Chapter 13 Basis Adjustments to Partnership Property

1. Chapter 13 Basis Adjustments to Partnership Property

2. Basis Adjustment to Partnership Property - §743(b) • Under the general entity approach of §743(a), the price paid by the purchasing partner affects only the partner’s adjusted basis in his or her partnership interest, not the basis of his or her share of the partnership assets • Under §743(b), if the partnership makes a §754 election in the year of sale or has a substantial built-in loss immediately after the transfer, the transfer of a partnership interest will trigger a required adjustment to the basis of partnership assets

3. §743(b) Transfers • §743(b) applies to any transfer of partnership interests considered a sale or exchange • It does not apply to the gift of a partnership interest, nor to the contribution of cash or property to a partnership in exchange for an interest in that partnership

4. §743(b) Adjustments-Overview • The amount of the §743(b) adjustment to all the partnership properties is the difference between the incoming partner’s basis for his or her partnership interest and that partner’s share of the adjusted basis of the partnership property at the time of purchase

5. §743(b) Adjustments-Overview (Cont.) • If the purchasing partner’s initial adjusted basis in the partnership interest is greater than his or her share of the adjusted basis of partnership assets, the total basis adjustment to the partnership assets is upward in an amount equal to the excess. And vice versa. • The total adjustment is then allocated among the partnership properties in accordance with § 755

6. Partnership with Substantial Built-in Loss • Basis adjustments under Code Sec. 743(b) are triggered by the transfer of a partnership interest if the partnership has a “substantial built-in loss” • A partnership has a substantial built-in loss if the adjusted basis of partnership property exceeds its FMV by more than $250,000 • In such cases, the partnership is required to adjust its basis in its assets under §743(b) even if no §754 election has been made

7. Partnerships Without Substantial Built-in Losses • If the partnership does not have a substantial built-in loss, no basis adjustment is required or allowed unless the partnership has a §754 election in effect or chooses to make one effective for the year of the transfer

8. Making the §754 election • The election is made by attaching a statement declaring a §754 election to the partnership’s “timely” (filed by due date, including extensions) Form 1065. The statement should include the partnership’s name, address and TIN and be signed by any partner. • The election applies to all sales, exchanges, transfers upon death, and the four distribution situations under §734(b), until the election is terminated

9. Making the §754 election (Cont.) • An application for revocation of a §754 election must be filed no later than 30 days after the close of the partnership’s taxable year with respect to which the election is intended to take effect

10. Making the §754 election (Cont.) • Acceptable reasons for revocation include: • A change in the nature of partnership trade or business. • A substantial increase in assets. • A change in the nature of assets. • An increasing administrative burden.

11. Calculating the §743(b) Adjustment • The total basis adjustment is the difference between the incoming partner’s basis in the partnership interest and their share of the adjusted basis of partnership property • In general, this difference is the same as the gain or loss the selling partner would have recognized if the partnership had sold all of its assets for their FMV

12. Allocating the §743(b) Adjustment • The total §743(b) basis adjustment is allocated first between two classes of property : • Capital gain property and • Ordinary income property • The basis adjustment allocated to each class is then allocated among the items within each class

13. Allocating the §743(b) Adjustment (Cont.) • The portion of the basis adjustment allocated to ordinary income property would be equal to the total income, gain and loss that would be allocated to the transferee upon the sale of the partnership’s ordinary income property if the partnership sold all its assets in a fully taxable transaction

14. Allocating the §743(b) Adjustment (Cont.) • The basis adjustment to capital gain property is equal to the total adjustment less the amount allocated to ordinary income property • If the basis adjustment to capital gain property is a decrease, it cannot exceed the partnership’s basis in capital gain property. • Any excess is applied to reduce the basis of ordinary income property

15. Allocating the §743(b) Adjustment (Cont.) • Within the class of ordinary income property, the basis of the purchaser’s share of each property is therefore generally equal to its FMV • However, this basis adjustment to FMV may be reduced by negative adjustments to capital gain property exceeding the basis of the capital gain property

