When ownership changes within an LLC or partnership, there’s a lot to think about. Despite the flurry of activity that may occur, a Section 754 election should be considered. That’s because this election, per Internal Revenue Code Section 754, could provide substantial tax timing benefits, especially for partnerships that hold commercial real estate.
Generally speaking, the 754 election allocates a step up in basis to the partnership’s underlying assets. Here’s what it could mean for your partnership.
What triggers a 754 election?
The 754 election could be triggered by three events:
- When units are redeemed by the partnership
- When a partner sells units
- Upon the death of a partner
How does it work?
If the partnership were to make a 754 election following any of the above events, the partner or partnership would see a step up in the basis of its assets.
For example, let’s say the tax basis capital of a partnership is $500,000, but the fair market value of the real estate held by the partnership is $1,500,000. If Partner A were to buy out Partner B who is a 25 percent partner, Partner A would purchase Partner B’s units for fair market value, or 25% of the $1,500,000 value, so $375,000. By making a 754 election, Partner A would be able to step up the differential between the tax basis capital and fair market value they paid for the units purchased from Partner B.
So Partner A would get a step up in the assets of the partnership, including real estate, $250,000 ($1,500,000 * 25% = $125,000 – $375,000), This means Partner A who made the $375,000 purchase would now be able to depreciate the $250,000 they paid for the purchase over the tax basis of the asset in the partnership and get an annual ordinary tax deduction.
If the partnership did not make the 754 election and the $250,000 paid in excess of the capital in the partnership by Partner A, this would add basis to Partner A’s partnership units (not the real estate). Thus, this strategy would not provide a tax benefit until Partner A sold their units or the partnership liquidated. The $250,000 step up in basis asset would be depreciable over the tax life of the related assets of the partnership. In this case, Commercial real estate would be depreciated over 39 years.
What about future partnership ownership transitions?
Once you choose to make a 754 election, it will apply to any of the three triggering events going forward. You can revoke an election, but this requires IRS approval. This is important to know this because there are times where it may not be advantageous, such as when you have depreciated value assets held in the partnership.
How do I make the election?
The partnership must make the election (and include the calculation of the step up) on the return for the tax year in which the triggering event occurred. It is possible that the IRS would grant late relief for a late election.
Does it make sense for my partnership?
Making a 754 election is typically a wise move for a commercial real estate partnership; however, be sure to discuss its potential benefits and ramifications with your tax advisor. Because the election can apply to all events going forward, it’s important to consider the future, too.