 Hello and welcome to the session in which we will discuss the partner's basis and the partnership. In the prior session, we looked at the initial formation of partnership and we established that the outside basis of partners equal to the adjusted basis of the property contributed. So if you contributed a piece of property, let's assume a piece of land and there's an adjusted basis of that land of 80,000 fair market value of 100,000 and you contributed this land. Well, pre-contribution gain, which we talked about this, but how much is the basis? How much is your basis in the partnership? You would use the adjusted basis of the property contributed. Now how do we come up with the adjusted basis? In the prior session, I did not emphasize this point because we learned about adjusted basis in prior session. Well, maybe you purchased this land for 80,000. Maybe it was gifted to you and we're using dual basis. Maybe you got it in form of an inheritance and it's either the fair market value of the date of that or an alternate valuation date. So you want to make sure you know how to compute the basis in the first place. The assumption is you know how to do that. So that's part of the outside basis. How else can you contribute to a partnership? Remember, we are contributing to a partnership. If you have money, great. So if you have cash, cash is easy. So obviously if you contribute cash, how about if you contributed fair market value of services? You contributed services and the fair market value of these services is your basis. So let's assume you did some consulting work for this company or you provided some legal or accounting work worth of 50,000. In return, they provided you capital interest, not profit interest, capital interest. Well, the fair market value of your services is part of your basis. Now what we did not discuss in the prior session, we kept it simple is how about if you contributed a property, we know that the adjusted basis are used. How about if that property carries a mortgage with it, carries a debt? Well, what do we have to do? Well, let's go back to our S corporation. What happened if you contribute that to an S corporation? If you contributed that to an S corporation, your basis go down. Your basis go down. Think about it. If you came to me today, okay, and said, look, I'm going to give you my house. Okay, I'm going to give you my house. The fair market value of my house or my, let's go with adjusted basis. The adjusted basis of my house, I purchased it for $100,000. I want to give you this house. You'll be very happy. I did not tell you something. There is a mortgage, there is a lien, there is a debt against that house for $150,000. Guess what? If you take the house, if you take my house, which is with an adjusted basis of $1,000, you'd be like, yeah, it's free. It's not free. Why? Because with the house comes the mortgage. It's as if you gave me $50,000. You got me off the hook for $50,000. Why? Because I gave you $100,000, but I also relieved myself from $150,000 in debt. So simply put, you actually paid me $50,000. So every time you contributed that, it's like what? It's like as if you are making a transfer. It's going to reduce your basis. So, but how does it work for a partnership? Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. You reduce liability transferred assumed by others. Let's work a simple example. We have three partners, A, B and C. And you happen to contribute 900,000 of liabilities to this company. And to keep it simple, one-third, one-third, one-third. Each partner owns one-third. What's going to happen is this. You are going to reduce your basis by only 600,000. Why? Here's why. Yes. Initially, you're going to say, I'm going to reduce my basis by 900,000. Then what happened is this. After this 900,000 goes into the partnership. So you contributed a liability of 900,000. Your basis goes down by 900,000. But once that asset, what's that liability inside the partnership, two-third of it, remember, we have A, B, and C. Now, A is responsible for how much? A is responsible for 300,000. B is responsible for 300,000. And C is responsible for 300,000. We're assuming you are A. So guess what? Your basis goes down by 900,000. Then you are responsible for this 300,000. So once you are responsible for the debt, it's going to increase your basis. Therefore, the net is 600,000. So if you contributed liability, if you contributed liability, you reduce the liability that is assumed by others. How much is the liability assumed by others? The other 600. And I just showed you how you compute this. You would say, okay, I contributed. Generally speaking, I should reduce my liability. I should reduce my basis by 900. But I'm responsible. Once the liability is inside, they're going to say, A, you are responsible for 300,000. Well, then I only reduce it by 600. So simply put, liability transferred that's assumed by other is the reduction of my liability. Now let's assume others. Let's assume another individual and another partner contributed a liability of 300,000. Someone