Real estate owners often associate cost segregation studies with the acquisition, construction, or development of a property. Another opportunity may arise when an ownership interest in a real estate partnership changes hands.
When a Section 754 election is in place, the buyer may receive additional depreciation deductions through a Section 743(b) basis adjustment. In certain circumstances, a cost segregation study may help accelerate those deductions by identifying portions of the adjustment allocable to shorter-life assets eligible for 100% federal bonus depreciation.
This opportunity can be overlooked because transaction discussions often focus on valuation, financing, and deal terms rather than the tax attributes created by the ownership transfer.
Why Section 754 matters when buying a real estate partnership interest
A buyer who acquires an interest in a real estate partnership generally purchases an ownership stake from another partner rather than purchasing the underlying property directly.
Section 754 addresses basis mismatch
Without a Section 754 election, the partnership’s inside basis in its assets generally remains unchanged following the transfer. As a result, a purchaser may pay fair market value for a partnership interest while receiving tax allocations and depreciation associated with a lower historical inside basis.
Section 743(b) may create tax value
A Section 754 election can help address that mismatch by allowing the purchasing partner to receive a Section 743(b) basis adjustment that aligns the buyer’s share of inside basis more closely with the purchase price paid for the partnership interest. For real estate partnerships, that adjustment can represent a meaningful tax attribute.
Section 755 guides the allocation
The next step is determining how the adjustment should be allocated among the partnership’s underlying assets. The Section 743(b) basis adjustment must be allocated among the partnership’s underlying assets under Section 755 and the accompanying regulations.
In many real estate partnerships, the process begins by distinguishing between land and depreciable improvements, after which the adjustment is allocated among the partnership’s assets based on the applicable tax rules. That allocation is typically supported by property tax statements, appraisals, or similar valuation information.
Depending on the facts and available information, the Section 755 allocation and cost segregation analysis may be performed as part of a coordinated study rather than as separate exercises. In those situations, valuation and engineering-based analyses can work together to identify the portions of a Section 743(b) basis adjustment attributable to shorter-lived assets and land improvements.
Using cost segregation to analyze a Section 743(b) basis adjustment
Cost segregation is a tax planning strategy that identifies portions of a building or real estate project that are properly classified as shorter-life assets for tax depreciation purposes.
Rather than depreciating all qualifying building costs over 27.5 years for residential rental property or 39 years for commercial real estate, a cost segregation study analyzes the underlying assets and allocates costs to the appropriate recovery periods under the tax rules.
Although commonly used for acquired, constructed, or significantly improved real estate, the same concepts may apply to a Section 743(b) basis adjustment arising from the purchase of a partnership interest.
Some taxpayers assume a Section 743(b) basis adjustment related to real estate must be recovered over the life of the building, but a cost segregation study may support a different result. A cost segregation study can help identify the asset components to which the Section 743(b) basis adjustment is attributable and support allocation of those amounts among the appropriate recovery periods.
To the extent a Section 743(b) basis adjustment is allocated to assets eligible for bonus depreciation under the applicable federal tax rules, the purchasing partner may be entitled to accelerate a significant portion of the deduction into the year of acquisition.
State tax treatment should be evaluated separately because conformity to federal bonus depreciation rules varies by jurisdiction.
What to consider before buying a real estate partnership interest
The potential depreciation benefit associated with a Section 743(b) basis adjustment depends on both the tax analysis and the terms of the partnership transaction. Understanding this benefit before closing can support purchase price negotiations and provide a more complete picture of the transaction economics.
The partnership agreement should be reviewed early in the process to determine whether transfers are permitted and whether consent from the general partner, managing member, or another controlling party is required. If the transaction cannot proceed under the partnership agreement, the tax benefits become secondary.
It is also important to determine whether a Section 754 election is already in place or whether the partnership is willing and able to make the election. In addition, the availability of historical property records, construction information, and other supporting documentation may affect the feasibility and value of a cost segregation study.
Addressing these considerations before transaction terms are finalized can help the buyer evaluate the potential tax benefit alongside the legal, economic, and approval requirements of the transfer.
Why transfers at death may change the depreciation benefit
The analysis changes when a basis adjustment arises from the transfer of a partnership interest upon a partner’s death.
Although a Section 754 election may still create a Section 743(b) basis adjustment upon a partner’s death, basis adjustments attributable to inherited interests generally do not qualify for bonus depreciation. As a result, the main benefit associated with combining cost segregation and bonus depreciation is often unavailable.
A cost segregation study may still have value in certain circumstances. The economics and expected benefits, however, should be evaluated carefully before the study is commissioned.
How CLA can help
Evaluating a partnership interest acquisition requires more than analyzing the underlying real estate. The partnership agreement, partner capital accounts, transfer restrictions, Section 754 election status, anticipated Section 743(b) basis adjustment, available records, and federal and state tax treatment can all affect the outcome.
CLA advises on all of these considerations before transactions are finalized. When appropriate, our partnership tax and cost segregation professionals work together to help clients quantify potential depreciation benefits and understand the after-tax economics of a proposed transaction.
This blog contains general information and does not constitute the rendering of legal, accounting, investment, tax, or other professional services. Consult with your advisors regarding the applicability of this content to your specific circumstances.