Real estate funds and family offices are two types of investors[1] that often (i) purchase equity interests in partnerships[2] and (ii) make in-kind asset distributions for tax planning purposes.[3] Well advised real estate and family office investors will work to ensure basis is appropriately accounted for to both comply with tax laws and maximize investment returns.

Persons or funds that buy partnership equity from existing partners take a cost basis in the acquired equity and succeed to the seller’s (book and tax)[4] capital accounts and share of inside basis.[5]  This means that following an equity purchase, there is almost always a disparity between the buyer’s outside basis and share of inside basis.  The delta between the two represents the amount by which the buyer is temporarily over or under taxed.[6]  The buying partner often requires the partnership to make a § 754 election, which enables the buyer to benefit from a § 743(b) adjustment.  The § 743(b) adjustment resolves the inside versus outside basis disparity by providing the buyer with a unique special basis adjustment that treats it as if it had purchased an interest in each partnership asset.[7]

The partnership distribution rules create disparities between inside and outside basis in two common situations: (1) when the distributee partner recognizes gain or loss[8] on a distribution and (2) when the distributee takes a tax basis in distributed property which differs from that of the partnership.  In those situations, a § 734(b) adjustment provides the partnership with a basis adjustment.[9]

This post explores the intersection of §§ 743(b) and 734(b) when both types of basis adjustment apply to a factual situation.[10]  First, a § 743(b) adjustment must exist and be usable by a partner.  Second, the partnership must determine how to account for the partner specific § 743(b) adjustment when making its own basis adjustments under § 734(b).  Part of the reason for the second step’s difficulty is that § 734(b) adjustments are based on a reference to a distributee partner’s outside basis.  As noted above, once a partner has purchased equity in a partnership, there is almost always a difference in the partners’ aggregate outside basis and the partnership’s inside basis.  Therefore § 734(b) adjustments that follow distributions to a partner that purchased post-formation equity have to consider § 743(b) adjustments. Fortunately, the Treasury Regulations provide useful examples.  The following examples are adapted from those examples[11] and illustrate the application of the intersecting basis adjustment rules.

Assume Purchaser is a partner in what becomes a multi-asset real estate development partnership.  Purchaser bought its interest four years ago from Seller when the partnership had only a single asset (Building-1) with a § 754 election in place.  Purchaser’s § 743(b) adjustment was $1,000, all of which was allocated to Building-1.  Partnership later acquired Building-2 and earned cash from rental operations. For the following examples assume the partnership books-up in preparation of making a liquidating distribution and has no debts, so that its balance sheet reads as follows:

Further assume that Partner-1 and Partner-2 each have $4,000 outside basis, and Purchaser has a $5,000 outside basis.  Each partner’s share of inside basis will equal one-third of the $12,000 total, or $4,000 each, but Purchaser also benefits from its $1,000 § 743(b) adjustment.

Issue 1: Partnership completely liquidates Partner-1’s interest in exchange for Building-1.

Issue: Preserving § 743(b) adjustments when property to which such adjustment is subject is distributed to another partner.

Analysis: The partnership will liquidate Partner-1’s interest for Building-1. However, Purchaser has a $1,000 § 743(b) adjustment in Building-1. The Treasury Regulations prevent Purchaser from losing its adjustment by first allocating its $1,000 special basis adjustment among the partnership’s remaining assets of the same class.[12]  Since Building-2 is the only other capital asset, Purchaser’s § 743(b) adjustment is applied to Building-2. Next, the partnership has to calculate its § 734(b) adjustment.  Partner-1 takes a basis in Building-1 equal to its outside basis of $4,000,[13] which is $1,500 more than partnership’s basis in Building-1, so a negative § 734(b) adjustment of $1,500 is required. Partnership must reduce its tax basis in Building-2 by $1,500 to $500.

Issue 2: Partnership completely liquidates Purchaser for cash.

Issue: Accounting for a § 743(b) adjustment after an all-cash liquidation.

Analysis: Purchaser will receive cash in the amount of $7,500 when it has an outside basis of $5,000. Purchaser will therefore have a $2,500 capital gain because of the distribution.[14]  Purchaser fully recovered its after-tax investment in the partnership.[15]  Normally when a partner recognizes gain on a distribution when the partnership has a § 754 election in place, a § 734(b) adjustment is required.  Here that adjustment would (seemingly) be a positive $2,500.[16]  However, the remaining partners have a collective outside basis of $8,000 and the Partnership’s remaining total inside basis (in the two buildings) equals $4,500, for a difference of $3,500.  If the partnership’s § 734(b) adjustment is a positive $2,500, then Partner-1 and Partner-2 still have an inside-outside basis disparity of $1,000.  Thus, if Purchaser’s § 743(b) adjustment is not considered, then $1,000 of after-tax basis is lost. 

Fortunately the Treasury Regulations supply a helpful answer. If a partner is liquidated but does not use a remaining § 743(b) adjustment in determining its basis in distributed property then the remaining adjustment will affect the partnership’s remaining property.[17]  The $2,500 § 734(b) adjustment is increased by Purchaser’s § 743(b) adjustment amount of $1,000 to $3,500.  The $3,500 will be allocated among Building-1 and Building-2 under the § 755 regulations.[18]  This is a somewhat common scenario in an all-cash liquidation because Purchaser receives no property for which it’s § 743 adjustment can be used.

Issue 3: Distribution of Building-1 to Purchaser.

Issue: Accounting for a partnership’s § 734(b) adjustment when property subject to a § 743(b) adjustment is distributed to the partner benefitting from the § 743(b) adjustment.

