tax preparation Partner's Basis for Distributed Property Unless there is a complete liquidation of a partner's interest, the basis of property (other than money) distributed to the partner by a partnership is its adjusted basis to the partnership immediately before the distribution. 2010 tax preparation However, the basis of the property to the partner cannot be more than the adjusted basis of his or her interest in the partnership reduced by any money received in the same transaction. 2010 tax preparation Example 1. 2010 tax preparation The adjusted basis of Emily's partnership interest is $30,000. 2010 tax preparation She receives a distribution of property that has an adjusted basis of $20,000 to the partnership and $4,000 in cash. 2010 tax preparation Her basis for the property is $20,000. 2010 tax preparation Example 2. 2010 tax preparation The adjusted basis of Steve's partnership interest is $10,000. 2010 tax preparation He receives a distribution of $4,000 cash and property that has an adjusted basis to the partnership of $8,000. 2010 tax preparation His basis for the distributed property is limited to $6,000 ($10,000 − $4,000, the cash he receives). 2010 tax preparation Complete liquidation of partner's interest. 2010 tax preparation   The basis of property received in complete liquidation of a partner's interest is the adjusted basis of the partner's interest in the partnership reduced by any money distributed to the partner in the same transaction. 2010 tax preparation Partner's holding period. 2010 tax preparation   A partner's holding period for property distributed to the partner includes the period the property was held by the partnership. 2010 tax preparation If the property was contributed to the partnership by a partner, then the period it was held by that partner is also included. 2010 tax preparation Basis divided among properties. 2010 tax preparation   If the basis of property received is the adjusted basis of the partner's interest in the partnership (reduced by money received in the same transaction), it must be divided among the properties distributed to the partner. 2010 tax preparation For property distributed after August 5, 1997, allocate the basis using the following rules. 2010 tax preparation Allocate the basis first to unrealized receivables and inventory items included in the distribution by assigning a basis to each item equal to the partnership's adjusted basis in the item immediately before the distribution. 2010 tax preparation If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess. 2010 tax preparation Allocate any remaining basis to properties other than unrealized receivables and inventory items by assigning a basis to each property equal to the partnership's adjusted basis in the property immediately before the distribution. 2010 tax preparation If the allocable basis exceeds the total of these assigned bases, increase the assigned bases by the amount of the excess. 2010 tax preparation If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess. 2010 tax preparation Allocating a basis increase. 2010 tax preparation   Allocate any basis increase required in rule (2), above, first to properties with unrealized appreciation to the extent of the unrealized appreciation. 2010 tax preparation If the basis increase is less than the total unrealized appreciation, allocate it among those properties in proportion to their respective amounts of unrealized appreciation. 2010 tax preparation Allocate any remaining basis increase among all the properties in proportion to their respective fair market values. 2010 tax preparation Example. 2010 tax preparation Eun's basis in her partnership interest is $55,000. 2010 tax preparation In a distribution in liquidation of her entire interest, she receives properties A and B, neither of which is inventory or unrealized receivables. 2010 tax preparation Property A has an adjusted basis to the partnership of $5,000 and a fair market value of $40,000. 2010 tax preparation Property B has an adjusted basis to the partnership of $10,000 and a fair market value of $10,000. 2010 tax preparation To figure her basis in each property, Eun first assigns bases of $5,000 to property A and $10,000 to property B (their adjusted bases to the partnership). 2010 tax preparation This leaves a $40,000 basis increase (the $55,000 allocable basis minus the $15,000 total of the assigned bases). 2010 tax preparation She first allocates $35,000 to property A (its unrealized appreciation). 2010 tax preparation The remaining $5,000 is allocated between the properties based on their fair market values. 2010 tax preparation $4,000 ($40,000/$50,000) is allocated to property A and $1,000 ($10,000/$50,000) is allocated to property B. 2010 tax preparation Eun's basis in property A is $44,000 ($5,000 + $35,000 + $4,000) and her basis in property B is $11,000 ($10,000 + $1,000). 2010 tax preparation Allocating a basis decrease. 2010 tax preparation   Use the following rules to allocate any basis decrease required in rule (1) or rule (2), earlier. 2010 tax preparation Allocate the basis decrease first to items with unrealized depreciation to the extent of the unrealized depreciation. 2010 tax preparation If the basis decrease is less than the total unrealized depreciation, allocate it among those items in proportion to their respective amounts of unrealized depreciation. 