Real Estate Private Equity Funds: The Key Internal Revenue Code Section 754 Takeaways

It is always a smart move to take advantage of tax benefits that are available. A good example of how you can use rules and regulations to your potential advantage would be Internal Revenue Code Section 754. 

With a section 754 election, there is an opportunity to apply depreciation and amortization rules in relation to increases in asset values in the context of real estate private equity funds and increases in asset values over that partnership’s adjusted costs. 

Here is a look at some of the key aspects associated with a section 754 election and certain specific considerations that are relevant when it comes to the context of real estate private equity funds. 

It also helps to look at a couple of typical scenarios where a section 754 election would come into play. 

Section 754 election explained 

The purpose of a Section 754 election is to allow a partnership to declare an election that will step up or increase the basis of the assets held within the partnership. 

This election is a tax instrument that can be used in a step-up situation to equate a partner’s basis in their interest in the partnership. In effect, it is a way of altering an interest, from an outside interest to an inside interest, for instance in a tax efficient way. 

This election is available in several forms. It can either be in the form of distribution of partnership property or by way of a transfer of an interest by a partner. This event might be triggered by a death or simply as a proposed exchange or sale of an asset. 

When an event like this takes place through the partnership it is viewed as a taxable transaction. This could be a scenario such as when a partnership purchases an interest from another partner. This can be a transaction that involves either distributing cash or redeeming property in respect of a partner’s interest.

This step-up is considered allocable to all of the partners. The transaction is subsequently reported on the partnership’s balance sheet. This described process is known as a Section 734(b) basis adjustment. 

It should be noted that when there is a taxable sale or exchange of a partnership’s interest, or a transfer of a descendants estate due to the death of a partner, the step-up can only be allocated to the new partner. This is a Section 743(b) basis adjustment. 

The subsequent elections are made alongside correspondence detailing the Section 734(b) and 743(b) in the form of a written statement that also includes calculations of the step-up. This has to be submitted in a timely manner in line with tax return requirements. 

This election is generally regarded as irrevocable and is considered an election for the tax year it is filed in and any subsequent years. There are extreme circumstances where this election could be revoked, but it is rare and requires IRS consent. 

Therefore, it is wise to seek appropriate professional guidance before submitting any election to the IRS. 

In what way does Section 754 offer benefits to a partner? 

An obvious question to ask is how does the Section 754 election deliver tangible benefits? 

In a situation where the partnership’s assets also include amortizable or depreciable property, the increase in basis that Section 754 provides allows a partner to take amortization and depreciation deductions on an incremental basis. 

This can be done at the beginning of the chosen year of election, although it is possible to do it later if the partnership is going to be sold or liquidated. 

Key takeaways to know about Section 754 Election 

If you are considering an opportunity to buy into a partnership it is very important to appreciate and understand the equity value of the existing assets held in the partnership and how it might impact your tax obligations. 

The primary purpose of a Section 754 election of the tax code provides a legal framework where the code allows the partnership to make an adjustment to their tax basis. The reason for doing this would be to help prevent new partners from paying taxes on either gains or losses that they have not benefited from. A key to using a Section 754 election is understanding how it changes the landscape regarding partnership taxation. It helps when you know more about inside basis, outside basis, step-ups and step-downs, and when they can be applied in the most tax-efficient way. 

A partnership, from a tax perspective, is considered to be an entity where any income or losses made by the partnership is passed to each partner, divided according to ownership percentages. There are certain scenarios where it can be advantageous to be a partnership rather than a corporation. Always check with a professional advisor whether this is the best option.

 In simple terms, when talking about inside and outside basis, inside basis means the partnership’s valuation of an asset, often the figure they paid for an asset, and outside basis describes each individual partner’s value of an asset. 

It helps to create this distinction between inside and outside basis when transacting an ownership change or for distribution purposes. 

When should you opt to make a 754 Election? 

There are two main ways to help assess whether it might be beneficial to make a 754 Election. 

The first would be to make a comparison between the valuation on the balance sheet and the assets and liabilities of the partnership. Another consideration would be to consider whether making a 754 Election step-up would minimize the tax burden by allowing for amortization and depreciation deductions. 

It should be noted that making a 754 Election can create additional administrative burdens that may be considered onerous. However, if it is a situation that creates a more advantageous tax liability for the partnership, it may be considered worthwhile dealing with the added filing requirements. 

When you consider that a 764 Election is generally irrevocable, it makes sense to talk to a professional about your options before you make any final decisions.