This is an important question as it can have a material impact on the tax position and cash flow of a taxpayer. We will show you how to maximize your client's cash flow when an IRC Section 754 election is made.
What is an IRC Section 754 election?
There are several common occasions where additional basis is added to a property's depreciation schedule including:
· acquiring a partnership interest in a property; and
· inheriting a property as part of an estate.
The new owner of the property will assume the previous owner's basis (inside basis) in both of these cases. The amount paid for the partnership interest, or the fair market value of the property transferred from the decedent to the successor becomes the total tax basis in the property (outside basis). The difference between the inside and outside basis can be considerable.
An IRC Section 754 election allows a partnership to equalize a new owner's basis in a property. Without this election the disparity in the inside and outside basis can deprive the new partner of depreciation deductions and inflate their share of gain from subsequent property dispositions.
Optimum Treatment of Step-Up Basis
The step-up can generate a considerable amount of additional basis and future depreciation, especially if the property was held by the decedent or previous partner for a significant amount of time and is fully depreciated. Many accountants will depreciate the step-up over 27.5 or 39 years. There is a better way.
We look to IRC Section 755, which specifies the rules for allocating an incoming partner's basis adjustment to particular assets. We can treat the additional basis as an acquisition of property and apply MACRS rules as is typically done in any acquisition. Therefore, the relative fair market values of the 5, 7 and 15 year property should be determined to properly allocate basis. This results in accelerated depreciation deductions which can reduce taxable income and increase cash flow. Cost segregation is a viable solution in this situation.
This can be especially helpful for an estate transfer where properties are mostly depreciated and are generating significant income in the hands of the successor. Without these accelerated deductions, the successor will be stuck with a lot of taxable income and a large tax liability.