2010 tax preparation Allocate any remaining basis decrease among all the items in proportion to their respective assigned basis amounts (as decreased in (1)). 2010 tax preparation Example. 2010 tax preparation Armando's basis in his partnership interest is $20,000. 2010 tax preparation In a distribution in liquidation of his entire interest, he receives properties C and D, neither of which is inventory or unrealized receivables. 2010 tax preparation Property C has an adjusted basis to the partnership of $15,000 and a fair market value of $15,000. 2010 tax preparation Property D has an adjusted basis to the partnership of $15,000 and a fair market value of $5,000. 2010 tax preparation To figure his basis in each property, Armando first assigns bases of $15,000 to property C and $15,000 to property D (their adjusted bases to the partnership). 2010 tax preparation This leaves a $10,000 basis decrease (the $30,000 total of the assigned bases minus the $20,000 allocable basis). 2010 tax preparation He allocates the entire $10,000 to property D (its unrealized depreciation). 2010 tax preparation Armando's basis in property C is $15,000 and his basis in property D is $5,000 ($15,000 − $10,000). 2010 tax preparation Distributions before August 6, 1997. 2010 tax preparation   For property distributed before August 6, 1997, allocate the basis using the following rules. 2010 tax preparation Allocate the basis first to unrealized receivables and inventory items included in the distribution to the extent of the partnership's adjusted basis in those items. 2010 tax preparation If the partnership's adjusted basis in those items exceeded the allocable basis, allocate the basis among the items in proportion to their adjusted bases to the partnership. 2010 tax preparation Allocate any remaining basis to other distributed properties in proportion to their adjusted bases to the partnership. 2010 tax preparation Partner's interest more than partnership basis. 2010 tax preparation   If the basis of a partner's interest to be divided in a complete liquidation of the partner's interest is more than the partnership's adjusted basis for the unrealized receivables and inventory items distributed, and if no other property is distributed to which the partner can apply the remaining basis, the partner has a capital loss to the extent of the remaining basis of the partnership interest. 2010 tax preparation Special adjustment to basis. 2010 tax preparation   A partner who acquired any part of his or her partnership interest in a sale or exchange or upon the death of another partner may be able to choose a special basis adjustment for property distributed by the partnership. 2010 tax preparation To choose the special adjustment, the partner must have received the distribution within 2 years after acquiring the partnership interest. 2010 tax preparation Also, the partnership must not have chosen the optional adjustment to basis when the partner acquired the partnership interest. 2010 tax preparation   If a partner chooses this special basis adjustment, the partner's basis for the property distributed is the same as it would have been if the partnership had chosen the optional adjustment to basis. 2010 tax preparation However, this assigned basis is not reduced by any depletion or depreciation that would have been allowed or allowable if the partnership had previously chosen the optional adjustment. 2010 tax preparation   The choice must be made with the partner's tax return for the year of the distribution if the distribution includes any property subject to depreciation, depletion, or amortization. 2010 tax preparation If the choice does not have to be made for the distribution year, it must be made with the return for the first year in which the basis of the distributed property is pertinent in determining the partner's income tax. 2010 tax preparation   A partner choosing this special basis adjustment must attach a statement to his or her tax return that the partner chooses under section 732(d) of the Internal Revenue Code to adjust the basis of property received in a distribution. 2010 tax preparation The statement must show the computation of the special basis adjustment for the property distributed and list the properties to which the adjustment has been allocated. 2010 tax preparation Example. 2010 tax preparation Chin Ho purchased a 25% interest in X partnership for $17,000 cash. 2010 tax preparation At the time of the purchase, the partnership owned inventory having a basis to the partnership of $14,000 and a fair market value of $16,000. 2010 tax preparation Thus, $4,000 of the $17,000 he paid was attributable to his share of inventory with a basis to the partnership of $3,500. 2010 tax preparation Within 2 years after acquiring his interest, Chin Ho withdrew from the partnership and for his entire interest received cash of $1,500, inventory with a basis to the partnership of $3,500, and other property with a basis of $6,000. 2010 tax preparation The value of the inventory received was 25% of the value of all partnership inventory. 2010 tax preparation (It is immaterial whether the inventory he received was on hand when he acquired his interest. 2010 tax preparation ) Since the partnership from which Chin Ho withdrew did not make the optional adjustment to basis, he chose to adjust the basis of the inventory received. 