7766 / What is the effect of a partnership not electing to adjust the basis of partnership property on the sale or exchange of a partnership interest or on the death of a limited partner?
Large syndicated limited partnerships generally state that they will not elect to adjust the partnership basis in property on the sale or exchange of an interest or on the death of a partner. Failure to make the election can have unfavorable tax consequences for an individual who purchases or succeeds to an interest.
Generally, a partner’s adjusted basis in a partnership interest reflects the partner’s proportionate share of the partnership’s basis in its property. However, this is not necessarily true of a person who buys or succeeds to a partnership interest from another partner. See Q 7757, Q 7765.
Example. A, B, and C are partners in a partnership having $3,000 in cash, and real property with an adjusted basis of $24,000. Each partner’s adjusted basis in his partnership interest is $9,000. C sells his 1/3 interest in the partnership to D for $15,000, at a time when the fair market value of the land is $42,000. The balance sheet of the partnership at the date of sale shows the following:
| Assets | Capital | ||||
| Assets | adjusted basis | market value | adjusted basis | market value | |
| cash | $ 3,000 | $ 3,000 | A | $ 9,000 | $15,000 |
| land | 24,000 | 42,000 | B | 9,000 | 15,000 |
| $27,000 | $45,000 | C | 9,000 | 15,000 | |
Following the sale, the partnership’s adjusted basis in its property remains at $27,000 and each partner’s share of partnership basis remains at $9,000, but D’s basis in his partnership interest is $15,000, its cost to D.
If the land is sold in 2024 for $42,000, its fair market value, the partnership will realize a capital gain of $18,000. Each partner must report a capital gain of $6,000 as the partner’s distributive share of the partnership gain. In effect, D is now realizing gain and paying tax on $6,000 of appreciation that was already included in the purchase price paid to C (and that was taxed to C at that time).
Assume the partnership terminates in 2025, distributing $15,000 to each partner in liquidation of his or her 1/3 interest. D has an adjusted basis of $21,000 in the partnership interest ($15,000 purchase price plus $6,000 distributive share of capital gain) and so will have a $6,000 capital loss in 2024 on the liquidation of the interest. However, D’s capital loss in 2025 will not make D whole for the capital gain in 2024. D’s $6,000 loss may be of limited use in 2025, and D will have lost use of the amount paid in taxes in 2024.
In acknowledgement of the unfair results (of course, if these would be the results, D should probably not have paid $15,000 for the interest in the first place), the IRC permits the partnership to elect to adjust the partnership’s basis in partnership property with respect to a partner to whom an interest in a partnership is transferred by sale or exchange or on the death of a partner. (Adjustment is not made in the case of a gift.) Furthermore, for transfers after October 22, 2004, a basis adjustment is required if the partnership has a built-in loss of more than $250,000 immediately after the transfer.
The adjustment decreases or increases the partnership’s basis in partnership assets by the amount by which the purchasing or succeeding partner’s basis in the interest exceeds or is less than the partner’s proportionate share of the adjusted basis of partnership property. The effect of the adjustment is limited to the particular partner.1 If a partnership is terminated by a sale of an interest in the partnership, an election under IRC Section 743 that is in effect for the year the sale occurs applies to the incoming partner. The bases of property are adjusted before their deemed contribution to the new partnership.2
Example. Under the facts in the above example, if the election had been in effect with respect to C’s transfer to D, A’s share of partnership basis would have continued to be $9,000, B’s share of partnership basis would have continued to be $9,000 and D’s share would have been adjusted to $15,000. Thus on sale of the property in 2024, D’s account would not reflect a share of the gain:
| Partnership | A’s share | B’s share | D’s share | |
| Sale price of land | $42,000 | $14,000 | $14,000 | $14,000 |
| Less adjusted basis | ||||
| common basis | 24,000 | 8,000 | 8,000 | 8,000 |
| adjustment to | ||||
| partnership basis | ||||
| for D | 6,000 | 0 | 0 | 6,000 |
| Total adjusted basis | $30,000 | $8,000 | $8,000 | $14,000 |
| Taxable gain from sale | $12,000 | $ 6,000 | $ 6,000 | $ 0 |
If, instead of selling the interest, C dies in 2024 and D succeeds to C’s interest, D’s basis would be stepped up to the fair market value on date of death.3 See Q 7763. Therefore, D would have a problem similar to that of the purchaser of an interest, if the partnership does not make the election.
An incoming partner of an upper-tier partnership (UTP) is entitled to an adjustment in his or her share of the lower-tier partnership’s (LTP) adjusted basis in the LTP’s partnership property, if and only if, the election has been made by both the UTP and the LTP.4
Regulations require that the election be filed with the partnership return for the taxable year during which the transfer occurs.5
In the case of an electing large partnership, see Q 7733.