Advantages of an optional partnership basis adjustment.

• Author: Ellentuck, Albert B.

Optional basis adjustments allow partners to correct certain distortions by increasing (or decreasing) the transferee's allocable basis in the underlying partnership assets

The transfer of a partnership interest can cause a discrepancy between the transferee partner's inside and outside basis when the partnership's basis in its assets does not equal fair market value (FMV) at the time of the transfer. One result of this discrepancy is that in the case of appreciated property, the transferee will recognize taxable gain when the partnership sells the property even though the transferee has not realized an economic gain (i.e., because the transferee paid for the unrealized appreciation when he acquired his interest). The transferee partner is also limited to his allocable share of depreciation based on the partnership's adjusted basis.

Example 1: E purchases a 25% interest in G Partnership for $10,000. G Partnership's sole asset is a tractor-trailer with a $16,800 adjusted basis. Without a Sec. 754 election, E's allocable share of the remaining depreciation deductions is $4,200 (25% of $16,800). If E had purchased a 25% interest in the tractor-trailer itself, his total depreciation deductions would be $10,000.

The optional basis adjustment election is an attempt to allow partners to correct these types of distortions by increasing (or decreasing) the transferee's allocable basis in the underlying partnership assets (to simulate the effects of a direct purchase of an undivided interest in the partnership assets by the transferee).

Of course, if the partnership's basis in the property is greater than the FMV of the property, the optional basis adjustment has a negative effect. Therefore, before a practitioner recommends that the partnership make a Sec. 754 election, he or she must consider the FMV of all partnership property in relation to its basis. Since the Sec. 754 election applies to all transfers and property distributions made during and after the year that the election is made, the practitioner must also consider potential future appreciation and depreciation, and future transfers and distributions. A basis adjustment is required to be made to a transferred partnership interest if the partnership has a substantial built-in loss immediately after the transfer (unless the partnership is an electing investment partnership or a securitization partnership).

Example 2. Determining the tax advantages of a Sec. 754 election upon the sale of a...