2010 tax preparation His share of the partnership's basis for the inventory is increased by $500 (25% of the $2,000 difference between the $16,000 fair market value of the inventory and its $14,000 basis to the partnership at the time he acquired his interest). 2010 tax preparation The adjustment applies only for purposes of determining his new basis in the inventory, and not for purposes of partnership gain or loss on disposition. 2010 tax preparation The total to be allocated among the properties Chin Ho received in the distribution is $15,500 ($17,000 basis of his interest − $1,500 cash received). 2010 tax preparation His basis in the inventory items is $4,000 ($3,500 partnership basis + $500 special adjustment). 2010 tax preparation The remaining $11,500 is allocated to his new basis for the other property he received. 2010 tax preparation Mandatory adjustment. 2010 tax preparation   A partner does not always have a choice of making this special adjustment to basis. 2010 tax preparation The special adjustment to basis must be made for a distribution of property (whether or not within 2 years after the partnership interest was acquired) if all the following conditions existed when the partner received the partnership interest. 2010 tax preparation The fair market value of all partnership property (other than money) was more than 110% of its adjusted basis to the partnership. 2010 tax preparation If there had been a liquidation of the partner's interest immediately after it was acquired, an allocation of the basis of that interest under the general rules (discussed earlier under Basis divided among properties) would have decreased the basis of property that could not be depreciated, depleted, or amortized and increased the basis of property that could be. 2010 tax preparation The optional basis adjustment, if it had been chosen by the partnership, would have changed the partner's basis for the property actually distributed. 2010 tax preparation Required statement. 2010 tax preparation   Generally, if a partner chooses a special basis adjustment and notifies the partnership, or if the partnership makes a distribution for which the special basis adjustment is mandatory, the partnership must provide a statement to the partner. 2010 tax preparation The statement must provide information necessary for the partner to compute the special basis adjustment. 2010 tax preparation Marketable securities. 2010 tax preparation   A partner's basis in marketable securities received in a partnership distribution, as determined in the preceding discussions, is increased by any gain recognized by treating the securities as money. 2010 tax preparation See Marketable securities treated as money under Partner's Gain or Loss, earlier. 2010 tax preparation The basis increase is allocated among the securities in proportion to their respective amounts of unrealized appreciation before the basis increase. 2010 tax preparation Transactions Between Partnership and Partners For certain transactions between a partner and his or her partnership, the partner is treated as not being a member of the partnership. 2010 tax preparation These transactions include the following. 2010 tax preparation Performing services for, or transferring property to, a partnership if: There is a related allocation and distribution to a partner, and The entire transaction, when viewed together, is properly characterized as occurring between the partnership and a partner not acting in the capacity of a partner. 2010 tax preparation Transferring money or other property to a partnership if: There is a related transfer of money or other property by the partnership to the contributing partner or another partner, and The transfers together are properly characterized as a sale or exchange of property. 2010 tax preparation Payments by accrual basis partnership to cash basis partner. 2010 tax preparation   A partnership that uses an accrual method of accounting cannot deduct any business expense owed to a cash basis partner until the amount is paid. 2010 tax preparation However, this rule does not apply to guaranteed payments made to a partner, which are generally deductible when accrued. 2010 tax preparation Guaranteed Payments Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership's income. 2010 tax preparation A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner. 2010 tax preparation This treatment is for purposes of determining gross income and deductible business expenses only. 2010 tax preparation For other tax purposes, guaranteed payments are treated as a partner's distributive share of ordinary income. 2010 tax preparation Guaranteed payments are not subject to income tax withholding. 2010 tax preparation The partnership generally deducts guaranteed payments on line 10 of Form 1065 as a business expense. 2010 tax preparation They are also listed on Schedules K and K-1 of the partnership return. 2010 tax preparation The individual partner reports guaranteed payments on Schedule E (Form 1040) as ordinary income, along with his or her distributive share of the partnership's other ordinary income. 2010 tax preparation Guaranteed payments made to partners for organizing the partnership or syndicating interests in the partnership are capital expenses. 