Geoffrey Kayton, CPA
04.26.21 | TAX Chat
Step-ups are powerful, and I believe they should be more widely understood. To that end, the following paragraphs attempt to explain this topic for those of us who are not tax nerds. I have done so using a real estate partnership context.
A step-up is an adjustment to basis, which accounts for an increased value, on the date of a taxable event. In the real estate partnership context, the most common taxable events, giving rise to step-ups, are the redemption or death of a partner, or a sale of an interest from an existing partner to a new one. This statutory mechanism accounts for differences between a partner’s basis (outside basis) and the allocated share of basis in partnership assets (inside basis).
Adjusting basis of partnership assets, for an increase in value, is elective (i.e., IRC 754 Election). When a step-up occurs, the basis in the partnership’s assets are adjusted according to relative unrealized/built-in gain of the assets. Step-ups associated with a transfer from an existing partner to a new partner are owned by the recipient, and reported by the partnership (i.e., IRC 743 Basis Adjustment). This type of transfer can be a taxable sale or transfer to a decedent’s estate. Alternatively, another opportunity occurs when a partnership purchases an interest from a partner in a taxable transaction and in excess of tax basis (i.e., IRC 734 Basis Adjustment). This step-up is owned by the partnership and is reported on the partnership’s balance sheet. The adjustments are made to the assets owned by the partnership. For either type, if the adjusted assets are depreciable, then the step-up is also depreciable. Also, in the event of an asset disposition, since step-ups are associated with specific assets, the undepreciated basis of the associated step-ups are also written off against the gain or loss on disposition.
To provide some context, here are some examples.
Example 1 (IRC 743): On the date of his passing, Joe personally owns an interest in a real estate partnership with a basis of $10,000. It’s valued at $30,000 for his taxable estate. The interest now owned by Joe’s estate is eligible for a basis adjustment of $20,000. The step-up is allocated among building and land based on relative built-in gain, and the portion allocated to building is a new depreciable asset, which tracked by the partnership and owned by Joe’s estate. These mechanics are similar to that of a sale from one partner to another.
Example 1.1 (IRC 754 vs no 754): Assume the same facts as Example 1 and further assume that sometime later the partnership sells the real estate, but does not dissolve the partnership. Also assume, the gain on the sale allocated to Joe’s estate is $20,000, and the estate took $500 of depreciation on the step-up. Joe’s estate reports a $500 gain. That is, $20,000 gain allocated, and $19,500 of net step-up basis written off.
Now, let’s assume the partnership did not make a 754 election. Joe’s estate cannot write off the excess basis, because no step-up exists. In a weird turn of events, the estate is fully taxed on the $20,000 gain and the difference remains trapped as basis in the partnership interest until it’s disposition.
Example 2 (IRC 734): Jane is excited to retire. She wants to sell her interest in a real estate venture. The basis in her interest is $100,000, with a fair market value of $500,000. An unrelated party makes an offer of $500,000. Her partners have the right of first refusal, and they pay $500,000 for the interest, using cash from the partnership. Jane has a $400,000 gain on redemption. This is an opportunity to adjust the basis of the real estate owned by the partnership. The new basis is allocated among building and land based on relative built-in gain and is owned by the partnership. The amount allocated to building is depreciable. The tax attributes of the step-up are allocated among the remaining partners based on the partnership agreement.
When joining an existing partnership, it’s important to understand whether a 754 election is in place, or should be made, and the types of assets within. As indicated by the examples, these facts can drastically change after-tax returns on your investment. When there is a death in the family, it’s important to understand the assets that are part of the estate, and the newly-adjusted basis. These concepts can be complex, so, in many cases, gaining a general understanding is not enough. If you need help, contact to your Berdon Tax Advisor (the sooner, the better); many of us deal with these issues constantly.
Questions: I can be reached at 212.331.7525 | firstname.lastname@example.org
Geoffrey Kayton is a Tax Manager with more than 10 years of professional experience. He advises a diverse array of clients across the real estate sector on a variety of tax matters.