Preface: Partnership Section 754 basis step-ups are a complex area of the tax code. If you have a partnership, chances are you will be involved in Section 754 basis adjustments.
Partnership Taxation: What is 754 Basis Step-Up
If you are working on a partnership ownership change, you would be advised to have your tax accountant approve the deal before inking sale agreements. One of the common complexities is a Section 754 basis step-up.
Technically, a 754 Basis Step-Up is an election in the partnership tax code permitting partners to adjust the basis of their partnership interest when a distribution, sale, or exchange of ownership occurs. A Section 754 adjusts the basis of a partnership inside basis. A Section 754 basis adjustments can be governed by Code Section 743 in the sale of partnership interest; or Code Section 734 in the distribution of property. A Section 754 can also result in a step-down of basis, but most common are basis step-ups.
How a Section 754 works in theory? Let’s say that Karl and Harry each contribute $500,000 to a partnership and purchase investment land. After a few years, the land is appraised for $2,000,000. Since the partners contributed each $500,000, the partnership basis is $1,000,000. Let’s say Karl decides to sell his partnership interest to Monty for $1,000,000. The partnership capital accounts are $500,000, less real estate taxes, and property surveillance. Let’s say Karl and Harry contributed cash to finance these yearly expenses so the capital accounts maintain $500,000. When Karl sells his partnership interest, he realizes a $500,000 capital gain. Monty on the other hand, now has an outside basis of $1,000,000.
This is where the Section 754 election works. The partnership can elect a Section 754 basis step-up and adjust the land value on the partnerships books higher to $1,500,000 of inside basis ($500,000 + $1,000,000 of outside basis). The Section 754 requires specific partnership tax filing expertise, to file the election accurately. Accounting for a Section 754 basis adjustment is additional work beyond the standard partnership filing; and this is example is easy to understand because land is not a depreciable asset.
If the partnership sells the land investment in future years for $2,200,000, the land basis would be $1,500,000, and not the original $1,000,000 of capital contributed. So the capital gain Karl realized on the sale of his interest to Monty, and corresponding Section 754 basis step-up, reduces the future capital gain inside the partnership.
If a partnership has depreciable property, then the 754 becomes increasingly complex. If the property being stepped-up is depreciable, then the depreciation on the step is allocated specifically to the purchasing partner stepping up his basis. The complexity includes the fact special depreciation schedules must be maintained to segregate that depreciation expense to the partner each year with a special allocation; resulting in additional specialized tax work.
Example: Let’s say Karl and Rob launched an excavating partnership, and each contributed a $500,000 of capital. After five years, let’s say from successful ops revenue and additional capital expenditures the partnerships equipment book value is $500,000 and fair market value is $1,000,000. If Rob sells his 50% interest for fair market value, the inside and outside basis difference of partnership on just the equipment, could result in a Section 754 basis step-up for $250,000 – capital value difference between book and fair market value (($1,000,000 – $500,000) *.5). The Section 754 would require maintaining segregated depreciation records to deduct the additional basis step-up depreciation each year, and corresponding special allocation of that expense to the purchasing partner. If Rob and Karl each sell say 15% of their interest, it only increases the complexity of tax accounting on the partnership basis adjustments.
Summary: If you are exchanging a partnership interest, talk with your tax advisor(s) on the tax ramifications.