2010 tax preparation Generally, organizational and syndication expenses are not deductible by the partnership. 2010 tax preparation However, a partnership can elect to deduct a portion of its organizational expenses and amortize the remaining expenses (see Business start-up and organizational costs in the Instructions for Form 1065). 2010 tax preparation Organizational expenses (if the election is not made) and syndication expenses paid to partners must be reported on the partners' Schedule K-1 as guaranteed payments. 2010 tax preparation Minimum payment. 2010 tax preparation   If a partner is to receive a minimum payment from the partnership, the guaranteed payment is the amount by which the minimum payment is more than the partner's distributive share of the partnership income before taking into account the guaranteed payment. 2010 tax preparation Example. 2010 tax preparation Under a partnership agreement, Divya is to receive 30% of the partnership income, but not less than $8,000. 2010 tax preparation The partnership has net income of $20,000. 2010 tax preparation Divya's share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). 2010 tax preparation The guaranteed payment that can be deducted by the partnership is $2,000 ($8,000 − $6,000). 2010 tax preparation Divya's income from the partnership is $8,000, and the remaining $12,000 of partnership income will be reported by the other partners in proportion to their shares under the partnership agreement. 2010 tax preparation If the partnership net income had been $30,000, there would have been no guaranteed payment since her share, without regard to the guarantee, would have been greater than the guarantee. 2010 tax preparation Self-employed health insurance premiums. 2010 tax preparation   Premiums for health insurance paid by a partnership on behalf of a partner, for services as a partner, are treated as guaranteed payments. 2010 tax preparation The partnership can deduct the payments as a business expense, and the partner must include them in gross income. 2010 tax preparation However, if the partnership accounts for insurance paid for a partner as a reduction in distributions to the partner, the partnership cannot deduct the premiums. 2010 tax preparation   A partner who qualifies can deduct 100% of the health insurance premiums paid by the partnership on his or her behalf as an adjustment to income. 2010 tax preparation The partner cannot deduct the premiums for any calendar month, or part of a month, in which the partner is eligible to participate in any subsidized health plan maintained by any employer of the partner, the partner's spouse, the partner's dependents, or any children under age 27 who are not dependents. 2010 tax preparation For more information on the self-employed health insurance deduction, see chapter 6 in Publication 535. 2010 tax preparation Including payments in partner's income. 2010 tax preparation   Guaranteed payments are included in income in the partner's tax year in which the partnership's tax year ends. 2010 tax preparation Example 1. 2010 tax preparation Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without regard to the income of the partnership. 2010 tax preparation Her distributive share of the partnership income is 10%. 2010 tax preparation The partnership has $50,000 of ordinary income after deducting the guaranteed payment. 2010 tax preparation She must include ordinary income of $15,000 ($10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share) on her individual income tax return for her tax year in which the partnership's tax year ends. 2010 tax preparation Example 2. 2010 tax preparation Lamont is a calendar year taxpayer who is a partner in a partnership. 2010 tax preparation The partnership uses a fiscal year that ended January 31, 2013. 2010 tax preparation Lamont received guaranteed payments from the partnership from February 1, 2012, until December 31, 2012. 2010 tax preparation He must include these guaranteed payments in income for 2013 and report them on his 2013 income tax return. 2010 tax preparation Payments resulting in loss. 2010 tax preparation   If guaranteed payments to a partner result in a partnership loss in which the partner shares, the partner must report the full amount of the guaranteed payments as ordinary income. 2010 tax preparation The partner separately takes into account his or her distributive share of the partnership loss, to the extent of the adjusted basis of the partner's partnership interest. 2010 tax preparation Sale or Exchange of Property Special rules apply to a sale or exchange of property between a partnership and certain persons. 2010 tax preparation Losses. 2010 tax preparation   Losses will not be allowed from a sale or exchange of property (other than an interest in the partnership) directly or indirectly between a partnership and a person whose direct or indirect interest in the capital or profits of the partnership is more than 50%. 2010 tax preparation   If the sale or exchange is between two partnerships in which the same persons directly or indirectly own more than 50% of the capital or profits interests in each partnership, no deduction of a loss is allowed. 