754 Elections Have Immediate Impact when Selling, Buying or Liquidating Partnership Interest – UPDATED Under Tax Reform by Dustin Grizzle
Posted on January 05, 2018 by Dustin Grizzle
The sale, exchange or liquidation of partnership interest in appreciated property, such as real estate, is a common occurrence among partners and members of partnerships and LLCs taxed as partnerships. Whether due to disagreements among the partners, the death or divorce of a partner, or the addition of new partners, these transactions can result in a discrepancy between a property’s fair market value (FMV) and its basis, which can ultimately affect the tax treatment of each partner’s reported income, gains and losses. To remedy this, a partnership may make a 754 election under Internal Revenue Code sections 743(b) and 734(b) to equalize the buyer’s basis in the purchased partnership interest in property (outside basis) and the buyer’s share of the basis of the assets inside the partnership net of liabilities (inside basis).
While this election can be somewhat complex and time-consuming, it provides an incoming partner with a step-up or step-down in basis to reflect the FMV of the property at the time of the transfer; failing to make a 754 election can represent a missed opportunity for a partner to accelerate deductions and recover basis in a shorter period of time.
Understanding the Basics of Basis
When an entity or person buys an interest in a partnership with appreciated assets, its “outside basis” in the property increases to the purchase price. Subsequently, the entity or person may reduce or even eliminate taxable gains when it sells the property in the future.
In general, partners or members of pass-through entities will typically increase their basis in partnership interests through partnership contributions and taxable and tax-exempt income; their basis in the property will decrease due to distributions, nondeductible expenses and deductible losses. Therefore, when existing partners sell their interests in property owned by the partnership, they will typically recognize a gain or loss, while the new partner’s basis in the property will become the purchase price that he or she paid. If the property is highly appreciated, the buyer’s outside basis in the partnership interest will far exceed the inside basis in those assets. Ultimately, this can remove the new partner’s rights to immediate depreciation deductions and defer his or her benefit of additional basis until the underlying property is sold.
A 754 election bridges the gap between inside and outside basis by immediately stepping-up or stepping-down the basis of the remaining partnership assets. This permits the entity the option to equalize the partners and provide them with a tax asset. This tax asset allows the new partner to reduce or eliminate the tax on gains and losses already reflected in the price he or she paid for the partnership interest when the asset is sold. In addition, when the adjustment relates to depreciable or amortizable property, such as real estate, the new partner may begin taking those deductions in the year the election is made rather than waiting to recoup his or her basis when the property is transferred or sold in the future.
Exceptions to these rules exist for “substantial basis reductions” and “substantial built-in losses” that require a step-down in basis, even in the absence of a 754 election, when one of either of the following criteria are met:
the partnership has a built-in loss of $250,000 or more;
there is a downward basis adjustment of $250,000 or more; or
The transfer or sale involves an electing investment partnership, such as a hedge fund.
In addition, the tax reform package that President Donald Trump signed into law effective Jan. 1, 2018 updates this language to include the following:
The partnership has a substantial built-in-loss with respect to a transfer of partnership interest if either a) the partnership’s adjusted basis in the partnership property exceeds by more than $250,000 the fair market value of the property (Code Sec. 743(d)(1)(A) as amended by 2017 Tax Cuts and Jobs Act §13502(a)), or b) the transferee partner would be allocated a loss of more than $250,000 if the partnership assets were sold for cash equal to their fair market value immediately after the transfer.
Under all of these circumstances, anti-stuffing rules will apply in order to limit a buyer’s ability to benefit from overvalued net operating losses (NOLs) and NOLs earned in years prior to the date of the purchase.
How a 754 Election Works
Assume that in 2000, partners A, B and C contribute $100 each in exchange for a 1/3 interest in Donut LLC. Donut purchases a $300 asset depreciable over 10 years on the straight line method and earns $900 income before depreciation over the first 5 years. Donut distributes $600 of that amount to each partner in 2005, providing it with an inside basis of $450 ($300 asset – $150 depreciation + $900 income – $600 distribution). This amount equals the total of each partner’s individual outside basis ($150 X 3) in her or her partnership interests.
Now consider that in 2006, Partner C sells his entire 1/3 interest in Donut LLC to New Partner D for $250 cash. Partner C will incur a $100 long-term capital gain on his 2016 personal tax returns ($250 sales price – $150 basis). Subsequently, Partner D will take over Partner C’s capital account of $150, which exceeds by $100 his proportionate share of his basis ($250) in Donut LLC’s assets.
If Donut breaks even in years 2006 through 2016 and disposes of the property without a Section 754 election on Jan. 1, 2017, Partner D will not recover his outside basis or $100 (purchase price in excess of “inside basis”) until the year of liquidation.
Had Donut LLC made a Section 754 election in its 2006 tax returns, Partner D would have recovered his inside/outside basis difference of $100 as a $10 ordinary depreciation deduction each year until the additional basis was fully recovered. The ultimate sale of the asset in 2017 would result in the same capital gain to all partners. Without the 754 election, Partner D would have missed the benefit of timely deductions during the years 2006 through 2016.
How to Make a Section 754 Election
Section 754 elections are available only to partnerships and LLCs taxed as partnerships for which the entity’s income and losses pass through to each partner. A valid election requires strict adherence to procedural guidelines, including the filing of a written statement with the partnership’s tax return in the year that the distribution or sale occurred. Because the election is made at the entity level, the statement must specify the name and address of the partnership, and it must contain a declaration that the partnership elects under section 754 to apply the provisions of section 734(b) and section 743(b). Once the election is made, it will remain in effect for all future years, unless the partnership applies for and receives IRS approval to revoke it.
The decision to make a Section 754 election can be complicated and burdensome, but it may be well worth the effort for accelerating a partner’s tax deduction following a sale, exchange or liquidation of partnership interest. However, making this determination is best accomplished under the guidance of professional accountants.
The advisors and accountants with Berkowitz Pollack Brant work with domestic and international businesses to meet regulatory compliance obligations, optimize profitability and maintain tax efficiency.
About the Author: Dustin Grizzle is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides tax-planning and compliance services to high-net-worth individuals and businesses in the manufacturing, real estate management and property investment industries. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at email@example.com.