In previous articles the issue surrounding a variance in inside and outside basis has been discussed and examples provided. Now the question arises, can the issue be fixed? The article below has been prepared by a Denver tax attorney at The McGuire Law Firm to further this discussion and to discuss the 754 election.
In our previous example, Woody purchased his 25% interest from Terry and even though Woody receives step up in basis to the purchase price, he will step into Terry’s shoes regarding the capital account and his share of the inside basis. Thus, the variance & disconnect between inside an outside basis has been created.
The variance may be prevented if the partnership makes an election under IRC Section 754, which allows a partnership to adjust the inside basis of partnership property when there is the sale of a partnership interest under IRC 743 or there is a distribution of partnership property under IRC 734.
In this article, we will discuss the scenario whereby a partnership interest is sold, which will match the fact pattern we have been following whereby Terry sold his interest to Woody.
So how can IRC Section 754 help? Under Section 743, the inside basis of partnership property is adjusted as the result of a sale of a partnership interest if a Section 754 election is made. The partnership can increase the adjusted inside basis of its property by the excess of the purchasing partner’s outside basis in the partnership interest over such partner’s share of the partnership’s inside basis of partnership assets.
Based off of our example, when Woody purchases the interest for $350,000, his outside basis will be $350,000 and inside basis is $250,000. If a Section 754 election is made or in effect the partnership can increase the basis of the asset by the excess of Woody’s outside basis in the interest over Woody’s share of the inside basis. Thus, the partnership could increase the basis of the land by $100,000 ($350,000 – $250,000). The $100,000 should match the amount that the selling partner (Terry) recognized on the sale. It is important to remember that the basis increase is a tax concept only and specific to Woody, the purchasing partner.
Ok, so the election has been made, what happens when the partnership now sells the land? There will be a book gain of $400,000 because the book basis was still $800,000 and the property sold for $1.2 M. Thus for book purposes $100,000 would be allocated to all partners and increase their capital accounts to $350,000. When computing the partnerships tax gain, the basis in the land for tax purposes is $900,000 rather than $800,000 because of the $100,000 increase. Thus, $300,000 of tax gain is recognized which is allocated to the three partners apart from Woody (John, Jimmy and Jeff) and no gain is allocated to Woody. This gain will increase outside basis of the other three partners. Thus now the partner’s all have a capital account of $350,000 and basis of $350,000.