Chapter 13 Basis Adjustments to Partnership Property

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Chapter 13 Basis Adjustments to Partnership
Property
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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 partners 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

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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

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743(b) Transfers (Cont.)

• When property is held as community property and
  either the husband or wife dies, the decedents
  (but not the surviving spouses) share of the
  partnership interest is includable in his or her
  gross estate at its value on the applicable
  valuation date
• Tax basis of both the decedents and the spouses
  interest in the partnership is increased to FMV
• If the partnership has a 754 election in effect,
  the bases of both spouses shares of the
  partnership assets will be adjusted

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743(b) Adjustments-Overview

• The amount of the 743(b) adjustment to all the
  partnership properties is the difference between
  the incoming partners basis for his or her
  partnership interest and that partners share of
  the adjusted basis of the partnership property at
  the time of purchase

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743(b) Adjustments-Overview (Cont.)

• If the purchasing partners 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

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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

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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

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Making the 754 election

• The election is made by attaching a statement
  declaring a 754 election to the partnerships
  timely (filed by due date, including
  extensions) Form 1065. The statement should
  include the partnerships 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

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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 partnerships taxable year with
  respect to which the election is intended to take
  effect

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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.

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Calculating the 743(b) Adjustment

• The total basis adjustment is the difference
  between the incoming partners 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

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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

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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
  partnerships ordinary income property if the
  partnership sold all its assets in a fully
  taxable transaction

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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 partnerships
  basis in capital gain property.
• Any excess is applied to reduce the basis of
  ordinary income property

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Allocating the 743(b) Adjustment (Cont.)

• Within the class of ordinary income property, the
  basis of the purchasers 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

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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
  partnerships items of capital gain property)

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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).

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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 transferees
  distributive share of the items of partnership
  income, deduction, gain, or loss to reflect the
  effects of the transferees basis adjustment

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743(b) Adjustment Made for Benefit of Transferee
(Cont.)

• Generally, if the basis of a partnerships
  recovery property is increased as a result of the
  transfer of a partnership interest, then the
  increased portion of the basis is taken into
  account as if it were newly-purchased recovery
  property placed in service when the transfer
  occurs and any applicable recovery period and
  method may be used to determine the recovery
  allowance with respect to the increased portion
  of the basis

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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 partners 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

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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 partners 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

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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 partners
  basis adjustment
• With a 754 election, a new basis adjustment is
  calculated

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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

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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

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Amount of the 734(b) Adjustment

• If a distribution of money is greater than the
  partners 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

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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 partners
  interest the total adjusted basis of the assets
  in the distributee partners 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

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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

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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

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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 partners
  adjusted basis in the distributed property being
  less than or greater than the partnerships
  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

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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

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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

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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