Transcript
Speaker: Welcome back to Tax News Now. I'm your host, Mark Gallegos. Imagine you've spent your years building a business with a partner, and now one of you is ready to move on. You agree on the price, everyone shakes hands, and you think the hard part is over. Then someone asks, what are the taxes going to look like?
Speaker: And suddenly there's a little bit more to talk about, right? And that's what we're going talk about today. Decisions behind selling your share of a business, buying out a partner, and figuring out what comes next for your money you've worked so hard to build.
Speaker: I'm very pleased to welcome Brian Lovett back to the show. b Brian is a CPA and attorney, a partner at Witham, and the leader of the firm's real estate. strategic tax planning team. He brings extensive experience working with business owners and real estate investors. And I'm looking forward to setting his perspective on the questions that come up when the owner is ready for change.
Speaker: And we'll talk about surprises that could show up in a buyout, why the deal always gets put together in a certain way, and what people are asking about tax deferrals, whether it it's opportunity zones, 1031 exchanges or exchange funds.
Speaker: Whether you you advise business owners or not, the goal here is to help you recognize the questions worth asking while you still have time to act. Brian, welcome back to the show. Thanks, Mark. Happy to be here and looking forward to the discussion today.
Speaker: Yeah. So, Brian, so what has been keeping you busy lately? Like, for example, what are business owners and real estate investors asking right now that you've been seeing a theme of?
Speaker: Yeah. So, I mean, since, um you know, the the one big beautiful bill last year, we've been doing a lot with depreciation cost segregation, right? So having the having the um the new you know, available again on a reasonably permanent basis, right? Not currently legislated to expire.
Speaker: um You know, taxpayers are really looking for, you know, getting that return on their investment. They want to buy the asset or invest the capital and know that that is going to benefit their P&L, that they're not going to have to wait for that deduction, right? So we're definitely seeing a rush to let's accelerate deduction as much as possible.
Speaker: You know, and obviously, as you mentioned, um you know, one of the things that everybody's looking to do is defer or, I mean, eliminate, but there's not a whole lot of elimination provisions there, but deferral provisions throughout the code. So we're definitely seeing a lot with, um as we look at year-end planning, you know, it's already, um as we record this, we're moving into the fourth quarter.
Speaker: um What can I do to, you know, look at the timing of transactions, accelerate some deductions here into 2026, maybe look at deferring some income into 2027. So, you know, it's that that tax planning play. We have reasonable certainty in the code right now, which is always nice for planning, and it's not where we've been for a long time, um where we have some certainty in the provisions that are there.
Speaker: And so we really are seeing taxpayers kind of step back and say, what can I do this year that's going to benefit me? What am I going to push to next year if I do this improvement, if I make this capital improvement, if I fix my parking lot?
Speaker: That's going to be a deduction I get to take today, where if I need to do a building improvement that's going to be trapped on my balance sheet for 39 years, then maybe I reorder my capital investment to say, let me do the parking lot this fourth quarter, and I'll push the building improvement until January because That building improvement is not going to get me as much of a tax savings in 2026 as it will, you know, if i if I wait and do the parking lot in January or February. Now I'm not seeing that benefit on my tax return until April of 2028, as opposed to my April of 2027 tax payments. So we're doing a lot with that. We're looking at a lot of acceleration of deduction and deferral of of income to the extent possible.
Speaker: No, that's great. And I think, I think you're so correct. I mean, with the tax law right now, we have certainty, we know what is in front of us, whether it's certain provisions, we know what the tax rates look like, we know how to do planning around that in advisory work.
Speaker: And, you know, it's, it's all about what lever to pull, right? Whether it's to accelerate deductions now or a combo of accelerating deductions and accelerating income and trying to keep everyone within some sort of bracket, right?
Speaker: Right. And match the two together. And exactly to your point, some of it's bracket management. We know there's a lot of provisions in the code that start to sunset um or phase out once income hits certain levels. So you're trying to play that game to your point and pull those levers to like, hey, we can recognize some of this income, but we can't recognize maybe we do an installment sale of something and we can push some of the income into future years so we don't pick up too much this year. And we then push ourselves over the salt limitation or we push ourselves over some of these other limitations that that have income AGI tie outs to them.
Speaker: That makes sense. And in the partnership world, you know, we'll we'll just stick there. I mean, when you have, you know, two partners or obviously more than two partners and, you know, obviously everything goes along just fine until maybe one of them wants out or maybe they want to go different directions or they have different ideas of what the future may look like.
Speaker: What helps us start a productive conversation if you're brought in from an advisory standpoint with them? ah You know, I think the first thing is to make sure that, you know, the first is make sure all your advisors are at the table together, right? When we do these conversations, I want to make sure we're talking to the partners, the partners accountants, if they have other accountants, the lawyers who are going to draft the documents.
Speaker: um You want to make sure you're starting with everybody on the same page, right? You start to talk to, I talk to my client who then goes and talks to his partner, who then talks to his accountant, you know, and you get a lot of, you know, a lot gets lost in that game of telephone.
Speaker: And then they make a deal that isn't really, or or you have two people who look at it and make a deal, but neither of them talk to their accountants. Nobody talked to the lawyer. You know, so we're not getting full information sharing across the entirety of the interested parties.
Speaker: Maybe not not everybody's getting the best advice because you're not getting all that information on the table. So I think starting there and making sure that all the and all the interested parties, whether it's the other accountants, attorneys are all at the table together.
Speaker: And the other thing is to understand what everybody's goals are. Right. Because, you know, one may want to. you know One may want out, but does he want out and want his cash today? Does he want his cash over time? does he um you know Is he looking to really get out now or does he just need some kind of liquidity event where maybe we don't need a an exit and we don't need a sale of an interest or an unwind? We need to think about a liquidity event so that we can...
