Leveraging Section 754 Elections in Real Estate Private Equity Funds
For astute investors in real estate private equity funds, understanding the intricacies of Internal Revenue Code ("IRC") Section 754 elections can provide significant advantages. Implemented correctly, Section 754 elections can offer opportunities to amplify depreciation or amortization for increases in asset values over a partnership’s adjusted cost basis. RealCap Analytics presents a thorough analysis of Section 754, outlining its implications for private equity funds.
Consider some typical scenarios:
The fund buys out a partner's stake: Could this maneuver have tax benefits?
A partner passes away: With basis "step-up" at death, is it possible for the estate to make a Section 754 election regarding its slice of the investment?
A new partner purchases an existing stake in the fund.
Understanding Section 754 Elections
A Section 754 election allows a partnership to implement an increase, also known as a "step-up" in the basis of partnership assets. This election serves to align the partner's basis in their stake in the partnership (outside basis) with the partnership's asset basis (inside basis) for tax considerations. This election is available during a transfer by a partner or through the distribution of partnership properties.
The nature of the transaction determines the recipients of the step-up. For instance, a taxable transaction that purchases an interest from a partner results in a Section 734(b) basis adjustment, applicable to all partners, and can reflect directly on the partnership’s balance sheet. In contrast, a Section 743(b) basis adjustment occurs during a taxable sale or exchange of a partnership's interest or transfer due to the partner's death, and the step-up is alloted solely to the new partner.
Entering a Section 754 election requires a comprehensive statement, including calculations of the step-up, attached to a prompt tax return. Relatively persistent, these elections generally remain effectual in the year they were filed and subsequent years, although rare circumstances may allow revocation with IRS approval.
Benefits of a Section 754 Election
In scenarios where a partnership's properties are depreciable or amortizable, the elevated basis facilitates the partner to undertake additional depreciation and amortization deductions, commencing in the election year or the year the property enters service.
Considering a theoretical case where Partnership A buys a stake in Fund X from an existing partner, John, for $400. John’s initial tax basis in the partnership stood at a lower value of $100. Given that Fund X's assets include a residential building already in operation, this excess purchase price over cost basis would qualify for a step-up.
The value of this step-up could be allocated differently among the fund’s assets, based on individual fair market values as compared to each component’s relative tax basis. Assuming that the assets include just land, building, and bonus-eligible furniture and fixtures, the effects of a cost segregation study on a Section 754 election can be quite significant.
Critical Considerations for Private Equity/Funds
Although Section 754 elections come with substantial perks, they are not always practical in the context of funds due to several reasons:
Irrevocability: With very limited exceptions, you cannot revoke the Section 754 election.
Mandatory elections by Lower-Tier Partnerships ("LTPs"): To benefit from depreciation and amortization deductions for LTP-owned assets, both the fund and the LTP must make the Section 754 election.
Timing: The benefits of immediate deductions may not align with the exit period late in the fund lifecycle.
Compliance Costs: The costs associated with making the election and the administrative burden of tracking asset basis and depreciation/amortization schedules can outweigh the tax benefits.
Investment managers should judiciously consider the potential benefits vs burdens associated with a Section 754 election, discussing in detail with a tax advisor on the feasibility in each specific circumstance. Furthermore, inclusivity of language in organizational documents that address whether they would be making a Section 754 election and determine the final authority on this matter can serve investment managers well.
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