Partnership tax basis and long term investing

[Sam Dangremond]

I have a somewhat specific tax related question I'd like to see if anyone has encountered before.

(Standard disclaimers apply, you're not giving me tax advice or financial advice, just looking for general resources etc.)

Here's the scenario: a partnership owns one or more long term rental properties.  Each partner contributed say $100,000 to the partnership to purchase the rentals.  No leverage used.  So, each partner has a tax basis and capital account in the partnership of $100,000.  Then, each year the rentals give off more cash than profits because of depreciation - all normal stuff.

But here's what I don't understand: if the partners withdraw all the cashflow each year, then each of their tax basis will gradually go down (because they are withdrawing more in distributions than their share of the profits due to depreciation).  Eventually, the tax basis will hit zero won't it? And when that happens, apparently every additional dollar withdrawn is taxed at long term capital gains? 

Example:

Year 1 - partner's tax basis is $100k... annual partnership cashflow is $20k.... partner withdraws $10k in cash (half of the cash)... however the partner's yearly profits reported on K-1 are only say $5k... because the partner withdrew more in cash than his share of profits, his tax basis goes down by the other $5k.   Accordingly, after 20 years this partner will have a zero tax basis.... correct? Or no?

This means that eventually the cashflow itself is taxed as a gain, because the partner has "used up" all his tax basis?

Is my understanding correct?

If so, how does this interact with depreciation recapture, other long term capital gains, or anything else, at sale of the property or disposition of the partnership? 

Any guidance is much appreciated!

[Michael Plaks]

@Sam Dangremond

Let me give it a shot, as I'm afraid the discussion missed some fundamentals.

1. Distributions come from income, and taxable income increases partners' capital account and basis.

Say partners contributed $100k each and ignore depreciation. The partnership made $20k of income, or $10k for each partner. They distributed every penny. 

Because of the $10k cash distribution, partners' capital accounts and bases dropped to $90k. However, because of the $10k taxable income, they are increased by $10k, bringing them right back to $100k. In other words, if you distribute all income, your basis and capital accounts do not change.

2. Now throw in deprecation.

Same scenario, except now we have $16k depreciation, or $8k per partner. We still distribute the entire $20k income, $10k per partner. But due to depreciation, taxable income is only $4k or $2k per partner.

Result: partners' $100k capital accounts and bases are reduced by $10k distribution and increased by $2k taxable income, ending up $92k. In other words, capital accounts and bases go down if we have distributions in excess of taxable income.

3. Hitting the floor.

Bases and capital accounts will continue to slide down as you continue to take depreciation and distribute the entire cash flow. However, your total depreciation cannot exceed the total cost of the property. And your total cost of the property, in the absence of leverage, cannot exceed your capital contributions.

Result: you can never hit the $0 floor this way.