2010 tax preparation   The basis of each partner's interest in the partnership is decreased (but not below zero) by the partner's share of the disallowed loss. 2010 tax preparation   If the purchaser later sells the property, only the gain realized that is greater than the loss not allowed will be taxable. 2010 tax preparation If any gain from the sale of the property is not recognized because of this rule, the basis of each partner's interest in the partnership is increased by the partner's share of that gain. 2010 tax preparation Gains. 2010 tax preparation   Gains are treated as ordinary income in a sale or exchange of property directly or indirectly between a person and a partnership, or between two partnerships, if both of the following tests are met. 2010 tax preparation More than 50% of the capital or profits interest in the partnership(s) is directly or indirectly owned by the same person(s). 2010 tax preparation The property in the hands of the transferee immediately after the transfer is not a capital asset. 2010 tax preparation Property that is not a capital asset includes accounts receivable, inventory, stock-in-trade, and depreciable or real property used in a trade or business. 2010 tax preparation More than 50% ownership. 2010 tax preparation   To determine if there is more than 50% ownership in partnership capital or profits, the following rules apply. 2010 tax preparation An interest directly or indirectly owned by, or for, a corporation, partnership, estate, or trust is considered to be owned proportionately by, or for, its shareholders, partners, or beneficiaries. 2010 tax preparation An individual is considered to own the interest directly or indirectly owned by, or for, the individual's family. 2010 tax preparation For this rule, “family” includes only brothers, sisters, half-brothers, half-sisters, spouses, ancestors, and lineal descendants. 2010 tax preparation If a person is considered to own an interest using rule (1), that person (the “constructive owner”) is treated as if actually owning that interest when rules (1) and (2) are applied. 2010 tax preparation However, if a person is considered to own an interest using rule (2), that person is not treated as actually owning that interest in reapplying rule (2) to make another person the constructive owner. 2010 tax preparation Example. 2010 tax preparation Individuals A and B and Trust T are equal partners in Partnership ABT. 2010 tax preparation A's husband, AH, is the sole beneficiary of Trust T. 2010 tax preparation Trust T's partnership interest will be attributed to AH only for the purpose of further attributing the interest to A. 2010 tax preparation As a result, A is a more-than-50% partner. 2010 tax preparation This means that any deduction for losses on transactions between her and ABT will not be allowed, and gain from property that in the hands of the transferee is not a capital asset is treated as ordinary, rather than capital, gain. 2010 tax preparation More information. 2010 tax preparation   For more information on these special rules, see Sales and Exchanges Between Related Persons in chapter 2 of Publication 544. 2010 tax preparation Contribution of Property Usually, neither the partner nor the partnership recognizes a gain or loss when property is contributed to the partnership in exchange for a partnership interest. 2010 tax preparation This applies whether a partnership is being formed or is already operating. 2010 tax preparation The partnership's holding period for the property includes the partner's holding period. 2010 tax preparation The contribution of limited partnership interests in one partnership for limited partnership interests in another partnership qualifies as a tax-free contribution of property to the second partnership if the transaction is made for business purposes. 2010 tax preparation The exchange is not subject to the rules explained later under Disposition of Partner's Interest. 2010 tax preparation Disguised sales. 2010 tax preparation   A contribution of money or other property to the partnership followed by a distribution of different property from the partnership to the partner is treated not as a contribution and distribution, but as a sale of property, if both of the following tests are met. 2010 tax preparation The distribution would not have been made but for the contribution. 2010 tax preparation The partner's right to the distribution does not depend on the success of partnership operations. 2010 tax preparation   All facts and circumstances are considered in determining if the contribution and distribution are more properly characterized as a sale. 2010 tax preparation However, if the contribution and distribution occur within 2 years of each other, the transfers are presumed to be a sale unless the facts clearly indicate that the transfers are not a sale. 2010 tax preparation If the contribution and distribution occur more than 2 years apart, the transfers are presumed not to be a sale unless the facts clearly indicate that the transfers are a sale. 2010 tax preparation Form 8275 required. 2010 tax preparation   A partner must attach Form 8275, Disclosure Statement, (or other statement) to his or her return if the partner contributes property to a partnership and, within 2 years (before or after the contribution), the partnership transfers money or other consideration to the partner. 2010 tax preparation For exceptions to this requirement, see section 1. 