16. Allocating the §743(b) Adjustment (Cont.) • The amount of the basis adjustment to each item of capital gain property is equal to: • 1. The amount of income, gain, or loss allocated to the transferee from the hypothetical sale of the item; reduced (increased) by • 2. The product of: • Total remaining unallocated gain or loss and • (FMV of the item of property)/(FMV of all of the partnership’s items of capital gain property)

17. §743(b) Adjustment Made for Benefit of Transferee • The basis adjustment constitutes an adjustment to the basis of partnership property with respect to the transferee only • For purposes of calculating income, deduction, gain, and loss, the transferee will have a special basis for those partnership properties, the bases of which are adjusted under §743(b).

18. §743(b) Adjustment Made for Benefit of Transferee (Cont.) • The partnership first computes its partnership items of income, deduction, gain or loss at the partnership level • It then allocates these items among the partners, including the transferee, and adjusts the partners’ capital accounts accordingly. • The partnership then adjusts the transferee’s distributive share of the items of partnership income, deduction, gain, or loss to reflect the effects of the transferee’s basis adjustment

19. §743(b) Adjustment Made for Benefit of Transferee (Cont.) • The amount of any negative basis adjustment allocated to depreciable property first decreases the transferee’s distributive share of the partnership’s depreciation deductions from that property • Then, if necessary, decreases the transferee’s distributive share of the partnership’s depreciation deductions from other property

20. Distribution of Property with §743(b) Adjustments • The §743(b) adjustment will continue to affect only the same partner • If the property subject to basis adjustment is distributed to the partner for whom the basis adjustment was made, that partner’s basis will take into account the basis adjustment • If the property is distributed to other partner(s), the special basis adjustment is shifted to property of like kind still remaining in the partnership

21. Distribution of Property with §743(b) Adjustments (Cont.) • When the interest of a partner to whom a basis adjustment is in effect is completely liquidated, the partner’s entire remaining adjustments in all partnership property must be allocated to the distributed property • The partner will have a total adjusted basis in the distributed property equal to the adjusted basis of his or her partnership interest

22. Transfer of Partnership Interests with §743(b) Adjustments • Transfers by sale: A new partner who acquires a partnership interest from an outgoing partner, in respect of whom a §743(b) adjustment was in effect, does not succeed to the selling partner’s basis adjustment • With a §754 election, a new basis adjustment is calculated

23. Partner-Level §743(b) Adjustments – §732(d) • A transferee partner, to whom a distribution of partnership property (other than money) is made within two years of the date the transferee partner acquired his or her partnership interest, can make an election to treat the adjusted basis of the distributed partnership property as if a §743(b) adjustment were in effect with respect to the partnership property

24. Technical Terminations • The transfer of a partnership interest can have a significant tax impact on the continuing partners if the transfer causes the “termination” of the partnership • A termination occurs only when 50 percent or more of the total interest in the partnership’s capital and profits is sold or exchanged within a 12-month period

25. Technical Terminations (Cont.) • The term “sale or exchange includes: • 1. Sales violating an anti-assignment agreement • 2. Taxable and tax-free exchanges • 3. The distribution of a partnership interest from a partnership or a corporation • 4. The contribution of a partnership interest to a corporation

26. Technical Terminations (Cont.) • The term “sale or exchange includes: • 5. The contribution of a partnership interest to another partnership • 6. Abandonment of a partnership interest when the partner is relieved of a share of partnership debt under §752(b) in excess of his or her basis in his or her interest; and • 7. The sale of a partnership interest to new or existing partners

27. Technical Terminations (Cont.) • The term “sale or exchange” does not include: • 1. Bequests and inheritances • 2. Gifts when the donor has no debt relief. Debt relief suggests a part gift/part sale analysis; and • 3. Entry of a new partner

28. Consequences of Partnership Termination • The following is deemed to occur upon the termination of partnership: • The partnership contributes all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership; and • Immediately thereafter, the terminated partnership liquidates, distributing interests in the new partnership to the purchasing partner and the other remaining partners in proportion to their respective interests in the terminated partnership

