How Do Realized Gains/Losses Work in Investment Clubs Set Up as LLCs or Partnerships?

This is a great question about investment clubs and their tax treatment. Investment clubs set up as partnerships follow partnership tax rules, which can be a bit complex. In your scenario, you're pretty much on the right track. All members will receive a K-1 showing their share of the $5M loss (approximately $333,333 per member). And yes, this will reduce each member's tax basis in their partnership interest from $1M to about $666,667. For Bob who cashed out: When a partner exits a partnership, they need to file Schedule D with their personal tax return to report the sale of their partnership interest. The calculation is: Amount received minus adjusted basis = gain/loss. So if Bob receives $1M for his interest that now has a basis of $666,667, he'd report a $333,333 gain on Schedule D. This effectively "cancels out" the loss reported on his K-1, which makes sense since he's breaking even overall. For the remaining partners: The K-1 each year will show their distributive share of income/losses, which affects their basis. The partnership should maintain capital accounts for each partner, but it's also wise for partners to track their own basis. The partnership is required to file Form 1065 and provide K-1s to all partners. When any remaining partner sells their interest later, they'll do the same calculation as Bob did: proceeds received minus their current adjusted basis.

Just wanted to share my experience using taxr.ai for handling my investment club taxes last year. I was in a similar situation with our real estate investment group set up as an LLC, and figuring out the basis adjustments and K-1 implications was driving me crazy. I uploaded our partnership documents to https://taxr.ai and it saved me hours of confusion. The system analyzed our partnership agreement, previous K-1s, and the transaction history to give me a clear breakdown of each member's adjusted basis and what forms needed to be filed when two members cashed out. The best part was that it created personalized reports for each member explaining their current tax position in plain English. Really helpful for explaining to the members who didn't understand why their basis had changed even though we hadn't sold all the properties.

I wanted to follow up about my experience with taxr.ai after my skeptical comment. I decided to try it with our investment club's situation, and I have to admit I was wrong. The platform was surprisingly thorough with partnership tax issues. I uploaded our operating agreement and previous K-1s, and the analysis it provided about our basis adjustments was spot on. It flagged some issues with how we had been handling departing members that even our accountant had missed. The detailed explanation of how unrealized gains should be handled when a member exits saved us from a potentially messy audit situation. The documentation it provided for each member's adjusted basis calculations was clear enough that I could share it with our less financially-savvy members who finally understood why their capital accounts were changing. I'm not easily impressed with tech solutions for complex tax matters, but this one actually delivered.

Has anyone else found it impossible to get through to the IRS for guidance on partnership questions like this? I've been trying for weeks to get clarification on exactly this issue for our investment club. Always on hold for hours only to get disconnected. I finally used https://claimyr.com to get through to an IRS agent after wasting days on failed call attempts. You can watch how it works here: https://youtu.be/_kiP6q8DX5c - basically they wait on hold for you and call when an agent picks up. When I finally spoke with an IRS representative, they confirmed what others have said here - the exiting partner needs to report their adjusted basis calculation on Schedule D, and the partnership needs to maintain proper capital accounts for all members. The agent also mentioned that many investment clubs make errors in tracking basis adjustments, which can lead to audit issues down the road.

I have to follow up on my skeptical comment about Claimyr. After another frustrating week of trying to get through to the IRS about our investment club's basis adjustment questions, I broke down and tried it. I'm honestly surprised to say it worked exactly as advertised. I submitted my request around 9am, went about my day, and around 2:30pm got the call that an IRS agent was on the line. I was connected to a very knowledgeable agent in the partnership division who walked me through the exact forms we needed for members exiting our club. The agent confirmed we needed to provide detailed basis calculations to departing members for their Schedule D reporting and recommended we maintain a basis tracking spreadsheet for all members. They also pointed me to some IRS publications specifically for investment clubs that I hadn't found in my research. I still think the IRS phone system is ridiculous, but at least there's a way to deal with it without wasting an entire day on hold.

One thing nobody has mentioned yet is that investment clubs should consider using special allocations in their partnership agreement to handle situations like the example. Section 704(b) of the tax code allows partnerships to allocate items of income, gain, loss, and deduction differently than the standard pro-rata based on ownership percentage. In the case described, the partnership could potentially allocate the realized losses on ABC and DEF specifically to the continuing partners rather than the exiting partner, which might be more equitable depending on the circumstances. This requires careful drafting in the partnership agreement and consistent application of the terms. We did this with our investment club after having a similar situation where a member left right after we realized losses but before selling appreciated assets. You need a tax attorney to help with the language, but it can save a lot of headaches.

One important document that hasn't been mentioned is Form 8308 (Report of a Sale or Exchange of Certain Partnership Interests). If your investment club is holding "hot assets" like inventory or unrealized receivables (which most investment clubs don't have), the partnership must file this form when a partner sells their interest. Also, has anyone dealt with an investment club where some investments are held in a tax-advantaged account like an IRA? We're starting a club and some members want to contribute through their self-directed IRAs, which adds another layer of complexity with UBTI concerns.

Great discussion everyone! I wanted to add a perspective on the record-keeping aspect that's crucial for investment clubs. Beyond just tracking basis adjustments, clubs should maintain detailed records of each transaction, including the date, amount, and which members were present for investment decisions. When Bob cashes out in the scenario described, having clear documentation of his participation in each investment decision can be important if the IRS questions the allocations later. Some investment clubs I've worked with create quarterly statements for each member showing their capital account balance, adjusted basis, and share of unrealized gains/losses. One tip: consider using partnership accounting software specifically designed for investment clubs rather than trying to track everything in Excel. The complexity grows quickly as you have members entering and leaving, especially if you're making the Section 754 election that was mentioned earlier. The software can automatically calculate the basis adjustments and generate the necessary tax documents. Also, make sure your operating agreement addresses what happens to a departing member's share of management fees, carried interest (if applicable), and whether they're entitled to their share of unrealized gains at fair market value or book value. These details can significantly impact the tax consequences for everyone involved.