Analysis: In this case property for which Purchaser has a § 743(b) adjustment is being distributed to it in liquidation of its interest. Purchaser’s outside basis is $5,000 and no cash is being distributed, so the $5,000 is allocated to Building-1.[19] This means that Purchaser’s § 743(b) adjustment is embedded in the building and Purchaser is made whole.

Before Purchaser’s interest was liquidated, its outside basis was $5,000, which is $1,000 more than its $4,000 share of inside basis. Further, Building-1’s tax basis increased in Purchaser’s hands from $2,500 to $5,000, which ordinarily means the Partnership has a negative § 734(b) adjustment equal to the amount of basis gained.[20]  If the Partnership applies a $2,500 § 734(b) reduction to Building-2, then Building-2’s tax basis is reduced to zero.  The Treasury Regulations again supply a fix. They provide that Purchaser’s § 743(b) adjustment must be added to the Partnership’s basis in Building-1 immediately before the distribution.[21] Using this rule, immediately before the distribution, Partnership’s tax basis in Building-1 increases by $1,000 (the amount of Purchaser’s § 743(b) adjustment) from $2,500 to $3,500.  When Purchaser receives Building-1 in liquidation of its interest, it spreads its $5,000 outside basis to Building-1; thus, the negative § 734(b) adjustment to Partnership is only $1,500.  Building-2’s tax basis therefore decreases from $2,000 to $500.  In this way Partner-1’s and Partner-2’s aggregate outside basis of $8,000 equal the Partnership’s remaining inside basis which consists of $7,500 and the $500 of tax basis in Building-2.

The foregoing examples are tailored from regulatory examples and illustrate only a few ways in which §§ 734 and 743 adjustments interact. These adjustments must often be considered in real estate partnerships and energy partnerships where in-kind distributions are occasionally used to liquidate interests. Thoughtful tax planners should consider the intersection of these types of basis adjustments in order to both comply with tax laws and ensure proper basis recovery.

[1] All partnerships must contend with these rules (although this is an area many tax professionals prefer not to think about). However, real estate funds and family offices are more frequently subject to these adjustments than many types of investors.

[2] “Partnership” as used in this post, refers to any entity taxed under Subchapter K of the Internal Revenue Code of 1986, as amended (the “Code”).  All “§” references used herein refer to specific sections of the Code.  

[3] For example, some partners in a real estate venture may wish to execute Code Section 1031 exchanges on exit while others want cash. Certain in-kind distributions can sometimes be used to facilitate such planning.

[4] Treas. Reg. § 1.704-1(b)(2)(iv)(l).

[5] In this context, inside basis refers to a partner’s share of the tax basis of partnership assets.  “Outside basis” refers to the partner’s tax basis in his, her, or its partnership equity and is a measure of the partner’s after-tax investment in the partnership.

[6] Temporary over taxation is relatively common, because if the partnership sells its assets for a gain, the buyer, having succeeded to the seller’s capital account, is taxed on income which the seller already recognized when it sold the partnership interest.  The over taxation is temporary in the sense that the buyer will eventually be able to recover its outside basis.

[7] Section 743(b) adjustments are mandatory in some cases and the special basis adjustment amount is applied to partnership assets under § 755.  The special basis adjustment under § 743(b) is unique to the buyer.  A full discussion of all aspects of the adjustment is beyond the scope of this post, but a quick method of checking the amount of a § 743(b) adjustment is to compare it to the purchaser’s outside basis less the sum of inherited tax capital plus liabilities (i.e. share of inside basis). 

[8] Recognizing a loss on a liquidating distribution is rarer than gain recognition.

[9] A full discussion of § 734(b) is beyond the scope of this post, but like § 743(b), such adjustments can be mandatory, and the application of § 755 with respect to the adjustment amount is not discussed in this post.

[10] This post is neither exhaustive nor intended to provide a detailed discussion of every basis adjustment intersection scenario. For example, it omits the potential application of § 751(b) or the Code’s mixing bowl rules.

[11] The examples presented in this post are highly simplified as compared to most commercial transactions and even the regulatory examples. See, e.g., Treas. Reg. § 1.743-1(g)(5) which includes a fairly sophisticated example with five assets. This post’s examples also omit debts.

[12] See Treas. Reg. § 1.755-1(c); Treas. Reg. § 1.743-1(g)(2)(ii) (“A transferee with a basis adjustment in property that is distributed to another partner reallocates the basis adjustment among the remaining items of partnership property under Section 1.755-1(c).”)

[13] Purchaser’s § 743(b) adjustment is preserved in Building-2 via Treas. Reg. § 1.743-1(g). As such, § 732(b) provides that Partner-1 spread its remaining outside basis over the distributed property.

[14] See § 731.

[15] In other words, Purchaser’s share of inside basis of $4,000 plus its § 743(b) adjustment of $1,000 equals the outside basis recovered.

[16] § 734(b)(1)(A).

[17] Treas. Reg. § 1.734-2(b)(1) (“If a transferee partner, in liquidation of his entire partnership interest, receives a distribution of property (including money) with respect to which he has no special basis adjustment, in exchange for his interest in property with respect to which he has a special basis adjustment, and does not utilize his entire special basis adjustment in determining the basis of the distributed property to him under section 732, the unused special basis adjustment of the distributee shall be applied as an adjustment to thebasis of the property retained by the partnership…”) (emphasis added).

[18] Treas. Reg. § 1.755-1(c).

[19] § 732(b).

[20] See § 734(b)(2)(B) (Decrease the basis of partnership property [in distributions to which § 732(b) apples] by the excess of the basis of the distributed property to the distributee over the adjusted basis of the distributed property to the partnership immediately before such distribution.)

[21] See Treas. Reg. § 1.734-2(a).