The transfer of a partnership interest can cause a discrepancy between the transferee partner's inside and outside basis when the partnership's basis in its assets does not equal fair market value (FMV) at the time of the transfer. One result of this discrepancy is that in the case of appreciated property, the transferee will recognize taxable gain when the partnership sells the property even though the transferee has not realized an economic gain (i.e., because the transferee paid for the unrealized appreciation when he acquired his interest). The transferee partner is also limited to his allocable share of depreciation based on the partnership's adjusted basis.
Example 1: E purchases a 25% interest in G Partnership for $10,000. G Partnership's sole asset is a tractor-trailer with a $16,800 adjusted basis. Without a Sec. 754 election, E's allocable share of the remaining depreciation deductions is $4,200 (25% of $16,800). If E had purchased a 25% interest in the tractor-trailer itself, his total depreciation deductions would be $10,000.
The optional basis adjustment election is an attempt to allow partners to correct these types of distortions by increasing (or decreasing) the transferee's allocable basis in the underlying partnership assets (to simulate the effects of a direct purchase of an undivided interest in the partnership assets by the transferee).
Of course, if the partnership's basis in the property is greater than the FMV of the property, the optional basis adjustment has a negative effect. Therefore, before a practitioner recommends that the partnership make a Sec. 754 election, he or she must consider the FMV of all partnership property in relation to its basis. Since the Sec. 754 election applies to all transfers and property distributions made during and after the year that the election is made, the practitioner must also consider potential future appreciation and depreciation, and future transfers and distributions. A basis adjustment is required to be made to a transferred partnership interest if the partnership has a substantial built-in loss immediately after the transfer (unless the partnership is an electing investment partnership or a securitization partnership).
Example 2. Determining the tax advantages of a Sec. 754 election upon the sale of a partnership interest: E wants to acquire B's 30% interest in P Partnership, an accrual-basis general partnership, for $45,000 cash. E will also assume B's portion of the partnership debt. E has asked his tax practitioner to review the transaction for potential tax planning opportunities. The sales price is based on the balance sheet in Exhibit 1 (below).
Generally, the sale of a partnership interest does not trigger an optional basis adjustment to the partnership's basis in its assets (Sec. 743(a)). However, if the partnership makes a Sec. 754 election, an optional basis adjustment is permitted to minimize the difference between the basis and FMV of partnership property (Sec. 743(b)). The optional basis adjustment applies only to the portion of partnership property allocable to the transferee partner.
Example 3: In reviewing the sale in Example 2, the practitioner identifies a discrepancy between E's outside basis in his partnership interest and his allocable share of the inside basis of the partnership's assets because of appreciation in the value of the inventory, building, and land. Therefore, the practitioner recommends the partnership make a Sec. 754 election so E can recover the basis in his partnership interest over a shorter period through increased depreciation deductions and a decrease in his gain upon a subsequent sale of partnership assets.
The optional basis adjustment is equal to the difference between the transferee's basis in his partnership interest (outside basis) and his allocable share of partnership basis in partnership property (inside basis).
E's outside and inside bases are shown in Exhibit 2 (below).
The difference between the basis of E's partnership interest ($75,000) and his proportionate share of the inside basis of partnership property ($60,000) results in a $15,000 positive optional basis adjustment.
If P Partnership agrees to make the Sec. 754 election, it should file an election statement as an attachment to the tax return for the year during which the transfer occurred.
Note: The potential negative impact of Sec. 754 elections became apparent for many real estate partnerships in the early 1990s and after the 2008 financial crisis. Because of declining property values, substantial basis reductions were often required for partnerships that had Sec. 754 elections in effect. Unfortunately, the IRS is reluctant to allow partnerships to revoke a Sec. 754 election in such situations. In addition, if a partnership has a large number of partners, it may not want to make a Sec. 754 election because of the recordkeeping burdens the election would create.
This case study has been adapted from PPC's Tax Planning Guide—Partnerships, 30th Edition, by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Sheila A. Owen, and Twila Bollinger, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2016 (800-431-9025; tax.thomsonreuters.com).