else contributed a liability. Let's assume B contributed a liability of 300. So this liability is inside the partnership now. And guess what? You are responsible for $100,000. Therefore, you would increase the partner shares of the liability partnership liability, because this 300,000 is inside the partnership. I, A, as a one-third partner responsible for $100,000. So you have to be very careful when dealing with liabilities. I know it's a little bit confusing. We'll work an example that you have to be comfortable with this. Remember, you contributed the liability. You reduce your basis by the liability transferred assumed by others. And I showed you how, but you could just say, what is the liability assumed by others? I would reduce my basis by that much. And I showed you how with this example, if others contributed a liability, I will add my share of that liability, because if others contributing that liability, we are responsible for it. I'm responsible for it. I am a partner and I'm responsible for that. And here we're assuming we're dealing with non-recourse that and we'll talk about that later, kind of define this. Remember, there's no gain, no loss when we form a partnership. Also, the inside basis of a partnership and its own asset also takes on the adjusted basis of the property, basically the same concept. And if there's any recognized gain, usually there is no gain. So this is basically an introduction. Let's start a little bit more about what happened subsequently to the initial basis. Now, initial basis subsequently changes. Outside basis changes. They could move upward, they could move downward. Why would they move upward? Maybe not maybe from income. If the partnership earns income, remember, in a partnership, once it earns income, that income is taxable. Anything that you pay taxes on it, it increases your basis. Same thing with going downward, if you incur losses. Now, why do we want to make sure the basis are adjusted? Because we want to make sure that our income is taxed once. And I'll show you an example, what does that mean? We want to make sure that any deduction, any losses are deductible. How? Well, do we have basis to deduct the losses? Is it deductible or not? Also, when we make a distribution later on, do we have basis? If it's not, it might be taxable. If we have basis, it may not be taxable. It could be just return of capital. Also, we need to compute our gain and loss when we sell that partnership interest. Eventually, we're going to sell our partnership interest. How do we know whether we have a gain or a loss? We have to keep track of our basis. Therefore, basis go up and down. Let me show you in a simple example why that is important. Let's assume Adam is a 30% partner in A&N partnership. Adam initially invested $22,000 in cash. That's Adam's initial investment. The partnership reported $50,000 in income. And at the end of the year, Adam sells his interest for $45,000. Now, let's work the example, assuming Adam adjusted his basis properly. What is Adam's basis by the time he sold his partnership? Well, he started with $22,000 cash. Then the partnership made $50,000 in income. Adam's share of this income is 30%. It means Adam's shares is $15,000. Therefore, Adam adds $15,000 to his basis. Why can he add this $15,000? What's the reason behind it? Because this $15,000 is taxable. This $15,000 flow through Adam's $10,000 and Adam paid taxes on this. And once you pay taxes on it, it should increase your basis because you don't want to pay taxes on it again. Therefore, by the time Adam sells his interest, his basis is $37,000. He sold it for $45,000. We deduct the basis and Adam will incur a gain of $8,000, which will have to pay taxes on that gain. Let's assume Adam did not adjust his basis, which he should, but let's assume that not so you understand why basis is important. Well, we're going to take $45,000. Well, how much we sold our basis for? Minus $22,000, our initial contribution. Therefore, we have a gain of $23,000. So notice, there's a difference in the gain amount. You might be saying, but hold on a second. Anyway, we recaptured the gain because we already paid taxes on the gain of $15,000. Well, there are timing differences. Sometimes it could be several years, so that's why you have to adjust your basis. You have to adjust your basis because you already paid your taxes. You don't want to pay your taxes twice. Let's look at more items that could affect your basis. It could affect your basis upward. It could affect your basis downward. Let's go back to the initial basis. Remember the formula when we started with? It's the adjusted basis of property plus fair market value of services. Remember why? Because you paid your taxes on that. It was ordinary income and in return, you got capital interest, not profit interest. Then you will deduct liability transferred assumed by others, whatever liability you transferred, that's assumed by others. Then you add your partner shares of liability transferred by others. We talked about this. Now let's talk about