Speaker: you know maybe he just needs some cash. He's going through something in his personal life. And so understanding everybody's goals, um you know even for the remaining partner, if it's just two partners, we have to think about the fact that, are we going to now disregard this partnership if he buys out his partner? And now we have a disregarded entity and we have some special tax rules there. And then we have reporting issues there. Now his tax return gets, his personal return gets more complicated and he's got a bank loan. So does he really want that sitting on his personal return? So You know, understanding the goals of all the parties is always the best way. And then again, to me, it's making sure that you're collaborating with all the professionals at the table, um all the partners at the table and getting that full information on the table so that we can make sure that we find the best answer for everybody. I mean, a lot of that stuff is push and pull, right? What's great for the remaining partner may not be great for the departing partner, but to the extent that you understand what everybody's goals are and you can work within that framework, you can usually come up with a solution that is
Speaker: acceptable to everyone. Yeah, I would agree. And I think, and think when you have that kind of dynamic and talking to the right, you know, actually you said talking to the partners versus just talking to people that, you know, you're hearing hearsay from, but having the direct knowledge of what they want, what their expectations are.
Speaker: And I think, you know, it's always funny because you can agree on a price like, Hey, okay, i need liquidity. I want to be bought out, whatever the case may be. But there's always on the back end of that, which a lot of people don't look at is what is the consequence of that? Right. Buyout. Right.
Speaker: And things they don't know. Yeah. Yeah. And when we look at sale of a partnership interest, I mean, that's one of the challenges. um It's not so much what the purchase agreement says. Right. The purchase agreement is going to give you a number.
Speaker: And that's really great. And that number is going to look really good to it. Maybe to allevi to a departing partner, he's going to look at that and be like, that's the right number. That's what I want. But really what he needs to focus on or you he or she needs to focus on is what they're going to keep at the end of the day.
Speaker: And the structure of the the transaction is going to really dictate that and drive that. Understanding the assets of the partnership is going to dictate that and drive that, right? They don't often think, partners in my experience, don't often think about, um,
Speaker: the impact of partnership liabilities, right? We know under Subchapter K debt allocated to a partner is part of their basis. And so if they're going to sell their interest and they're gonna walk away from that partnership, they're also going to be relieved of that debt. And that debt relief is part of the amount realized on that sale of that partnership interest. So, you know, oftentimes you have these partnerships, especially in real estate, we see it a lot with negative capital accounts, right? We have negative capital accounts, those negative capital accounts are propped up by debt.
Speaker: And so if you go to a taxpayer, and let's just say, for example, they have a half a million dollar negative capital account, and then them and the other partners agree that they're going to get bought out for a million dollars. They're thinking, okay, I'm going to pay tax on my million dollars. Well, no, when we start to take into account liabilities, and we put liabilities in your basis, and we put liabilities in your amount, realize Like you may actually pick up, you you very likely will pick up tax on a million and a half dollars, the million you receive plus the negative $500,000 capital account. So you're not starting to pay tax on, you know, potentially paying tax on more than you actually receive in dollars.
Speaker: Because when we look back to the history of the partnership, we received that benefit. You either receive that benefit in the form of a cash out refinance or in the form of depreciation deductions like we talked about earlier. And we took a lot of depreciation on this asset over the years. And so now you're picking back that negative capital account gets picked back up into income.
Speaker: And it's not necessarily something that taxpayers think about when they're like, okay, I'll sell for a million dollars and I'll pay 20% on that million dollars. And so I'll have 800,000. And it's not always that simple.
Speaker: Right. And I think i think there's there's these surprises, and I think that's our our role is to help them understand not only the economics of what they're receiving or not receiving, but also, obviously, then the tax consequences. The tax consequences, yeah. Go along with that.
Speaker: yeah Including things like hot assets. not to Exactly. to jump off that, right? We get into, know, they, again, think of 20%, but that partnership has depreciation recapture. We have Section 751 that tells us that hot assets need to be recaptured as ordinary income.
Speaker: um And so unrealized receivables and inventory items, maybe a cash basis taxpayer who's selling a partnership interest. And there's these unrealized receivables sitting on the balance sheet that don't have any tax basis right now, but some of the purchase price and that interest is going to get allocated to them. And so, um you know, a taxpayer who's thinking everything's capital, you know, finds under 751 that not everything's capital.
Speaker: Now I'm taxed on more than I'm getting and I'm taxed more than 20%. and you know They start to do the math on what I'm keeping, and then you know maybe maybe that purchase price wasn't enough for what I thought I was going to get at the end of the day.
Speaker: Yeah, so true. And I have that conversation quite a bit where the hot asset piece comes in. Because, I mean, everyone that thinks they're selling a partnership interest thinks they're just getting pure capital gain treatment.
Speaker: And like you said, they're not considering hot assets, not considering liability relief. And they may even not be getting all the cash that they've agreed to up front. And unfortunately, the ordinary piece of it gets recaptured all in the year of sale.
Speaker: Correct. Could be right. That's the timing of that that folks miss too. It's like, oh, I'll sell it over time. I'll recognize as I receive cash and that's fine. And I won't, you know, and i see a lot of people now talking about, and I'll make the first payment next year, right? We're getting close to the end of the year. As we get close to the end of the year I'll sell my capital, I'll sell my partnership interest, I'll be out of the partnership this year, I'll sell it on the installment method, I'll pick it up next year.
Speaker: And then you look through and you see under 751, there's these hot assets that really need to be recaptured. And all these recapture items, whether you receive dollars or not, get taxed this year. So now you have a tax bill with no corresponding cash. And so hopefully for the taxpayer, they've scheduled that payment to come in before April 15th because, you know, the government still expects that the tax dollars on the recapture items.
Speaker: And so because of those things, i think sometimes it's good that we have the dialogue to be involved with, you know, their, their consequences on selling, but also maybe the whole deal is to making sure it's structured in a way that benefits obviously both sides.
Speaker: Yeah. Yeah. I mean, the buyer, again, we talked at the beginning, understanding the goals. You know, the buyer's goal usually is traditionally in a partnership world is they want to know that when they're writing a check for this asset, that's going to be the basis of those assets, that there's going to be some economic benefit there for them, right? They're paying fair market value usually for an asset that maybe isn't being carried at that fair market value. Maybe for tax purposes, we've taken a lot of the depreciation, or maybe they're paying for you know, some kind of of goodwill, inherent value in the entity that is not on the books right now, right? And um so we look at these step ups and and things under 754 to try to make sure that that buyer gets the benefit that they're they're bargaining for in that environment.