2010 tax preparation 707-3(c)(2) of the regulations. 2010 tax preparation   A partnership must attach Form 8275 (or other statement) to its return if it distributes property to a partner, and, within 2 years (before or after the distribution), the partner transfers money or other consideration to the partnership. 2010 tax preparation   Form 8275 must include the following information. 2010 tax preparation A caption identifying the statement as a disclosure under section 707 of the Internal Revenue Code. 2010 tax preparation A description of the transferred property or money, including its value. 2010 tax preparation A description of any relevant facts in determining if the transfers are properly viewed as a disguised sale. 2010 tax preparation See section 1. 2010 tax preparation 707-3(b)(2) of the regulations for a description of the facts and circumstances considered in determining if the transfers are a disguised sale. 2010 tax preparation Contribution to partnership treated as investment company. 2010 tax preparation   Gain is recognized when property is contributed (in exchange for an interest in the partnership) to a partnership that would be treated as an investment company if it were incorporated. 2010 tax preparation   A partnership is generally treated as an investment company if over 80% of the value of its assets is held for investment and consists of certain readily marketable items. 2010 tax preparation These items include money, stocks and other equity interests in a corporation, and interests in regulated investment companies and real estate investment trusts. 2010 tax preparation For more information, see section 351(e)(1) of the Internal Revenue Code and the related regulations. 2010 tax preparation Whether a partnership is treated as an investment company under this test is ordinarily determined immediately after the transfer of property. 2010 tax preparation   This rule applies to limited partnerships and general partnerships, regardless of whether they are privately formed or publicly syndicated. 2010 tax preparation Contribution to foreign partnership. 2010 tax preparation   A domestic partnership that contributed property after August 5, 1997, to a foreign partnership in exchange for a partnership interest may have to file Form 8865 if either of the following apply. 2010 tax preparation Immediately after the contribution, the partnership owned, directly or indirectly, at least a 10% interest in the foreign partnership. 2010 tax preparation The fair market value of the property contributed to the foreign partnership, when added to other contributions of property made to the partnership during the preceding 12-month period, is greater than $100,000. 2010 tax preparation   The partnership may also have to file Form 8865, even if no contributions are made during the tax year, if it owns a 10% or more interest in a foreign partnership at any time during the year. 2010 tax preparation See the form instructions for more information. 2010 tax preparation Basis of contributed property. 2010 tax preparation   If a partner contributes property to a partnership, the partnership's basis for determining depreciation, depletion, gain, or loss for the property is the same as the partner's adjusted basis for the property when it was contributed, increased by any gain recognized by the partner at the time of contribution. 2010 tax preparation Allocations to account for built-in gain or loss. 2010 tax preparation   The fair market value of property at the time it is contributed may be different from the partner's adjusted basis. 2010 tax preparation The partnership must allocate among the partners any income, deduction, gain, or loss on the property in a manner that will account for the difference. 2010 tax preparation This rule also applies to contributions of accounts payable and other accrued but unpaid items of a cash basis partner. 2010 tax preparation   The partnership can use different allocation methods for different items of contributed property. 2010 tax preparation A single reasonable method must be consistently applied to each item, and the overall method or combination of methods must be reasonable. 2010 tax preparation See section 1. 2010 tax preparation 704-3 of the regulations for allocation methods generally considered reasonable. 2010 tax preparation   If the partnership sells contributed property and recognizes gain or loss, built-in gain or loss is allocated to the contributing partner. 2010 tax preparation If contributed property is subject to depreciation or other cost recovery, the allocation of deductions for these items takes into account built-in gain or loss on the property. 2010 tax preparation However, the total depreciation, depletion, gain, or loss allocated to partners cannot be more than the depreciation or depletion allowable to the partnership or the gain or loss realized by the partnership. 2010 tax preparation Example. 2010 tax preparation Areta and Sofia formed an equal partnership. 2010 tax preparation Areta contributed $10,000 in cash to the partnership and Sofia contributed depreciable property with a fair market value of $10,000 and an adjusted basis of $4,000. 2010 tax preparation The partnership's basis for depreciation is limited to the adjusted basis of the property in Sofia's hands, $4,000. 