increases. What could increase your basis? Well, you could make additional contribution. You could contribute cash. You could make additional contribution. Also, partner shares of the partnership. What could affect it? What could affect your basis? That increases. Again, if somebody transferred that to the partnership, and here we're looking at non-recourse debt, non-recourse debt. We're dealing with non-recourse debt. It means everyone is responsible for the debt, non-recourse debt. Here, whatever your percentage is, you would increase your basis by that because if there's more debt, there's more risk. If there's more risk, your basis go up. You increase your basis by income items, like if the partnership earned income, ordinary income, we saw earlier with the Adams example, $50,000 times 30%, you would increase your basis. Again, non-recourse debt. Here, we're assuming non-recourse debt. It means it's allocated to all partners. Non-recourse debt, generally speaking, it's collateralized. It means when we took that money out, there is a collateral, maybe a building, maybe a warehouse, in case something happened to that versus a recourse debt. Recourse debt is allocated to the general partner or partners. If we're dealing with recourse debt, only the general partner or partners are responsible for that, which is just for the sake of simplicity. We deal with non-recourse debt. Exempt income items, exempt income items, their income, they would increase your basis. Although they're exempt in a sense that they are not taxable, nevertheless, they would increase your basis. Here, we're talking about municipal bond. What could decrease your basis? Well, think about it. If contribution increased your basis, any deductions or withdrawal would reduce your basis. Here, they would reduce your basis. Well, think about what else? Think about debt. If we're saying taken on debt will increase your basis by the percentage of your liability, same concept. When debt decrease, when the partnership pay off the debt, your share of debt goes down. Of the hook, your risk goes down, your basis go down. Your basis go down. Think about when you contribute debt to the company, it's if you're taking a withdrawal because if you gave someone your debt, it's like they paid off your debt. So, this is why your basis go up because somebody is giving you, it's like you contribute debt to the company. Your risk is higher. Non-deductible expenses, just like exempt income, exempt income increases your basis. Also, non-deductible expenses like interest on municipal bond, on investment in municipal bond. It's non-deductible, nevertheless, it's going to reduce your basis. Other deductible and losses we'll talk about those later. Now, bear in mind, basis can never be negative. Your basis could go down to zero. Why? It's important to know this because sometime you can contribute liabilities and access of your basis. It cannot be zero. So, what do we have to do? So, what happened when contribution of liabilities, the partnership exceeds the basis? So, if you contributed something, let's assume $100,000 of liabilities and the adjusted basis of the asset is $75,000. So, you have an access liabilities over the adjusted basis of $25,000. Well, basically what you did is you relieved yourself. Somebody gave you $25,000. That's what happened really because you have a liability of $100,000 and somebody paid it off. Yes, they did take the $75,000, but you have a net of $25,000. So, that amount is taxable to you because if the adjusted basis is your starting basis, minus the $100,000, now you're negative. You cannot have a negative basis. Therefore, what you have to do, you have to pay taxes on that. When you pay taxes, it's good. So, Adam contributed the property with the basis of $200, subject to a $250,000 mortgage. Well, if we go with the formula, we're going to have a negative basis. We cannot have negative basis. And Adam, with Adam enjoyed, he relieved himself of $50,000 because he has an asset that if he sold it, he would still be on the hook for $50,000 and somebody took over that $50,000. So, Adam enjoyed a taxable gain of $50,000. Once it's taxable, once Adam paid taxes on it, well, that negative $50,000 of basis, which it doesn't exist. Well, since we paid taxes, once you pay taxes on something, that's the idea behind contributing services because it's taxable, that's going to increase your fair market value, then your basis is back to zero now. Work an example to illustrate the contribution that involves liability. Because it's not intuitive initially, but eventually it will be, hopefully it will become intuitive. So, we have partner A and B form AB partnership. They are equal partners. A contributed cash, let's keep it clean for A for now, contributed cash of $40,000. B contributed property. We have the adjusted basis of the property of $80,000. And we're going to say fair market value of this property contributed is $52,000. Now, at this point, we have what's called a pre-contribution loss. Just let you know. And the pre-contribution