Speaker: No, that's so good. So good. And, and when you're, when you're talking to these people and, you know, and this, you know, you start to see some of these things going on, what's the best way do you go about kind of explaining to them? Do you model it out? Do you show them what, you know, from a visual standpoint or you just have the conversation or what does it look like for you? I mean, I think it starts with a conversation, but some of this stuff is complex. Right. I mean, we've been doing this for a long time, you and I, and we talk about this stuff all the time. But so so to us, we get it right. We can think through it. We can visualize what it's going to look like because of years of experience. But it's very hard you know to explain some of these concepts that happen under Subchapter K.
Speaker: with words to people. Right. So I do find that, you know, oftentimes modeling is a really, really important part of this. um You know, even just yesterday, I was working through an issue with a client where we were working through partnership allocation and, you know, trying to talk about substantial economic effect. And until I put it on a simple Excel schedule that said, if we do it this way, this is what it looks like. If we do it the way you want to do it, this is what it looks like. And this is why it's a problem.
Speaker: um The numbers on paper usually seem to help people understand a little bit more. So as we're going through, you know, what a 754 adjustment is and why it exists and, you know, showing them, hey, this taxpayer, this partner who's leaving is in our my earlier example, they're going to pay tax on a million and a half dollars of gain.
Speaker: you're buying in for that fair market value, we want to make sure that at least as it relates to you under 754 and under 743V, we're creating an asset to fill that hole so that there's not two levels of tax on that gain. right If the partner's but paying the tax on the way out, then 754 should allow us to book up a ah step up for you, buyer, on a cross purchase, isolating this to a cross purchase, so that that million and a half dollars is taxed once,
Speaker: And not twice. Now, look, at the end of the day, if you miss the 754 election, it's it's expensive in the meantime, but eventually it'll all wash itself out. Right. That partner who bought in at a million and a half is going to have excess basis when that partnership winds down in theory.
Speaker: um But you do want to make sure that if they buy in at a million and a half and next week the partnership decides to sell the asset. that partner is going to be very, very disappointed in the advice they got if they're now paying tax on that million and a half dollars after they just bought in at fair value.
Speaker: um And so you know understanding how those step ups work and trying to get them on the same page with understanding why it's important, I find you know the conversation helps, but the the modeling and the explanation and the showing them in in actual dollars on ah on an Excel schedule or something and sitting down and walking through um all the inputs and how the flow goes and and really demonstrating some of these complex partnership concepts with simple round numbers so that they can, you know, none of the none of the examples we deal with are as easy as the examples we teach with, right? But um making sure that they get the opportunity to see what that looks like and not just sit back and be like, okay, I guess if you if that's what you're saying, you know, that's what it is.
Speaker: Yeah, it makes sense. Now, does it matter whether I purposely buy my partner out or the business buys them back, you know, redeems them? ah So to the to the seller, it doesn't matter, right? They're going to get their dollars.
Speaker: The tax treatment to them is going to largely be the same. um It may make a little bit of difference on how long they're in the partnership. We talk about that in a minute. So to the seller, Minimal impact, I would say, right, in the overall economics of the deal.
Speaker: um But to the buyer or to the partnership, there's pretty substantial um difference. um You know, first, I mean, I guess to the buyer it matters to a little bit, but or to the seller it matters. You know, if there's a redemption, that's governed by a different perspective.
Speaker: code section than if there's a cross purchase, right? And so the cross purchase is a little bit easier. You know, you get together, you you and your remaining partners pool together the dollars and you buy out the exiting partners interest.
Speaker: Even if you buy it out for paper, that is a closed transaction. At the time it happened outside of the partnership, that partner's gone. Their last day in the partnership is the day you bought it.
Speaker: If the partnership agreement calls for an inter interim closing of the books, you do your interim closing of the books. If you're gonna do per share per day, cause nothing really happens that's out, you know, extraordinary on either side of the transaction. You know, the partner's gone, they get their final K-1 for that tax year and they move on.
Speaker: The buying partners then are entitled to that 754 adjustment we spoke about as of the day of that transaction, even if they buy with paper, right? There's a assumption that they're gonna perform on that paper.
Speaker: And they get their basis adjustment starting that day and they can start to depreciate that basis adjustment. The cost recovery comes into play right now. um I see that, you know, more often you see the partner cross-purchase type of buyout as opposed to a redemption buyout.
Speaker: Under redemptions, you have to look to Section 736, which really governs that. And you have two different, it's like a bifurcation, a fork in the road under 740, under 736 to determine whether it's an A payment or a B payment.
Speaker: um But what you have is, you you know, effectively you have that partner either getting guaranteed payments or distributive share from the partnership for the entire company. term of that payout. So if that's going to be a step payment over years, you know what people fail to fail to see is like, even if there's an agreed upon amount today, and we're going to pay this guy out over five years, that partner, while they won't share in any profit or loss from that point forward, they should continue to get a partnership, a K-1 from that partnership for those five years.
Speaker: You're going to report the payments to them either as guaranteed payments or distributive share as governed by 736.
Speaker: And so, you know, a lot of times people get confused with respect to that and they say, well, they're out. Why am I still giving them a K-1? And the answer is if the partnership is redeeming them, you know, that's what the code says. They continue to get that payment until they got their, they continue to get that K-1 until they've gotten their last payment.
Speaker: And so like, even if that's a redemption where you have a 50-50 partnership and we redeem out partner A and partner B is the sole profit and loss partner, kind of the only person left, That partnership continues to file a partnership return until those payments to partnership partner A are made.
Speaker: The other thing that's really impacted by that is the timing of the step up, right? So now we're talking about a 754 adjustment and we're looking at 734B on these redemptions, which is a common partnership item. So it's not specific to the buying partner.
Speaker: It is a common partnership basis adjustment for all the remaining partners, but the timing is different. So until we've started to, we've over distributed that partner's capital account and that partner is picking up gain,
Speaker: that partnership doesn't book that 734B adjustment until those payments are made. So you see a big deferral in the cost recovery, right? So until that payment is made, that exceeds the capital account and can like rise to the level of now a seven four thirty four b adjustment.
