Partnerships as Real Property Acquisition/Disposition Vehicles: IRC Sections 743 & 754

Jechonias S. James, Esq.

November 8, 2021

The decision to acquire real property often necessitates considerations surrounding the different methods of holding title and associated consequences. Limited liability companies and limited partnerships are often utilized as title holding vehicles because they confer several benefits, which include, amongst other things: (1) coordination of investment and business objectives; (2) tax planning; (3) liability protection; and (4) some measure of anonymity. Indeed, the decision to acquire and hold real property in partnerships has become increasingly common in the U.S. Virgin Islands, a phenomenon driven by the desire to mitigate against local taxation on certain real estate dispositions.[1] This article aims to briefly address important considerations when transferring real property held in partnerships, and, more pointedly, those transfers that involve membership interest transfer agreements.

Allocation of Basis

In a partnership, the allocation of basis amongst partnership assets and a partner’s interest is an important and ongoing consideration. Here, the “adjusted basis” of property serves as helpful tool in measuring the amount of gain or loss realized by a taxpayer upon disposition of a capital asset. Generally, a higher adjusted basis results in lower tax liability upon realization and recognition of that gain.

Basis considerations are particularly relevant when deciding to contribute property to the partnership, operate the partnership business, and make distributions to partners. A partner takes a basis in her partnership interest in an amount equal to the cash (plus the adjusted basis of property other than cash, increased by any gain recognized) contributed to the partnership—outside basis.[2] Generally, a partnership’s basis in the contributed property is the adjusted basis the contributing partner held in the property at the time it is contributed, with adjustments for gain recognized to the contributing partner.[3] And, a portion of the partnership’s basis in partnership assets is attributed to each partner in proportion to her interest in the partnership—inside basis. Thus, where a partnership is used solely as a real property acquisition vehicle, the partnership takes an adjusted basis equal to the cost of the property, and each partner’s share of the inside basis is generally equal to her respective portion of total partnership contributions (i.e. the partner’s contributed cash used to acquire the real property).[4]

Increase and Decrease in Basis

A partnership’s business operations will often trigger adjustments to the outside basis of partners as well as the inside basis the partnership holds in its assets. For example, a partner’s outside basis is increased by her distributive share of taxable income, non-taxable income to the partnership, and excess deductions for depletion over the basis of the depleted property.[5] In contrast, her outside basis is decreased by her distributive share of partnership losses, non-deductible expenditures of the partnership not charged to her capital account, and certain oil and gas property deductions.[6] Similarly, a partnership’s basis in partnership property may be decreased by deductions for depreciation of certain eligible property.[7]

Events that Cause Disparity in Inside and Outside Basis

Generally, a partner’s inside basis should match her outside basis given partnership items of income, deductions, loss, gains, and credits flow through to said partner. However, there are events that may cause a mismatch between a partner’s inside and outside basis, which include: (1) sale of part or all of a partner’s partnership interest; (2) a current distribution or distribution in liquidation of a partner’s interest; or (3) a partner dies. Relevant to this discussion is the sale of part or all of a partner’s partnership interest, which is often accomplished through membership interest transfer agreements. These transactions implicate § 743 concerns upon disposition of the property because the transferee-partner generally pays a premium to acquire the transferor-partner’s partnership interest; an amount in excess of the transferor-partner’s share of the inside basis.[8] This, however, results in a mismatch between the transferee-partner’s inside and outside bases, and creates issues regarding the amount and timing of income. Consider the following example:

A, B, and C form ABC Partnership (“ABC”), and each hold a 1/3 interest in ABC. No partner is allocated a disproportionate amount of gain. In Year 1, ABC acquires an apartment building for $120. ABC’s adjusted basis in the apartment building is $120, the inside basis. A, B, and C each have an outside basis of $40, and their respective share of the inside basis is also $40.[9] In Year 2, A sells her 1/3 interest to X for $50. X’s outside basis is $50, but her share of inside basis is $40. If ABC were to sell the apartment building for $150, the partnership would recognize $30 in gain, and allocate $10 of taxable gain to X despite the gain having accrued while A held the interest.

Here, the solution is for ABC to have a valid § 754 election in place. Section 743 provides that, upon a § 754 election, the partners in the above example are able to reallocate X’s basis to account for the mismatch in outside and inside basis. Although this article will not address the mechanics of a § 754 election, it hopefully highlights the importance of such consideration when consummating acquisitions/dispositions of real property through partnership. For more information on § 754 elections, please feel free to contact Jechonias S. James, P.C., or see your local tax professional.

DISLCAIMER: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

[1] The term “partnership” is used to denote state entities that are taxed under Subchapter K of the Internal Revenue Code. [2] 26 U.S.C. § 722. [3] Id. at § 723. [4] Partners may allocate tax items (i.e. income, deductions, gain, loss, credits) as they see fit provided that such allocations have “substantial economic effect.” Treas. Reg. § 1.704-1(b)(2). [5] 26 U.S.C. § 705(a)(1). [6] Id. at § 705(a)(2). [7] 26 U.S.C. §§ 167, 168. [8] A discounted sale of partnership interest carries the same potential. [9] Each member’s share of the inside basis is equal to their portion of the total contributions used to acquire the building ($120/3=$40).