Navigating Secs. 743 and 734 in the current economy.

• Author: Smith, Edward J., Jr.

Given the current economy and the resulting decline in the value of investment partnership portfolios, tax practitioners must be familiar with the mandatory basis adjustments under Secs. 743 and 734 and the alternative rules for electing investment partnerships (EIPs).

Historically, in an appreciating asset environment, a partnership would make a Sec. 754 election upon the taxable transfer of an interest in the partnership or death of a partner. That election would allow the partnership to increase the basis of its assets for the benefit of the transferee partner under Sec. 743, reflecting the excess of the transferee's basis in the acquired partnership interest over his or her share of the partnership's basis in its assets. Where asset values are decreasing, a partnership would not make a Sec. 754 election where the transferee's basis was less than his or her share of the partnership's inside basis because, by doing so, the partnership would be required to make a negative basis adjustment.

Similarly, a partnership would tend to make a Sec. 754 election upon making a distribution to a partner that would cause a positive basis adjustment to the partnership's assets under Sec. 734(b) but would not make the election if the resulting adjustment would be negative.

Secs. 734(b) and 743(b) were originally made elective because Congress recognized that computing and tracking the resulting basis adjustments could be a significant administrative burden. However, that electivity also provided planning opportunities that Congress came to consider abusive. In October 2004, Congress significantly reduced the perceived abuse potential by enacting the American Jobs Creation Act of 2004, P.L. 108-357. The act amended Secs. 743 and 734 to require negative basis adjustments in certain cases even in the absence of a Sec. 754 election. Negative Sec. 743 adjustments are now mandatory where there

is a "substantial built-in loss" in the partnership immediately after the transfer, and negative Sec. 734(b) basis adjustments are mandatory where there is a "substantial basis reduction."

Substantial Built-in Loss Under Sec. 743(d)

Under Sec. 743(d), a substantial built-in loss exists when the adjusted basis of partnership property exceeds its fair market value by more than $250,000.

Example 1: Three partners, A, B, and C, each contribute $1 million to Partnership ABC. ABC does not make a Sec. 754 election. ABC purchases land for $3 million, which subsequently declines...