29. Basis Adjustments Upon Distributions of Property - §734(b) • When a distribution results in a “substantial” basis reduction, the partnership is required to adjust its basis in remaining partnership properties under §734(b) regardless of whether the partnership makes a §754 election or not

30. Basis Adjustments Upon Distributions of Property - §734(b) (Cont.) • A “substantial basis reduction” exists when the sum of the two items below exceeds $250,000 : • The amount of loss recognized by the distributee partner on receipt of the distribution; and • The step-up in basis of distributed property in the distributee partner’s hands

31. No §754 Election in Effect • Generally, unless the partnership has a §754 election, the distribution of property or cash are nontaxable events for the partnership • However, the partnership may be required to recognize gain or adjust the basis of its assets if the distribution triggers the disproportionate distribution or the deemed sale rules

32. §754 Election in Effect or Substantial Basis Reduction • Generally, the basis of retained partnership property will not be adjusted upon a distribution to partner(s) under §734(a) • However, if the partnership makes a §754 election or there is a substantial basis reduction, a §734(b) basis adjustment will be made to the retained partnership property

33. §754 Election in Effect or Substantial Basis Reduction (Cont.) • The adjustment process has two steps: • Computing the total adjustment, and • Allocating the total adjustment to the partnership assets

34. Amount of the §734(b) Adjustment • If a distribution of money is greater than the partner’s outside basis, the partnership will increase the adjusted basis of its assets by the amount of gain recognized by the distributee partner • If a distribution to a partner consists solely of money, unrealized receivables, and/or inventory in complete liquidation of his or her partnership interest and the distributee partner recognizes a loss, the partnership will reduce the adjusted basis of its undistributed assets by the amount of the loss

35. Amount of the §734(b) Adjustment (Cont.) • In a distribution of property in which the partner takes a lower basis in the property than the partnership had, the partnership will increase its basis in remaining properties by a like amount • If upon complete liquidation of a partner’s interest the total adjusted basis of the assets in the distributee partner’s hands is greater than it was in the hands of the partnership, the partnership must decrease the adjusted basis of retained partnership property by the amount of this difference

36. Amount of the §734(b) Adjustment (Cont.) • §734(b) basis adjustment is made for the benefit of all remaining partners and allows the partners to avoid any distortion in reporting their future shares of partnership taxable income

37. Allocation of §734(b) Adjustment (Cont.) • The allocation rules first apportion the total §734(b) adjustment between: • ordinary income property and • §1221/1231 “capital gains” property • Then the amount of the adjustment allocated to each class is further allocated among the assets within each class

38. Allocation of §734(b) Adjustment (Cont.) • If a positive or negative §734(b) adjustment arises when the distributee partner recognizes gain or loss, respectively, then the upward or downward adjustment is to be allocated only to “capital gains assets” • If the adjustment is caused by the partner’s adjusted basis in the distributed property being less than or greater than the partnership’s adjusted basis, then the increase or decrease is allocated to the partnership assets that are of a character similar to that of the distributed property

39. Allocation of Adjustment Among Property within a Class • If there is an increase in basis to be allocated to a group of properties within a class, the increase must be allocated first to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation before such increase • Any remaining increase must be allocated among the properties within the class in proportion to their FMV

40. Allocation of Adjustment Among Property within a Class (Cont.) • If there is a decrease in basis to be allocated to a group of properties within a class, the decrease must be allocated first to properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation before such decrease • Any remaining decrease must be allocated among the properties within the class in proportion to their adjusted bases

41. Substantial Basis Reduction • §734(a) requires the partnership to adjust its basis in remaining assets following a distribution that results in a “substantial basis reduction” regardless of whether a §754 election is made or not • The partnership is required to decrease its tax basis in its remaining properties in order to ensure that remaining partners are not allowed to artificially inflate their shares of subsequent partnership losses