2010 tax preparation In effect, Areta purchased an undivided one-half interest in the depreciable property with her contribution of $10,000. 2010 tax preparation Assuming that the depreciation rate is 10% a year under the General Depreciation System (GDS), she would have been entitled to a depreciation deduction of $500 per year, based on her interest in the partnership, if the adjusted basis of the property equaled its fair market value when contributed. 2010 tax preparation To simplify this example, the depreciation deductions are determined without regard to any first-year depreciation conventions. 2010 tax preparation However, since the partnership is allowed only $400 per year of depreciation (10% of $4,000), no more than $400 can be allocated between the partners. 2010 tax preparation The entire $400 must be allocated to Areta. 2010 tax preparation Distribution of contributed property to another partner. 2010 tax preparation   If a partner contributes property to a partnership and the partnership distributes the property to another partner within 7 years of the contribution, the contributing partner must recognize gain or loss on the distribution. 2010 tax preparation   The recognized gain or loss is the amount the contributing partner would have recognized if the property had been sold for its fair market value when it was distributed. 2010 tax preparation This amount is the difference between the property's basis and its fair market value at the time of contribution. 2010 tax preparation The character of the gain or loss will be the same as the character of the gain or loss that would have resulted if the partnership had sold the property to the distributee partner. 2010 tax preparation Appropriate adjustments must be made to the adjusted basis of the contributing partner's partnership interest and to the adjusted basis of the property distributed to reflect the recognized gain or loss. 2010 tax preparation Disposition of certain contributed property. 2010 tax preparation   The following rules determine the character of the partnership's gain or loss on a disposition of certain types of contributed property. 2010 tax preparation Unrealized receivables. 2010 tax preparation If the property was an unrealized receivable in the hands of the contributing partner, any gain or loss on its disposition by the partnership is ordinary income or loss. 2010 tax preparation Unrealized receivables are defined later under Payments for Unrealized Receivables and Inventory Items. 2010 tax preparation When reading the definition, substitute “partner” for “partnership. 2010 tax preparation ” Inventory items. 2010 tax preparation If the property was an inventory item in the hands of the contributing partner, any gain or loss on its disposition by the partnership within 5 years after the contribution is ordinary income or loss. 2010 tax preparation Inventory items are defined later in Payments for Unrealized Receivables and Inventory Items. 2010 tax preparation Capital loss property. 2010 tax preparation If the property was a capital asset in the contributing partner's hands, any loss on its disposition by the partnership within 5 years after the contribution is a capital loss. 2010 tax preparation The capital loss is limited to the amount by which the partner's adjusted basis for the property exceeded the property's fair market value immediately before the contribution. 2010 tax preparation Substituted basis property. 2010 tax preparation If the disposition of any of the property listed in (1), (2), or (3) is a nonrecognition transaction, these rules apply when the recipient of the property disposes of any substituted basis property (other than certain corporate stock) resulting from the transaction. 2010 tax preparation Contribution of Services A partner can acquire an interest in partnership capital or profits as compensation for services performed or to be performed. 2010 tax preparation Capital interest. 2010 tax preparation   A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds were distributed in a complete liquidation of the partnership. 2010 tax preparation This determination generally is made at the time of receipt of the partnership interest. 2010 tax preparation The fair market value of such an interest received by a partner as compensation for services must generally be included in the partner's gross income in the first tax year in which the partner can transfer the interest or the interest is not subject to a substantial risk of forfeiture. 2010 tax preparation The capital interest transferred as compensation for services is subject to the rules for restricted property discussed in Publication 525 under Employee Compensation. 2010 tax preparation   The fair market value of an interest in partnership capital transferred to a partner as payment for services to the partnership is a guaranteed payment, discussed earlier. 2010 tax preparation Profits interest. 2010 tax preparation   A profits interest is a partnership interest other than a capital interest. 2010 tax preparation If a person receives a profits interest for providing services to, or for the benefit of, a partnership in a partner capacity or in anticipation of being a partner, the receipt of such an interest is not a taxable event for the partner or the partnership. 2010 tax preparation However, this does not apply in the following situations. 