Chapter 13 Basis Adjustments to Partnership Property

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

§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

§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

§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

Section 754 Adjustment Sec 743 adjustments Occur only when a Sec. 754 election is in place. Once the election is made, it is in place for all subsequent years unless the revocation of election is approved by the IRS. Adjustments designed to ensure that a partner’s outside basis and inside basis are the same. Total amount of the adjustment is equal to the difference between the outside tax basis and the inside tax basis. (adjustment can be positive or negative Sec. 755 mandates that the adjustment be allocated among the assets of the partnership using 2 categories (Sec 1221/1231 assets & other assets)

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

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

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.

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

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

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

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

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

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)

§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).

§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

Sec. 734 - Partnership Adjustments Designed to eliminate differences between inside and outside bases of the partnership interests that occur because of partnership property distributions. This section provides the partnership to adjust the tax bases of partnership assets in situations where the transferee partner does not take the asset at the adjusted basis in the hands of the partnership. This ultimately suggest that an effective or real gain or loss has been recognized by the recipient partner. Therefore, the partnership should adjust their bases to prevent double recognition of any gain or loss.

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

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

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

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

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

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

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