Partnerships, Real Estate, and Selected Basis Issues

Bill Johnson, CPA, ABV

Jeff Olson, CPA

Babush, Neiman, Kornman & Johnson, LLP

www.bnkj.com

A Universal Given????

Cost = Basis

or, to say it another way,

Basis = Cost Is either just what was paid? What is “cost basis”?

What’s the Big Deal About Basis?????Transaction economics and tax accounting may differ! Why?Transactions negotiated on fair valueTax accounting may record them at something other than negotiated value

Carry over cost basis (as in 1031 exchanges with deferred gain) But, not always

What’s the Big Deal About Basis?????

It effects reported gain Who reports it How much

What is Cost?

Seems simple, but that depends: Whose cost?

The partner’s or the partnership’s Inside basis/outside basis

Depending on which you mean, then you have to determine

Is it reflected, or not, on the partnership’s books/tax records?

Partnership Basis Topics IRC Code Sections 721/704

and 754Only an overview It is very complex

What gives rise to these complicated tax accounting rules?

Can tax basis presentations ever have any useful meaning if they are not always based on the value/economics of a deal?

Problem Cause #1A Partner’s contribution of

property to, or distributions

from, a partnership generally do

not trigger a recognizable tax

event - Section 721 This is generally a good thing - deferred

recognition of appreciation gains It just screws up the tax accounting relative to

the “deal” economics

Basic Example - No Issues

Example 1: 50/50 partnership:

Partners contribute cash to buy assets-partnership cost -2,000Partnship develops, leases sells-sales proceeds 3,000

Gain 1,000

Distributions per partner 1,500Less what they put in (1,000)

Gain per partner 500

Basic Example - 721 Issue

Example 2: 50/50 partnership, $500 carryover basis:

Partner 1 contributes appreciated land - value = $1,000 (500)Partner 2 contributes cash for improvements (1,000)Partnship develops, leases sells-sales proceeds 3,000

Gain 1,500

Distributions per partner 1,500Less what they put in at value (1,000)

Gain per partner 500

Whoops, that is a total gain of only 1,000Extra gain???? Does partner 2 report any? 500

Basic Example - 721 IssueComparative balance sheets: Exple. 1 Exple. 2

Straight tax basisReal estate 2,000 1,500

Capital Partner 1 1,000 500Capital Partner 2 1,000 1,000

Total capital 2,000 1,500

Improved presentationReal estate 2,000 1,500704(c) asset 500

Total assets 2,000 2,000

Capital Partner 1 1,000 500Capital Partner 2 1,000 1,000704(c) equity-deferred gain to Partner 1 500

Total capital 1,000 2,000

Assets Subject to Debt

Other potential complications What if the asset is not sold, but

held for rental and depreciated? What if only part of the project is

sold in a tax year?● What cost is being depreciated?● How is it allocated among the partners?

Complex Example - 721 Issue

Example 3: 50/50 partnership, but contributed assets subject to debt :3-A

Land contributed - carry over basis 500704(c) asset 500Improvements funded with Partner 2 capital 1,000

Total assets 2,000

Assumed debt 750Partner 1 capital-carryover basis (land less debt assumed) (250)Partner 2 capital 1,000704(c) equity 500

Total equity 2,000

Assets Subject to Debt

Contributions of assets subject to debt can trigger recognizable gain to the contributing partner

But limited to the proportion of the debt shifted to other partners Up to the debt in excess of his basis in the contributed asset

Assets Subject to Debt

Example 3: 50/50 partnership, but contributed assets subject to debt :Debt

Calculation of gain recognition 100% ShiftedDebt relieved/assumed 750 375Contributor basis in assets (500) (250)

Excess (negative contribution/recognized gain) 250 125

Gain recognized by contributing partner increases his basis in the assetand decreases his deferred gain---Section 754 election.

Complex Example - 721 Issue

Example 3: 50/50 partnership, but contributed assets subject to debt :3-A 3-B

Land contributed - carry over basis + gain recognized 500 625704(c) asset 500 375Improvements funded with Partner 2 capital 1,000 1,000

Total assets 2,000 2,000

Assumed debt 750 750Partner 1 capital-carryover basis (land less debt assumed) (250) (125)Partner 2 capital 1,000 1,000704(c) equity 500 375

Total equity 2,000 2,000

The Problem Cause #2

Transactions betweenpartners may give rise toaccounting on thepartnership’s books:

Home Depot example Partnerships are different!

Example 754 IssueSale of partnership interest

Assets are adjusted upward (stepped up) to account for the value paid by the new partner

The purchase value of a new partner’s interest is “pushed down” to the partnership

Partner’s capital account at the date of contribution equals his purchase price

Example 754 Issue

Example 4: 50/50 partnership, sale of partnership interest:Old New

Assets 2,000 2,250

Partner 1 capital 1,000 1,000Partner 2 capital 1,000 0New partner 3 capital - 754 election 0 1,250

Total capital 2,000 2,250

Section 754 Effects

Acquiring partner’s stepped up basis gives appropriately larger depreciation deductions to that partner

Upon sale, increased basis reduces gain recognizable to that partner

Former partners are unaffected Only a proportionate step up --- not to

100% of asset values as in 704(c)

Contribution of Development Fees

Contribution of services, immediate capital account credit (capital interest)● equals immediate taxable income---

ordinary

Distribution priority (future profits interest)● No immediate tax event● If partnership gains are capital, then some

of the “services” treated as capital gain