Section 754 Elections for Real Estate Private Equity Funds
December 12, 2022
By David Rackman
Internal Revenue Code (“IRC”) Section 754 elections provide certain new partners in a partnership with the opportunity to take additional depreciation/amortization for increases in asset values over a partnership’s adjusted cost basis. The following is a brief overview of the election and includes a discussion of special considerations in the private equity/fund context.
Consider These Three Scenarios
- A partnership buys out an investor in a fund, and a key question arises as to whether there is any tax benefit for the buyout.
- An investor’s estate notifies the fund that the investor has passed away. Since there is a “step up” of basis at death, the estate would like to know whether the partnership can make a Section 754 election with respect to its investment.
- An investor purchases an interest in the fund from another investor.
What Is a Section 754 Election?
A Section 754 allows a partnership to elect to increase, or step up, the basis of the assets within the partnership. The step-up is used to equate, for tax purposes, the partner’s basis in their interest in the partnership (i.e., outside basis) to the partnership’s basis in its assets (i.e., inside basis). The election is available in either a distribution of partnership property or a transfer of an interest by a partner (by sale/exchange or death).
When a partnership purchases an interest from a partner (i.e., distributes cash and/or property in redemption of the partner’s interest) in a taxable transaction, the step-up is allocable to all partners and is reported on the partnership’s balance sheet. This is known as a Section 734(b) basis adjustment.
Where there is a taxable sale/exchange of a partnership’s interest or transfer to a decedent’s estate due to the partner’s death, the step-up is allocable only to the new partner. This is known as a Section 743(b) basis adjustment.
The election and corresponding Section 734(b) or 743(b) basis adjustment are made by the partnership by attaching a written statement, which includes calculations of the step-up, with a timely filed (including extensions) tax return. The election is in effect for the year filed and any subsequent years. It is generally irrevocable, although it can be revoked, in extremely limited circumstances, with IRS consent.
How Does the Section 754 Election Benefit the Partner?
When the partnership’s assets include depreciable or amortizable property, the increase in basis will allow the partner to take incremental depreciation and amortization deductions beginning in the year of the election, or if later when the property is placed in service (rather than reducing gain when the partnership interest is sold or the partnership is liquidated).
Partnership A purchases an interest in Fund X from John, an existing investor, for $400. John’s tax basis in the partnership is $100. Fund X owns a residential building previously placed into service.
The excess of the purchase price ($400) over the cost basis of the interest ($100) would be eligible for a step-up. This amount ($300) would be allocated among the fund’s assets based on the fair market values of each of the components as compared to each component’s relative tax basis. This example assumes that the only assets are land, building, and bonus-eligible furniture and fixtures.
To illustrate the effects of a cost segregation study on a Section 754 election, assume that Fund X orders a cost segregation study on the building. The property components allocable to Partnership A, based on the current fair market value, are as follows:
|Property Type||Value||Tax Basis||Step-Up Allocated|
|Building (27.5-year life)||240||60||180|
Furniture and Fixtures (7-year life; eligible for bonus depreciation
In addition to receiving an allocation of a pro-rata percentage of the depreciation on the existing tax basis of the partnership’s assets, a Section 754 election and corresponding 743(b) basis adjustment would allow Partnership A to take a total of $82 additional depreciation in the first year of the election, comprised of $7 for depreciation relating to the building ($180 over 27.5 years) and $75 of 100% bonus depreciation relating to the furniture and fixtures.
Section 754 Election in the Private Equity/Fund Context
While making a Section 754 election is generally advantageous, it is not necessarily practical in the fund context. Here are several issues in the private equity/fund context:
The election is irrevocable – Absent very limited and specific circumstances, the Section 754 election is irrevocable. The irrevocability of the election means that the fund would be required to make basis adjustments for all future transfers of partner interests (by purchase or death) as well as distributions of partnership property. This can be especially cumbersome in larger funds.
The election must be made by lower-tier partnerships (“LTPs”) – To take advantage of depreciation and amortization deductions for assets owned by LTPs, the Section 754 election would have to be made by both the fund and the LTP. The LTP may be unwilling to do so where an investor’s interest is not significant enough or due to any of the other above/below-mentioned issues.
Timing of fund lifecycle – A fund may be in the later stages/years of its fund term, and the timing of immediate deductions relative to the exit period are not long enough to render the election worthwhile.
Increased compliance costs – Compliance costs for making elections—as well as other administrative costs such as tracking the Section 754 assets’ basis and depreciation/amortization schedule, cost segregation studies and so forth—mean the after-tax benefits are not always worth the deductions received by making the election.
While the Section 754 election can be a beneficial tax election, the election should be made only in limited circumstances in the fund setting. Managers should have discussions with their tax advisors on the benefits and burdens associated with the election because each specific scenario will call for different considerations. Similarly, while forming a fund, managers should consider including language in fund organizational documents that addresses whether the fund would make a Section 754 election along with who has the authority to do so.