O’Brien v. Commissioner, 77 T. C. 113, 1981 U. S. Tax Ct. LEXIS 96 (1981)

A partner’s abandonment of a partnership interest, resulting in relief from nonrecourse liabilities, is treated as a distribution of money and results in a capital loss.

Summary

In O’Brien v. Commissioner, Neil J. O’Brien abandoned his 10% interest in the South Arlington Joint Venture, which held real estate secured by nonrecourse notes. The IRS treated the resulting loss as capital rather than ordinary. The Tax Court held that the abandonment led to a decrease in O’Brien’s share of partnership liabilities, deemed a distribution of money under section 752(b), and thus, under sections 731(a)(2) and 741, the loss was a capital loss. This decision clarifies the tax treatment of partnership interest abandonment when nonrecourse debt is involved.

Facts

Neil J. O’Brien was a 10% partner in the South Arlington Joint Venture, formed to hold real estate for investment. The venture purchased land in 1973 with a nonrecourse wraparound promissory note. In 1975, the original note was replaced by two notes, also nonrecourse. In 1976, O’Brien sent a letter to the general partner abandoning his interest in the venture. At the time of abandonment, the venture had nonrecourse liabilities of $989,549, and O’Brien claimed an ordinary loss of $14,865. 30 on his tax return.

Procedural History

The IRS determined a deficiency in O’Brien’s 1976 federal income tax, treating his loss as a capital loss rather than an ordinary loss. O’Brien petitioned the U. S. Tax Court, which held that the loss was indeed a capital loss under the relevant sections of the Internal Revenue Code.

Issue(s)

1. Whether the loss on O’Brien’s abandonment of his partnership interest should be treated as a capital loss or an ordinary loss.

Holding

1. Yes, because the abandonment resulted in a decrease in O’Brien’s share of the partnership’s nonrecourse liabilities, deemed a distribution of money under section 752(b), and thus, under sections 731(a)(2) and 741, the loss was a capital loss.

Court’s Reasoning

The court applied sections 752(b), 731(a)(2), and 741 of the Internal Revenue Code to determine that O’Brien’s abandonment of his partnership interest was treated as a distribution of money due to the decrease in his share of the partnership’s nonrecourse liabilities. The court reasoned that O’Brien’s abandonment resulted in a deemed distribution under section 752(b), which liquidated his interest in the partnership under section 731(a)(2), and the resulting loss was treated as a loss from the sale or exchange of a capital asset under section 741. The court rejected O’Brien’s arguments that he remained liable for partnership debts under Texas law, emphasizing that for tax purposes, his share of the nonrecourse liabilities was considered decreased upon abandonment. The court also distinguished prior cases cited by O’Brien, noting they were decided before the enactment of the relevant Code sections and did not involve nonrecourse liabilities.

Practical Implications

This decision impacts how losses from the abandonment of partnership interests are treated when nonrecourse debt is involved. Attorneys should advise clients that abandoning a partnership interest with nonrecourse liabilities results in a capital loss, not an ordinary loss, due to the deemed distribution of money under section 752(b). This ruling affects tax planning for partnerships, particularly in real estate ventures where nonrecourse financing is common. Practitioners should consider this case when structuring partnership agreements and advising on the tax consequences of withdrawal or abandonment. Subsequent cases like Arkin v. Commissioner and Freeland v. Commissioner have further clarified that certain abandonments may be treated as sales or exchanges for tax purposes.