Optimize Property Basis in a Partnership With the Section 754 Election

One of the most challenging areas for a tax preparer is correctly determining the basis of a client’s property to calculate any gains and losses realized when it is sold, transferred, or distributed. This becomes even more complicated when the property is held by more than one taxpayer in a partnership.

The Section 754 election allows tax preparers and partnerships to manage the tax consequences associated with the transfer of partnership interests. The primary goal of the 754 election is to ensure that the tax consequences to the transferring partner and the remaining partners are as equitable as possible.

This election allows a partnership to adjust the basis of its property when a partner’s interest is transferred or when there is a distribution of property to a partner. This adjustment helps align the inside basis (the partnership’s basis in the property) with the outside basis (the partner’s basis in the partnership interest) following these transactions.

This can provide significant tax advantages by allowing for:

1. Higher depreciation deductions for new partners
2. More accurate reflection of asset values
3. Potential mitigation of built-in gains or losses

Outside and Inside Basis

Outside basis is essentially a partner's "personal" tax basis in their partnership interest. It's like tracking a personal investment account, showing how much they've put in, how much they've earned or lost, and how much they've taken out.

Inside basis is the partnership's collective "cost account" for its assets. While outside basis tracks what each individual partner has invested, inside basis reflects the partnership's total investment in its assets from a tax perspective.

A simple analogy might be: If a partnership was a joint venture to buy a house, inside basis would be the total amount the partnership has spent on the house (purchase price, renovations, etc.), while outside basis would be how much each individual partner has contributed to that total.

Step-Up and Step-Down

When the inside basis and outside basis are factored in a 754 election, this can involve a step-up or step-down, which is an adjustment to the fair market value of an asset.

A step-up increases the tax basis of an asset to its fair market value at the time of a specific event, such as the death of the owner or a sale. This can reduce capital gains taxes when the asset is eventually sold.

A step-down decreases the tax basis of an asset to its fair market value at the time of a specific event, which can increase capital gains taxes when the asset is sold.

Advantages of a Section 754 Election

There are several scenarios where making a Section 754 election is beneficial.

1. When There’s a Sale or Exchange of a Partnership Interest:
   If a partner sells their partnership interest, the buyer’s outside basis in the partnership interest will typically be different from the inside basis. The 754 election allows the partnership to adjust the basis of its assets to reflect the new outside basis, which may help avoid potential double taxation on future sales or distributions. This is particularly useful if the buyer is acquiring the interest at a premium or discount compared to the original basis.
   
   
2.  When There’s a Distribution of Property:
   A distribution of property to a partner can lead to discrepancies between the partnership’s inside basis and the partner’s outside basis. If the partner's outside basis is greater than the inside basis of the property received, the 754 election ensures the inside basis is adjusted upward to match the partner’s outside basis, effectively avoiding any taxable gain or loss.
   
   
3. When the Partnership Has Significant Built-in Gains or Losses:
   For partnerships with property that has built-in gains or losses, the election allows for an adjustment of the inside basis to avoid distortion in the tax effects of future transactions. This is especially helpful in situations where there is substantial depreciation or appreciation in property values.
   
   
4. When a Partner Has a Substantial Interest:
   If one partner has a large interest in the partnership and the transaction involves a major change, a Section 754 election helps ensure that any future gain or loss recognized by the partnership aligns with the actual economic interests of all partners in the partnership.

When is a Section 754 Election Not a Good Idea?

While the Section 754 election can be beneficial, there are certain circumstances where it might not be the best strategy. These include:

1. If the Partnership Has Minimal or No Property with Depreciation or Appreciated Assets:
   If the partnership's property doesn't have significant depreciable or appreciated assets, the benefits of the 754 election may be minimal. The administrative costs associated with maintaining the election (record keeping, additional paperwork, etc.) may outweigh any tax benefit.
   
   
2. If the Partnership Plans to Dissolve Soon:
   A partnership that plans to liquidate or dissolve soon may not benefit from the election, as the benefits of the basis adjustments may not be fully realized before the partnership ends.
   
   
3. If the Partnership Has Multiple Transfers or Complex Ownership Structures:
   In situations where the partnership has frequent transfers or complex ownership structures, the election might complicate the partnership’s tax reporting and recordkeeping requirements, especially if it results in multiple basis adjustments that need to be tracked over time.

Information Needed for a 754 Election

To file a Section 754 election, certain details are required:

• Partnership’s Name, Address, and EIN: This information is found on Form 1065.
  
  
• The Statement of Election: The partnership must attach a statement to its tax return specifically stating that it is electing under IRC Section 754.
  
  
• Details of the Transaction: A description of the transaction leading to the election, such as the sale of an interest or a distribution of property, should be included.
  
  
• Partnership Agreements: The agreement may outline specific provisions regarding the treatment of assets, which should be reviewed before making the election.

Forms Used to Make the 754 Election

To make the Section 754 election, the following forms are typically required:

• Form 1065 (U.S. Return of Partnership Income):
  The election is made by filing IRS Form 1065 (U.S. Return of Partnership Income) with an attached statement indicating the election. Once the election is made, it applies to all future transfers of partnership interests and distributions unless the partnership revokes the election with the IRS.
  
  
• Schedule K-1 (Partner’s Share of Income, Deductions, Credits, etc.):
  If the partnership makes the Section 754 election, each partner’s Schedule K-1 will reflect any adjustments in their share of the partnership's income, deductions, and basis.
  
  
• Form 8886 (Reportable Transaction Disclosure Statement) (if applicable):
  In certain cases, the election may be considered a reportable transaction, and the partnership would need to file this form. However, most Section 754 elections do not require this additional form unless the transaction is deemed reportable.

Long-Term Implications of a 754 Election

The long-term implications of making a Section 754 election include the following:

• Continued Basis Adjustments: Once the election is made, the partnership must continue to make basis adjustments for all subsequent transfers or distributions until the election is revoked. This creates ongoing administrative responsibilities.
  
  
• Potential for Increased Depreciation Deductions: If the basis of the partnership’s assets is increased, this can result in additional depreciation deductions in future years, which could lower the partnership’s taxable income and thus reduce taxes owed.
  
  
• Complexity in Record keeping: Partnerships must maintain accurate records of the basis adjustments over time. Failure to do so can result in mistakes that affect tax filings, potentially leading to audits or penalties.
  
  
• Impact on the Taxable Sale of Property: When a partnership property is eventually sold, the adjustments made under the 754 election will affect the calculation of gain or loss. This could lead to either larger gains (due to upward adjustments) or larger losses (due to downward adjustments), depending on the circumstances.

Conclusion

The Section 754 election is a powerful tool for tax planning, but it should not be entered into lightly. As a tax preparer, you should carefully assess the potential benefits and drawbacks based on the specific circumstances of the partnership before advising the client. For partnerships with significant property holdings or those undergoing frequent ownership changes, the election can help align the tax treatment of these transactions with the partners’ economic realities. However, it’s important to weigh the administrative burden and costs against the potential tax savings to determine if the election is the right choice. Proper planning and recordkeeping ensure the election delivers the intended benefits without creating future complications for the client.

Resources

IRS FAQs for IRS Sec. 754 Election and Revocation

Form 1065 (U.S. Return of Partnership Income)

Schedule K-1 (Partner’s Share of Income, Deductions, Credits, etc.)

About Form 8886 (Reportable Transaction Disclosure Statement)

IRS Publication 551 Basis of Assets