At the beginning of year 1, Ed and Fran each contributed $1,000 cash to EF Partnership as equal partners. The partnership immediately borrowed $98,000 on a nonrecourse basis and used the contributed cash and loan proceeds to purchase equipment costing $100,000. The partnership leases out the equipment on a five-year lease for $10,000 per year. Over the five-year period, the partnership makes the following principal and interest payments on the loan:

Assume the partnership depreciates the equipment according to the following hypothetical schedule:

Year                             Depreciation

1 ………………………………… $40,000

2 …………………………………    25,000

3 …………………………………   15,000

4 …………………………………     8,000

5 …………………………………     8,000

6 …………………………………     4,000

At the beginning of Year 6, the partnership sells the equipment for $82,000. The partnership claims the last $4,000 of depreciation at the beginning of Year 6 as an expense, so the equipment has a zero basis when sold. At the beginning of Year 6, the partnership also pays off the $80,000 loan balance and distributes any remaining cash to Ed and Fran. Assume that each partner has a 33% ordinary tax rate and an 18.8% capital gains tax rate (including the 3.8% tax on net investment income).

a. Determine the partnership’s gain (loss) for each of the five years and the beginning of the sixth year.

b. Assume that depreciation recapture applies but that the at-risk and passive activity loss rules do not apply. Using the results from Part a and a 7% discount rate, determine the present value of tax savings for both partners combined over the five-year period including the beginning of the sixth year. Why do these tax savings occur?

c. Now assume the at-risk and passive activity loss rules do apply. Determine what the partners recognize over the five-year period including the beginning of the sixth year. Do the partners have any tax savings in this situation? Why or why not?

d. Provide a schedule analyzing each partner’s outside basis over the five-year period including the sixth year.

Transcribed Image Text:

Year Principal Interest S3,000 S7,000 3,500 6,500 3,500 6,500 4,000 6,000 4,000 6,000