Speaker: then you'd put it on, you'd start to cost recover it. But in the meantime, you're making payments of their capital account. That partnership's not getting any basis adjustment until they get through that. So it does matter to the, it certainly matters to the buyer.
Speaker: um It matters in the structure of the agreement. It matters in the timing of the payments, the reporting on the K-1. So on the compliance perspective, it matters. um And on that cost recovery, it matters as well. So I think that, you know, obviously that's a big, big,
Speaker: um decision point, who's going to make the buyout. um You know, obviously, from a practical perspective, too, if you're going to make a partnership redemption, you have to make sure the partnership has the the the the cash to redeem or the ability to get the cash to redeem. So, you know, it may be easier to find, you know, partners to do what they need to do, buy on paper, transfer it outside and and allow that to happen. But that's really a ah planning perspective that that folks really need to look at.
Speaker: Yeah, no, great points there. And I think from that planning perspective, you know, if I'm receiving payments over five years as part of a buyout, um you know, I think one of the questions that needs to come up is, hey, what's the buyer's ability to keep paying me over that five-year term, right? yeah and And in in a conjunction with that, you know, a partner may get two different types of offers. One that's higher price, but less favorable payment terms.
Speaker: And you kind of got to weigh what makes more sense along the way here, right? yeah Yeah, without a doubt. I mean, that's one of the challenges of taking money over time, right? You have to believe in the, whether it's from other partners or it's from the partnership itself, you have to believe in their ability to to pay you. um you know and And so it it goes into way in the offer and understanding, you know again, comes down to modeling, right? If I take this offer, it may be more money. I'm going to be waiting longer to to get the money or the payment terms are less favorable.
Speaker: What does that look like for for over a five-year period from a tax cost perspective and and all those other things? you know Again, like we used to worry a little bit with you know some of the back and forth on these tax proposals, am I deferring income into a higher tax jurisdiction? right if capital gains to If I sell and it's capital gains tax and it's 20% today, and there's a change in administration in a couple years and capital gains tax becomes 30%, well, I don't know. Did I make enough? right that it is the Is the purchase price enough so that if I start paying higher taxes on this right now, I think we're settled. I don't think that's a risk.
Speaker: But as you look at the future, you need to you know, kind of underwrite to there's certain variables, you know, you you sign a piece of paper and you take back an interest rate today. Is that interest rate a few years from now going to be worth waiting for the dollars? And, you know, and and so you're underwriting to a lot of variables, um ability to pay tax rules. Those are all, you know, part of the risk that comes with deferral.
Speaker: No, I think those are some great things. And I think, you know, You look at it, you know, you, you know, we've been talking primarily from the seller side typically, but on the buyer's side, you know, there are things that they need to be looking at too. And, you know, one of the things is, and you've already alluded to it in the 754 election, whether you, you know, under 743B from the outside or 734B from a redemption from the inside and kind of, kind of rehash, what does that really look like from the buyer's standpoint and and how how do the partner or partners benefit from that?
Speaker: Yeah, so so the 754 adjustment generally, right? Section 754 is the code section that allows the partnership to make optional basis adjustments um in the event certain transactions take place, sales or exchanges takes place take place.
Speaker: um Cross-purchase is one that we look at under seven forty three b um that's the outside of the partnership transaction that takes place where partner a maybe maybe have a b and c in a partnership b wants to go away a says i'll just buy your interest then i'll become two-thirds of the partnership in that case we'd be looking at making sure we book the proper step up for a under 743 b that would be personal to a that would kind of live outside of the partnership oftentimes you see it obviously reflected on a partnership return we have some special rules
Speaker: on schedule K and K1 where we report any cost recovery. um But that becomes a new asset um placed in service at the date of the transaction.
Speaker: And A is going to get a little bit of depreciation expense or or amortization expense depending on how that step up is allocated. right So that 743B step up gets calculated based on the price paid for the interest less the previously taxed capital of the exiting partner.
Speaker: um And then you look to Section 755 for allocation of that asset. So you do need to understand when you're doing this work, like what does the partnership own? What is the tax basis and what is the fair market value of those assets so you can allocate it properly?
Speaker: um and And then you allocate that adjustment and it provides A with a little bit of cushion. In effect, it gives a um depreciation or some kind of cost recovery over the years, depending on how it's allocated um or adjustment so that when the partnership collects on those receivables that may have been cash basis receivables. Now A has a basis in those receivables so that you know there's there's not ah ah ah so a substantial tax burden on A. Like I said, the biggest issue, you know and I find if we don't do this appropriately and we don't advise clients appropriately is A buys into a partnership for fair market value. We sell the assets, we wind down the next day,
Speaker: And now A is saddled with a whole host of gain. And A is looking at you, say, as the advisor saying, I just paid fair market value for this. And now I'm getting saddled on all this gain that really represents deductions, depreciation, all these other things that happened before I was even a partner.
Speaker: And, you know, why am I now paying tax again after this departing partner just paid tax? So the 754 adjustment under 743B is designed to make that cross-purchase partner kind of put them on even footing with what they paid for the interest.
Speaker: Now, yeah in a cross-purchase, we end up with a situation where um it's governed under 734B. Obviously, you know we get just flipped two numbers. Now you're talking about something totally different.
Speaker: um But that's a redemption. And so that creates common basis for the retained assets of the partnership for all the remaining partners. All the continuing partners are going to share in the basis of that.
Speaker: um you know Again, it gets to... to um It gets to the same place. It allows the partners who are remaining in the partnership to get a little bit and more cost recovery, maybe get a little bit of a basis adjustment because the partnership just paid out at a premium, ah a departing partner.
Speaker: And, you know, it's just different beneficiary there. So that's shared by all the partners as opposed to being, you know, specific to the the the cross-purchase partner.
Speaker: Yeah. Well, that makes a lot of sense. And obviously, this is all part of the planning, part of the advisory to help everyone understand for both sides. If 754 election should be made or or maybe there's already one that's been made in the past and it's already in effect and we've got a deal with I think that's the other issue, right? So yes, the partnership has to make the 754 election for these adjustments to happen, right? So partnerships don't by default have the right to do this. It's an election that has to be made.
