Manuel and Melissa want to form the equal MM Partnership. Melissa will contribute cash of $140,000. Manuel has cash of $40,000 and land (fair market value of $100,000, adjusted basis of $136,000). Manuel purchased the land several years ago as an investment (capital) asset. Manuel and MM LLC are trying to decide between two alternatives for Manuel’s contribution. In Alternative 1, Manuel will contribute the land to the LLC. MM will use the property as a § 1231 asset (a parking lot) and then sell it in six years at an estimated $100,000 price. (Disregard any potential improvements to the land.)
In Alternative 2, Manuel will sell the land immediately to a third party and contribute to MM the $100,000 cash proceeds from the sale. MM will use that cash to purchase similar land for $100,000 (also to be used as a parking lot).
Use the following additional assumptions: (1) neither Manuel nor MM will realize other capital or § 1231 gains or losses now or in the future, (2) Manuel’s marginal tax rate is 35%, (3) a reasonable annual discount rate is 3%, and (4) the tax treatment of capital and § 1231 gains and losses does not change in the foreseeable future.
a) For each alternative, when would the $36,000 loss be recognized, to whom would the loss be allocated, what is the character of the loss, and over what time period can the loss be deducted?
b) In these two alternatives, calculate Manuel’s tax savings each year from deducting his share of any loss allocated to him that year. Use the tables in Appendix E (or Microsoft Excel) to calculate the present value of these savings. Considering only tax savings, as Manuel’s tax adviser, would you recommend Alternative 1 or Alternative 2? Why? What other issues should Manuel consider?
c) How would the results in parts (a) and (b) change if MM were to sell the property in Alternative 1 after only four years? Answer conceptually; do not make calculations.