Inheriting a partnership interest in real estate can be a complex process, especially when it comes to understanding the tax implications. One of the most important considerations is the step-up in basis, which can significantly affect the amount of taxes owed.
Having provided real estate consulting and CPA services for numerous partnership properties, we’ve encountered many heirs who were unfamiliar with the process and had no idea how to navigate their inheritance. We developed this article to help guide such individuals. We’ll explain the step-up rules in real estate for a partnership inheritance and detail the steps we recommend taking after inheriting a partnership interest that is invested in real estate.
Understanding the Step-Up Rules
One term that’s helpful to understand when it comes to inheriting interests in partnerships is “adjusted basis”, which refers to the original cost of an asset for tax purposes—typically the purchase price—that is adjusted for improvements, depreciation, and other factors. Adjusted basis is crucial for calculating capital gains or losses when property is sold.
The Internal Revenue Code (IRC) Section 743 provides for basis adjustments to partnership property in specific circumstances, including when a partnership interest is sold, exchanged, or when a partner passes away. If a partnership has made a Section 754 election, the tax basis of the partnership’s property (the inside basis) can be adjusted to match the value of the partner’s interest in the partnership (the outside basis). Making this adjustment helps resolve disparities between the partner’s share of inside property tax basis and the outside tax basis of their partnership interest to ensure consistent taxation.
There are three scenarios under Section 743 that can trigger basis adjustments:
- Sale of Partnership Interest: When a partner sells their interest in the partnership, the disparity between the inside and outside basis can create tax complications.
- Exchange of Partnership Interest: Similar to a sale, exchanging partnership interests can trigger the need for a basis adjustment.
- Transfer Upon Death: When a partner passes away, their partnership interest is typically transferred to their heirs. This transfer can result in significant tax benefits if a step-up in basis is applied.
Benefits of a Step-Up in Basis
In real estate, property values often appreciate significantly over time. When a deceased partner’s interest in a real estate partnership is transferred to an heir, the heir’s basis in the property can be stepped up to the fair market value at the date of the partner’s death. This higher basis may provide larger depreciation deductions and reduced taxable gain upon later sale of the property.
Let’s look at an example: A partner passes away holding a partnership interest with a tax basis of $100,000 and a fair market value of $1,000,000. If the partnership does not have a 754 election in place, the beneficiary receives a tax basis in his partnership of $1,000,000, but there is no change to the tax basis of the partnership’s property. However, with a754 election, the partnership may step-up the beneficiary’s share of adjusted basis of partnership property by $900,000, the difference between the partner’s tax basis in his interest and the fair market value of his interest. To the extent the appreciation is allocable to depreciable or amortizable assets, the beneficiary will be entitled to increased depreciation or amortization If the partnership were to sell the property, any remaining undepreciated step-up basis will reduce the partnership’s gain allocated to the new partner.
What Is a Section 754 Election?
A Section 754 election is a one-time election that allows the partnership to make adjustments to increase or decrease the adjusted tax basis of its property to match the new partner’s outside basis in certain circumstances. This election must be made by the partnership, typically at the discretion of the general partner (or manager if an LLC), and isn’t mandatory If there is no Section 754 election in place, the partnership can make the election on its tax return for the year, or it can choose not to adjust the basis as long as the property has not lost over $250,000 of value. Once a Section 754 election is made, the partnership is required to adjust the basis on all future scenarios that trigger basis adjustments. If there is a sale, exchange, or transfer upon death, the partners must notify the partnership within a specific amount of time. The respective timeframes are:
- Transfer Upon Death: The partnership must be notified within one year of the partner’s death.
- Sale or Exchange of Partnership Interest: The partnership must be notified within 30 days of the sale or exchange of the partnership interest.
4 Steps for Handling Partnership Inheritance
To keep things as straightforward and stress-free as possible, we recommend following these four steps upon inheriting a partnership interest. Based on our experience in real estate consulting, following this process will help you avoid future complications or tax discrepancies:
- Appraise the Property: As the heir, it is your responsibility to provide the required information to the partnership. An executor or administrator of the estate or trustee of a trust may obtain valuations of the estate’s assets in order to determine its fair market value (FMV) at the date of death, net of any appropriate discounts. This appraisal is essential for accurately determining the step up on the partnership return as well as the value of the partnership interest reported on the estate tax return, if necessary.
- Consult Professionals: Engage CPA services or a tax professional to navigate the complexities of basis adjustments. They can help ensure that the step-up in basis is applied correctly and that all tax implications are considered.
- Coordinate with the Partnership: Inform the partnership’s CPA and your CPA or attorney about the inherited interest. Make sure that the value used for the partnership step-up matches the estate return value to avoid discrepancies.
- Consider the Timing: Be sure to adhere to the specific timelines for notifying the partnership of a transfer, as we detailed above.
Stay Informed About Step-Up Rules for Your Inherited Real Estate
Inheriting a partnership interest in real estate can be financially advantageous, especially if you’re able to take advantage of the step-up rules. Understanding IRC Section 743 and the benefits of a Section 754 election is crucial for managing the tax implications of your inheritance. For more detailed information, refer to the IRS guidelines on basis adjustments.
By engaging CPA services and ensuring accurate appraisals and reporting, you can maximize the benefits of your inherited property. Contact us to learn more.