Speaker: um But, you know, I think there's two traps here to be aware of. You know, one is if the partnership made it in the past, it is now no longer optional on these transactions. Like it has to be done. And so you could be going through an awful lot of hoops to do valuations and 755 allocations for what are deemed to be small immaterial numbers,
Speaker: Maybe there was a transaction, you know maybe the partner just came in and we a year or two later they sell to someone else and there's not that much difference, but you have to do it. right Once 754 election is made, these these, and I'll call them optional basis adjustments because you do have a choice if the 754 election is not in place to put the election in place.
Speaker: But once it's in place, those adjustments are now not optional. You need to make those adjustments because you have the election in place. The second one um that that always jumps out to people is, um you know, a few years ago, the law was changed around 743B adjustments, and there is a mandatory step down in the case of substantial built-in loss.
Speaker: um And so traditionally, even with no 754 election, you would just say, I'm buying for less than the current carrying value, right? The partnership's hurting, and I'm going to come in and try to fix it, but I'm paying less than the carrying basis, right? Inside basis over fair market value.
Speaker: i don't need to make a 754 election. I'm certainly not going to step down the basis of my assets. But um you know the code was updated. And now if there is a inside basis adjustment, if the fair market value is less than the inside basis by more than $250,000, if that transferee partner, that selling partner be allocated more than $250,000 loss if asset were the loss realized,
Speaker: would be allocated more than a two hundred and fifty thousand dollars loss if that asset were sold and the loss realized the the election or step down is no longer mandatory.
Speaker: um It or ah is no longer optional, it becomes mandatory. So they have to book the step down if it's over those thresholds, that $250,000 threshold.
Speaker: And that was expanded back in 2017 to add that second prong of if the partner would be allocated. So again, you can look at the partnership and say, yeah, the basis and the inside basis and the fair value are even.
Speaker: But if we have special allocation provisions in our agreement, there's book ups over the years and that partner would have been allocated that loss, you're stuck and whipsawed into this mandatory basis adjustment for a step down. And nobody wants, everybody wants step ups, nobody wants step downs.
Speaker: It's so true. So true. And, you know, you you brought something key there. And I think that is, you know, you may pick up a new client and you're like, oh, wow, they got a transaction a year or two into having that new client. But, you know, always look at the history. Did they make a 754 lecture or not? It should be something you always check on right away, you know, especially in a partnership.
Speaker: And the partnership return has been made a little more robust in the last few years. And that is now a question on the return. So, you know, as you get a new client, you know, reading that last year's partnership return or or getting the last two or three years partnership returns and actually looking at them, reading them, looking at the questions and seeing how they were answered. Now,
Speaker: Not every practitioner is going to answer them correctly. um But, you know, there's a lot of information now in a partnership return as you take on new clients um to to to try, assuming it was prepared completely and fully, to try to get a good idea of where they've been and what they've done. And to your point, as you're advising on a new transaction, it's a lot easier to understand how they got where they are and what elections are in place already.
Speaker: Right. And, you know, when it comes to partnerships also, you know, when when a partner and sometimes people get confused on this out there. So when a partnership goes from two owners to one or goes from so owner to multiple owners, there are some context of when, you know, you have a, you know, a partnership return or a final return and kind of kind of walk us through that for people that always get confused with that.
Speaker: Yeah. So, you know, there there are some guidance out there, um you know, Reprox in 99, I think it's 99.5 and 99.6 that really govern those transactions. You know, but ultimately, if you have a single member entity that's operating as a partnership and they go in and bring in capital,
Speaker: you're You're going to go then from a disregarded entity to a regarded partnership. As soon as you have two partners, now you have a regarded partnership. um you know Depending on how that capital was raised, if it was a 721 contribution into you know this partnership, you you know you you do have to you know work through um some of the... um you know, work through some of the particulars of it, you know, but you're going to go from this disregarded non-reporting entity to a reporting partnership. And you need to walk through filing a new partnership return, not missing deadlines like that. That one's an easier one because usually your good partnership is going to start and end with a December 31st.
Speaker: What I find more often is we end up in situations where we had a multi-member partnership. Partner A and B are together. Partner A wants out. Partner B buys them out. And now that is a termination of the partnership.
Speaker: um and the creation of this now single member LLC. And again, if we did that on February 1st and we didn't think about it or realize it or talk about it to the client until December, now that February partnership return is a little bit late that we have to deal with.
Speaker: um In that case, you're oftentimes looking at a an acquisition of the assets, right? So while you may buy, it this is where we get back to that first conversation about are we buying interests, partnership interests, we have all these special ah special rules.
Speaker: In that case, we have a special rule where we're buying a partnership interest, but the IRS treats it as what The way they would treat that transaction from going from regarded to disregarded is as if the partnership distributed all of its assets out to its two owners.
Speaker: partnership Partner B bought partner A's assets at whatever price was negotiated and allocated however they would allocate it. And then partner B now owns all of the assets, some with a carryover basis and some with a fair market value, a portion with a carryover basis and a portion with a fair market value basis based on what he paid partner A for. So now you no longer have a partnership return. You're reporting a Schedule C or a Schedule E, however, you know whatever the activity is, right? It's a disregarded entity. That's a sole proprietorship.
Speaker: And when you get to the basis in your assets, you could be tracking bifurcated basis in the same asset, 50% of it at the historical cost basis, 50% of it, of what I just bought from A. um So again, gets really complex around tracking and around planning and um you know making sure we don't miss the final partnership tax return and we get it all onto the Schedule C at the right basis.
Speaker: um you know and And those transactions happen you know, more often than probably we we want them to or we think they're going to. And um if we're not in front of our clients on a regular basis having these conversations, you know, oftentimes, you know, that 50-50 partnership between two buddies where they said, ah, just give me 50 grand and I'll be gone.
Speaker: You know, you you uncover that at the end of the year and it's a little late. You know first of all, you can't consult and advise. If the transaction is done, it's done. um And you have compliance deadlines and and you now need information, you know, to to be able to calculate the proper basis and assets.
Speaker: And it gets really messy. Yeah, no that's that's a great explanation. And I think, you know, that's a lot of clarity because this is something that I see out there that people have, they struggle with. and um But thank you for clarifying that. It's great stuff.