2010 tax preparation The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease. 2010 tax preparation Within 2 years of receipt, the partner disposes of the profits interest. 2010 tax preparation The profits interest is a limited partnership interest in a publicly traded partnership. 2010 tax preparation   A profits interest transferred as compensation for services is not subject to the rules for restricted property that apply to capital interests. 2010 tax preparation Basis of Partner's Interest The basis of a partnership interest is the money plus the adjusted basis of any property the partner contributed. 2010 tax preparation If the partner must recognize gain as a result of the contribution, this gain is included in the basis of his or her interest. 2010 tax preparation Any increase in a partner's individual liabilities because of an assumption of partnership liabilities is considered a contribution of money to the partnership by the partner. 2010 tax preparation Interest acquired by gift, etc. 2010 tax preparation   If a partner acquires an interest in a partnership by gift, inheritance, or under any circumstance other than by a contribution of money or property to the partnership, the partner's basis must be determined using the basis rules described in Publication 551. 2010 tax preparation Adjusted Basis There is a worksheet for adjusting the basis of a partner's interest in the partnership in the Partner's Instructions for Schedule K-1 (Form 1065). 2010 tax preparation The basis of an interest in a partnership is increased or decreased by certain items. 2010 tax preparation Increases. 2010 tax preparation   A partner's basis is increased by the following items. 2010 tax preparation The partner's additional contributions to the partnership, including an increased share of, or assumption of, partnership liabilities. 2010 tax preparation The partner's distributive share of taxable and nontaxable partnership income. 2010 tax preparation The partner's distributive share of the excess of the deductions for depletion over the basis of the depletable property, unless the property is oil or gas wells whose basis has been allocated to partners. 2010 tax preparation Decreases. 2010 tax preparation   The partner's basis is decreased (but never below zero) by the following items. 2010 tax preparation The money (including a decreased share of partnership liabilities or an assumption of the partner's individual liabilities by the partnership) and adjusted basis of property distributed to the partner by the partnership. 2010 tax preparation The partner's distributive share of the partnership losses (including capital losses). 2010 tax preparation The partner's distributive share of nondeductible partnership expenses that are not capital expenditures. 2010 tax preparation This includes the partner's share of any section 179 expenses, even if the partner cannot deduct the entire amount on his or her individual income tax return. 2010 tax preparation The partner's deduction for depletion for any partnership oil and gas wells, up to the proportionate share of the adjusted basis of the wells allocated to the partner. 2010 tax preparation Partner's liabilities assumed by partnership. 2010 tax preparation   If contributed property is subject to a debt or if a partner's liabilities are assumed by the partnership, the basis of that partner's interest is reduced (but not below zero) by the liability assumed by the other partners. 2010 tax preparation This partner must reduce his or her basis because the assumption of the liability is treated as a distribution of money to that partner. 2010 tax preparation The other partners' assumption of the liability is treated as a contribution by them of money to the partnership. 2010 tax preparation See Effect of Partnership Liabilities , later. 2010 tax preparation Example 1. 2010 tax preparation Ivan acquired a 20% interest in a partnership by contributing property that had an adjusted basis to him of $8,000 and a $4,000 mortgage. 2010 tax preparation The partnership assumed payment of the mortgage. 2010 tax preparation The basis of Ivan's interest is: Adjusted basis of contributed property $8,000 Minus: Part of mortgage assumed by other partners (80% × $4,000) 3,200 Basis of Ivan's partnership interest $4,800 Example 2. 2010 tax preparation If, in Example 1, the contributed property had a $12,000 mortgage, the basis of Ivan's partnership interest would be zero. 2010 tax preparation The $1,600 difference between the mortgage assumed by the other partners, $9,600 (80% × $12,000), and his basis of $8,000 would be treated as capital gain from the sale or exchange of a partnership interest. 2010 tax preparation However, this gain would not increase the basis of his partnership interest. 2010 tax preparation Book value of partner's interest. 2010 tax preparation   The adjusted basis of a partner's interest is determined without considering any amount shown in the partnership books as a capital, equity, or similar account. 2010 tax preparation Example. 2010 tax preparation Enzo contributes to his partnership property that has an adjusted basis of $400 and a fair market value of $1,000. 2010 tax preparation His partner contributes $1,000 cash. 2010 tax preparation While each partner has increased his capital account by $1,000, which will be re