loss is, we discussed this topic in a separate recording. We discussed it in partnership formation. If you're wondering, what do we do with this loss? We don't do anything with it, we just, we noted. Basically, we know that we have a pre-contribution loss. And later on, when we dispose of this property, we have to allocate it to the partner. We are going to have a pre-contribution loss and maybe post-contribution gain or post-contribution losses or less contribution losses. Regardless, this topic was covered separately. So if you want to look at this topic, make sure to look at another session, which is a partnership formation. So that assumed with this property is $12,000. So we contributed this property. We also contributed liability with it. We contributed liability with it of $12,000. And the partnership contributed the liability. We're going to assume that partnership has no debt or anything. This is just clean slate. So let's go ahead and start to calculate the outside basis for each partner. So we have partner A and partner B. And let's start by the property. So first is the property contributed by each property. We'll adjust the basis of property contributed, adjusted basis of property contributed. Remember, the basis are transferred. We don't care about the fair market value. For A, A contributed $40,000 in cash. A contributed $40,000 in cash. Good. B contributed the adjusted basis is $80,000. Remember, we ignore the fair market value. We don't care about the fair market value for now. We know that there is a loss. They contributed the property with a built-in loss. But we don't have to worry about this. So this is the initial, this is the contributed capital. So the formula said the next thing you need to do is you need to add, let's let me put the formula down, fair market value of services and what's the fair market value of services performed? 0 and 0. I know there's nothing, but I just wanted to put it down. So remind you about the formula. Recognized gain. How much recognized gain? Nothing. 0 and 0. Then liability transferred to the partnership. We're going to subtract. Now we're going to minus liability transferred to partnership. Well, what's going to happen is this. $12,000 was contributed to the partnership. B contributed this liability. So what happened? B will have to reduce his share of $12,000 in the liability initially. Initially, because you contributed $12,000, you contributed $12,000. Well, your liability is $12,000. It goes to you. So $80,000 minus $12,000. So right now, their basis is $68,000. But we're not done yet. This liability is transferred to the corporation. I'm sorry, to the partnership. And because it's transferred to the partnership, it's going to be assumed by the partnership. So liability assumed by the partnership. Once the liability is assumed by the partnership, all the partners are responsible for this liability. Therefore, the liability, once it's assumed, each of the partners will increase their basis by the amount of the debt that they are responsible for. Well, how do they determine this amount? Well, it depends on their ownership, their equal partners. So that's easy. So of the $12,000, A is responsible for 50% of it. 50% is $6,000. And B is responsible for 50%. Well, obviously, B is happy now because he used to have $12,000 liability. Now he's only responsible for six, if anything happened, because it's inside the partnership. So the liabilities is assumed. So now we could figure out the outside basis. We could figure out what we call the outside basis. And let's just sum them for A. For A, it's $46,000. And for B, it is $74,000. So those are the outside basis. And if we add them, the outside basis adds up to $120,000. So what are the inside basis? Well, remember, in a prior session, I talked about the inside basis. So the inside basis is the partnership basis in its own asset. So the partnership basis in its own asset. And the formula, I gave you the formula previously, it's the adjusted basis of property contributed, obviously property contributed, plus partners recognized gain, if there is any recognized gain. So here, what did we contribute? We contributed the cash, the adjusted basis of cash was $40,000. And the property, the adjusted basis is $80,000, $40,000 plus $80,000 equal to $20,000. So those are the inside basis. And this is basically how we deal with that when that is contributed. Remember, initially, it's an expanded formula. Initially, it reduces the partner's personal basis in total for the total debt, then that partner is going to go back and be responsible for some of that debt. So it will reduce it to that partner that's contributing the liability, then it go back and increase it. At the end of this recording, what should you do now? Go to Farhat Lectures, look at additional resources, lectures, multiple choice, two-fold that's going to help you understand this topic, whether you are a CPA candidate, you are an enrolled agent, or an accounting student, invest in yourself, invest in your career, good luck, and stay safe.