Speaker: Now, shifting gears a little bit, you know, we see people that have sold their partnership interest and maybe they have, you know, a capital gain. and And in their mind, they are looking for, hey,
Speaker: is there anything I can be doing to, you know, shelter this capital gain or defer it or, you know, everyone's always looking for that planning opportunity. There's this idea of the opportunity zones um and with, you know, what problem were they designed to solve? And now that with the one big beautiful bill, we have QOZ 2.0 that has come into play. Can you kind of speak at a high level to what that looks like?
Speaker: Yeah. So, you know, the opportunity zone was a pretty bipartisan part of the TCGA back in 2017 when it was passed um and was effective for 2018. And the the goal and I think the belief, if we go back to the very beginning of this program, was there is a whole lot of, you know, investors have a lot of built-in capital gain, whether it's in their investment portfolio or it's in assets that they own, whether those assets are real property or collectibles or or whatever assets they may own that would generate capital gain if sold.
Speaker: that there was a belief that there was an awful lot of built up gain inherent in people's assets. And Congress saw a need for patient investment into these dedicated low-income census tracts that would help with revitalization of certain areas. And then so the program was designed with that as a goal, right? Let's find a way to incentivize folks who may have built-in capital gains, who are then willing to realize those gains and reinvest the
Speaker: it reinvest cash equal to the gain amount into these opportunity funds that are designed to revitalize and reinvest in these designated low-income census tract areas. The governors and the chief executives of states had the opportunity to go out and identify areas within their states and propose propose opportunity zones that would be eligible for this type of investment.
Speaker: So that was the original plan. Now, what that did for the investor um It at the time it provided three benefits and those three benefits are back now with 2.0, as you mentioned. Right. So we'll focus. I'm going to focus a little bit on on 2.0 because the first program ends here in about three months with 1231, 2026. And so any investment now, really, I don't see as, you know, other than this final 10 year permanent exclusion for federal purposes.
Speaker: There's not a whole lot of benefit in going into a 1.0 right now. um But this this revitalization of the program, it's now been made as part of H.R. 1 a permanent incentive that recurs on a 10-year cycle.
Speaker: So the first cycle right now, governors and chief executives have have identified are in the process of identifying the areas within their states that will qualify for reinvestment.
Speaker: The government, the IRS is going to be able to sign off on that. And I think probably here in the next 60 or so days, we should see what those zones are. um This incentive now allows for the reinvestment of the gain portion.
Speaker: The nice thing here is you can take your cash as your basis off the table. You don't need to reinvest it um into these these zones. You would reinvest your gain portion. And the first benefit you would get is a five-year deferral.
Speaker: So if if starting in 2027, taxpayer recognizes some gain, they reinvest that gain into a qualified opportunity fund, they are now able to defer that gain for five years.
Speaker: So they won't pay the tax till 2032 their tax return It's nice benefit. It allows full investment into these zones. It allows the taxpayer to sit back a little bit and not have to pay their tax bill.
Speaker: um the The second benefit is a basis adjustment. So now it's I invest $100 into an opportunity zone. I'm not going to pay tax on that $100 for five years.
Speaker: If I hold it for five years, I get an automatic 10% basis adjustment. So now instead of paying tax on my $100, I'm only paying tax on 90. So tax on $10 just kind of goes away.
Speaker: This new program also is really designed to to incentivize rural development. So the H.R. 1 bill creates these new rural opportunity zones. They're going to be identified as such, right? Non-urban tracks really designed to try to spur rural development.
Speaker: And if you do a rural opportunity zone, that basis adjustment is now tripled. So instead of 10%, it's 30%. So if I take $100 and put it into an opportunity zone that's a rural opportunity zone, I wait my five years, I'll pay tax on $70 instead of $90. It's a good benefit if you multiply that 100 by a real number.
Speaker: um And then the third benefit is a 10-year permanent exclusion. So as I mentioned when we talked about why, the why was patience, right? The why was long-term committed investment. So they didn't want you going in, making a quick investment, flipping it in two years and taking your money out, and now you run away from this zone and and any kind of short-term benefit you know gets gets ripped out when that investor leaves.
Speaker: So there's this 10-year hold. If I hold my investment for 10 years, it's qualified investment, I exit after that 10 years, any appreciation on that investment is now permanently excluded from federal tax and a lot of states that follow.
Speaker: So I make my $100 investment. I invested in a rural opportunity zone. Five years from now, I pay tax on $70. And then if I hold for the next five years and after that 10 year anniversary, it doesn't have to be immediately after, it can be 12 years, 13 years down the road.
Speaker: I have the opportunity to exit on for $200. That $100 that I just made on that investment is permanently excluded for federal league income tax. So again, it's is designed to try to get people comfortable with if I liquidate this position,
Speaker: Now it's going to generate a tax bill. Well, you can defer that tax bill. You can partially eliminate some of that tax bill with the basis adjustment. And then really you can supercharge your return because you don't have to pay tax on any of that return when you reinvest that $100. And so that's the spirit of the program. There's a lot of interest in it now after um the the bill last summer.
Speaker: um You know, a lot of folks, I get a lot of calls. Folks are wanting to know where the zone where are the zones, what are they going to be? But it does allow for at least a conversation as a practitioner um when a taxpayer has what you're talking about, right? I sold my partnership interest. I'd like to defer maybe some of, some, and maybe not all. Maybe I want defer some of my gain.
Speaker: An opportunity zone is one way that if you have a generated capital gain on whether it's a partnership interest or an investment portfolio or whatever it may be, Yeah, a taxpayer could choose to um reinvest a portion of that gain or all of that gain and see some short-term deferral and potential 10-year exclusions.
Speaker: Yeah, no, that's, that's great. And I think, I think we, it's just another opportunity to think we're going to have more, more to come on this. And I think people are going to, you know, start to see there might be some benefit, especially as the the opportunities are there to invest in rural America and in various investments.
Speaker: Are you with, you know, obviously in the real estate world that you work in with, are you hearing more conversations on this or is it just slowly going to start picking up, you think, as time goes on here? You know, it was real hot for a while at the at the initiation of the program back in 2018. We did a lot, of we still do a lot of work with Opportunity Zones. Obviously, there's continuing work that has to be done on the compliance side.
