Debt Relief and Phantom Income
Recall that a partnership’s inside basis is the cost of its assets, which include the amount of its debt. Tax basis will decrease with cash distributions. When a partner decides to sell his capital interest, his taxable income will generally be the difference between the price he receives and his tax basis.
When the seller’s tax basis includes debt, the purchaser of the seller’s outside basis will take on that debt obligation. The selling partner will be relieved of that debt liability. This debt relief is treated by the IRS as a cash distribution. As a distribution, it reduces the seller’s tax basis by the amount of the debt, removing the liability from adjusted cost basis. This has a definite impact on the seller’s capital gains.
Example: Deidre has a 20% interest in Freeport, LLC. The LLC’s inside basis is $1,000,000, consisting of $600,000 in cash and a $400,000 mortgage. Deidre’s tax basis is $200,000, of which $120,000 represe