Almost two years ago, the DEF Partnership was formed when Demetrius, Ebony, and Farouk each contributed $100,000 in cash. They are equal general partners in the real estate partnership, which has a December 31 year-end. The partnership uses the accrual method of accounting for financial accounting purposes but uses the cash method of accounting for tax purposes. The first year of operations resulted in a $50,000 loss. Because the real estate market plummeted, the second year of operations will result in an even larger ordinary loss. On November 30, calculations reveal that the year's loss is likely to be $100,000 for financial accounting purposes. Financial accounting results for the year are as follows:
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Quarter
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First
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Second
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Third
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Fourth*
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Revenue
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$40,000
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$60,000
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$80,000
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$100,000
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Maintenance expense
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(30,000)
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(58,000)
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(70,000)
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(85,000)
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Interest expense
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(10,000)
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(30,000)
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(35,000)
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(50,000)
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Utilities expense
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(3,000)
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(3,000)
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(3,000)
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(3,000)
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Projected loss
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($ 3,000)
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($31,000)
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($28,000)
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($38,000)
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* Fourth quarter results are the sum of actual October and November results along with estimates for December results. December estimates are revenue, $33,000; maintenance, $60,000; interest, $20,000; and utilities, $1,000.
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Cash has been short throughout the second year of operations, so more than $65,000 of expenses for second year operations have resulted in bills that are currently due or overdue. The unpaid bills are for July 1 through November 30 interest on a loan from the bank. In addition, all but essential maintenance has been postponed during the fourth quarter so that most of the fourth quarter maintenance is scheduled to be completed during December.
The DEF partners wants to attract a new partner to obtain additional capital. Raj is interested in investing $100,000 as a limited partner in the DEF Partnership if a good deal can be arranged. Raj would have a 25% profits and loss interest in the partnership but would expect something extra for the current year. In the current tax year, Raj has passive income of more than $200,000 from other sources, so he would like to have large passive losses allocated to him from DEF.
Required: Your tax partner has asked you to prepare a memorandum suggesting a plan to maximize the amount of current year loss that can be allocated to Raj. Assume none of the partners performs more than one-half of his or her personal service time in connection with real estate trades or businesses in which he or she materially participates. She reminded you to consider the varying interest rules for allocating losses to new partners found in Sec. 706 and to look into the possibilities of somehow capitalizing on the cash method of accounting or of using a special allocation. She wants you to be sure to check all the relevant case law for the plan you suggest.