Speaker: And now we have a lot of taxpayers who did it back in 2018 who are looking at their exit event here in December 31st of 2026, right? So those folks with QOZ 1.0 investments,
Speaker: Right. All pay their tax based on the the December 31st, 2026 date. um So we're doing some planning around that. I'm getting a lot of calls on 2.0. I think folks are a little bit, you know, they're calling and saying, where are the zones going to be? What can I do? Right. So as you mentioned in real estate, you know, one of the things those real estate developers do is, you know, they, they have gains. Maybe they're going to exit a current deal and they want to get into the new deal and they want to use this as their equity into the new deal.
Speaker: um But they got to understand where the zones are and where they can build. um They'll create a self, they'll certify a fund themselves and do kind of all the structuring themselves. They're not necessarily looking at the syndicated funds that are out there.
Speaker: um But I think, yes, there's a lot of interest. um I think until the zones are are released, it's still a lot of talk. but um But the rural has certainly been something that that folks have been calling about. um You know, this is one of those things that finds its way to, um you know, I think it finds its way to some of the, they see a lot of the headlines, let's put it that way, right? So,
Speaker: You see a lot of headlines on this and it's like, hey, hold it for 10 years. and You don't pay any tax. And they kind of miss the beginning part. So we get a whole lot of calls up front that say, I hear if I invest in one of these, I don't have to pay taxes on it if I hold it for 10 years. And so once you walk through the real rules and you talk about the short term deferral and the basis adjustment and really that third year or that third benefit of the 10 year hold only on the appreciation, not on the entirety of the gain, because I think that's what they're thinking is there's this ability to permanently wash away the gain um that they would reinvest.
Speaker: I wouldn't say it it tempers, I guess, interest a little bit because they realize that you know the one challenge that I always advise people is you're going to lock up your gain with this, whether it's a fund or you're doing it self-certified.
Speaker: you know You have to invest the whole gain in order to get full deferral. And there's no guarantee that within five years, there's going to be some kind of permanence permanent financing or liquidity event or anything where the fund itself is gonna be able to give you the dollars back to pay the tax. So like the the tax bill is gonna come on that fifth anniversary and whether or not you've seen any return out of the investment at that point in time, the tax bill still comes.
Speaker: So we need to make sure that we're like thinking about and coaching clients through that. But yes, i am seeing a lot of interest. The rural opportunity zones with the 30% basis adjustment. And also for those folks who are going to do the building, there's ah a reduced substantial improvement threshold. So in order for the asset to qualify, if you buy it for a million, you have to spend another million dollars you know improving, renovating.
Speaker: In rural zones, that 100% reinvestment threshold has dropped to a 50% substantial improvement threshold. So if you buy for a million, you only have to invest another 500 into the property for it to qualify as good opportunity zone property.
Speaker: I'm seeing a lot of interest around that, or at least a lot of discussions. Oh, that's good. That's good. And I think we'll we'll continue to hear more on that, I'm sure. Without a doubt. Without a doubt. Then another deferral area that has been around, but you know, I'm sure you, you deal with a lot is, you know, client owns a rental property or, or any kind of property and they want to sell it.
Speaker: And they're looking to buy an, you know, reinvest that into another piece of property because they're upgrading or whatever they're deciding to do in plain English. Can you help explain 1031 exchange and why this helps them?
Speaker: Yeah, so 1031 has been something that's been around forever. Every time tax reform comes up, it's talked about as being curtailed, limited, but currently there's no cap on it.
Speaker: The one change back in 2017 with the TCGA was that it was limited to only real property. So investment or business real property, and you can defer the gain. So that's one area where I think there's there's a lot of, of we get a lot of calls that 1031s don't work.
Speaker: you know But at a 30,000 foot level, a like-kind exchange, a section 1031 exchange allows a taxpayer to sell a piece of property that they own for investment purposes or for business use, use in a trader business, a rental property or something like that.
Speaker: um they can sell it and they can buy a replacement property without recognizing gain, so long as they meet a lot of the rules. Now, um there are a lot of rules, right? So one challenge of this is there's some really tight timelines and you can't touch the funds, right? So you get involved, if you're going to have a sale, you're going to assign that to a qualified intermediary that qualified intermediary is going to step in and run the transaction for the taxpayer. Because if the taxpayer touches the dollars, and I get these calls all the time, I sold my property yesterday, I'd like to do a 1031 exchange, the money's in my attorney's escrow account.
Speaker: That doesn't work. We need to have the intermediary involved up front. um And we need to have the intermediary kind of step in and take over the sale, hold those dollars, you know lock up those dollars with the qualified intermediary while you identify and close on your replacement properties.
Speaker: If you get that call, i opportunity zone is a great um conversation to have, right? Oh, I sold my property yesterday. I'd like to do a 1031. Well, you can't. The rules are, the door's closed for you, but hey, there's this opportunity zone. So keep that in your back pocket for when people call with with this issue.
Speaker: um the The 1031 exchange, again, going back to that, you sell, the intermediary steps in. From that day, the seller buyer, the exchanging party is on a pretty tight timeline.
Speaker: They have 45 days to identify replacement properties. There's some special rules around replacement um or identification, but you're gonna notify your qualified intermediary in writing within those 45 calendar days not business days. That's one thing that I think folks often miss. Weekends, holidays all count towards those 45 days.
Speaker: um You're going to identify in writing what you plan to acquire as replacement property to them within 45 days. And then you have up until day 180 from the sale date to close on that replacement property.
Speaker: Assuming you do all that, um you can fully defer your gain into the new property. So if the plan is, hey, I've taken this asset to the end of its useful life. I don't think there's anything more I can do with it. Or um oftentimes we see it like, you know, a couple, they're getting a little older, they have a rental property, but they don't want the day-to-day rental issues. They don't want to deal with tenants. They don't want to deal with the management of the property.
Speaker: They'd like to sell the property. They'd like to still be in real estate. but they don't want to be involved in the day-to-day. So then you sell the property via 1031 exchange, maybe you reinvest in their case, maybe you look at a Delaware statutory trust, a DST interest, owning something like AAA rated, you know, national retailer that performs more like a coupon, but it counts like fee simple in real estate. So that taxpayer is able to get out of the management of the day-to-day real estate to come over to ownership of what is real estate, but performs a little bit more like a coupon and much more passive to them.
Speaker: and do that without paying any tax. um And they would just defer that gain into the replacement property and it's an indefinite deferral. So unlike opportunity zones, which is five years from now, you're paying your tax.
Speaker: This one is like, you stay deferred until you sell that replacement property. And when you sell that replacement property, if 1031 is still part of the code, you can use 1031 on that again. There's no limit on using it a second time.
Speaker: And so you defer your tax again and and you know never never want to advise folks to use death as a tax planning tool. But um if you 1031 and 1031 and 1031 all the way up until you own a property at death, we all know that under the the current law, that property steps up to the fair market value at the date of death. And all that inherent deferred gain is now wiped off the off the ledger. And um you know we've managed to take property A that we owned for 50 years and turn it into something worth a lot more.
Speaker: and And nobody paid any tax on that appreciation. Yeah, no it's and it's a great, it's still a great planning tool, right, for people. And, you know, it's meant to help defer and, you know, the time value of money on not paying taxes is the key there, right? so Yeah, without a doubt.
Speaker: um Now, the term in 1031 that we continue to hear is, you know, the the phrase exchange fund, you know. So how is that different from a 1031 exchange and what does that mean? No, I mean, I think when we talk about that, it's like the exchange funds, right? So it's really like when you're that money comes in, you have to make sure you're spending that money on good, qualified opportunity zone assets.
Speaker: um The other thing that sometimes people talk about is these Delaware statutory trusts, right, as exchange funds. It's not a, you know, you're not going out and and taking the deed to a um to a piece of real property.
Speaker: You're actually getting an interest in what it's it's designed, I'm gonna say the word partnership, but it's not a partnership and it's very specifically and carefully not a tax partnership. Because one of the challenges, you cannot exchange partnership interests.
Speaker: So when we talked earlier about, I'm gonna sell my partnership interest. right If I'm in a real property trader business, I have a rental property and I own it with Mark and we're 50-50. And I'm gonna sell my interest to a buyer I can't sell that interest to the buyer and involve an intermediary and go buy real estate and say, I'm doing a 1031 exchange, right? Because partnership interests really do not work.
Speaker: So what you see is there are these largely, um these Delaware statutory trusts that are designed to perform as tenancy in common. So there's no management of them. There is no day to day. You are a hundred percent passive investor. You do absolutely nothing and have absolutely no control.
Speaker: But what it does do is it does allow a little bit more flexibility, right? I can't find the property I want. When I'm identifying, I'm looking for property in that 45 days and I can't find anything I can afford. I can't find anything that profiles. I can't find anything that pencils.
Speaker: So what I do is I identify a tenancy in common interest or an interest in one of these Delaware statutory trusts that are a pooling of funds to go out and um invest in real estate and they go out and they invest in these, you know, often times large national tenants or portfolios of different things.
Speaker: And that taxpayer who's doing a 1031 exchange now owns an undivided interest in that fund. It's treated as a tenancy in common effectively for real property purposes. It's deemed to be a fee simple interest under a 1031 exchange. So you're able to do that without having to go out and buy a direct investment in a piece of real property.
Speaker: Yeah, no, I think it's it's another opportunity, but you got to make sure you're doing the right investing. Without a doubt. Yeah. As we wrap up, Brian, I just want to ask, you know, so if if if someone has got a client or they're an owner and they're considering a sale or partner buyout in the next, you know, year year or two, what is the most useful thing they can do now to start having the conversation and planning around that? You know, I mean, I think it's never too early to pro forma.
Speaker: Right. I mean, like really think about from ah from the perspective of that partnership or those partners really have the conversation about goals, have the conversation about, you know, what are we going to do? How are we going to structure this? What do we want the next generation, the remaining partners? What do you want the next generation to look like?
Speaker: and really start to pro forma what that really means. um Because again, as we talked through, there's a lot of variables, there's a lot of decisions that have to get made. um And you know while we just talked for you know an hour about some of the complexities of the code sections and all the other things that are gonna impact if we make a left here versus a right here,
Speaker: um All of those paths, you know kind of going into the transaction and understanding you know what the future state looks like, allows the advisor, allows us to come in, the attorneys to come in and say, okay, if this is where you are and this is where you want to be, right this is how we can use the code, the regs, structuring, timing, um the calendar, all of those things become tools that we can use to achieve that. And if it's a year or two, that's great because that gives us time.
Speaker: You know, oftentimes it's, I'm going to sell next week and you're really under a crunch or I sold last week. And then it's like, there's nothing, not much I can do for you. um but But I do think it's it's never too early to plan to really think about what everybody wants the future state to look like um and to really start to pro forma what that means and to start talking to the professionals and say, hey, I think this is where we want to end up.
Speaker: What can we do to get there? And it allows the the advisors to wield some of these things as weapons instead of using some of these things like shields. That's great. That's great.
Speaker: Well, Brian, thank you for coming back to Tax News Now. I appreciate your time and your perspective and the way you help make these complicated tax issues so easy to understand and just put it in really good perspective. So thanks for being here. No, anytime, Mark. I appreciate the opportunity.
Speaker: You bet. So what stands out to me is that behind every transaction is someone making a big decision and someone is preparing to retire, buying into a business or deciding whether they want to leave the business or not. Right. And that's why these conversations matter and the outcome can shape all kinds of decision making in the process. It's like Brian said, we need to make sure we kind of get our arms around everything and just kind of be inquisitive and ask questions. Right.
Speaker: um So whether you're selling a business interest, buying out a partner or exploring your next investment, there's a lot of choices and a lot of things we need to incorporate. And that's where we come into play. And thank you for making Tax News Now part of your day. If today's conversation brought a client, colleague, or friend to mind, share this episode with them and keep that conversation going.
Speaker: Brian, again, thank you for joining us. It's been pleasure having you here. I'm Mark Gallegos. Until next time, stay curious, to keep asking good questions, and put what we've learned into work. Thanks for coming.
