Real Estate Ventures & the Hidden Built-in Gain (Loss)
Generally these formations are tax-free under Internal Revenue Code (IRC) Section 721 (assuming any debt on the property is not in excess of the underlying basis). To the extent that property is contributed with a built-in gain (loss), the rules under IRC Section 704(c) come into play. 704(c) requires the partnership to calculate and allocate the built-in gain (loss) back to the contributing partner over the term of the project either through the allocation of gain or loss on a sale or through depreciation and expense allocations. Without 704(c), a taxpayer could shift built-in gains or losses to other parties upon the contribution of such property to a partnership.
The Hidden Built-In Gain (Loss):
Revaluations can occur in these instances:
- a new or existing partner makes a contribution to a partnership of cash and/or property,
- a partnership makes a distribution to a partner as consideration for his or her interest (partial or whole) in a partnership,
- a partner is granted a partnership interest in exchange for services, or
- a partnership issues a non-compensatory option to acquire an interest in a partnership.
The appreciation or depreciation of the property must be allocated among the partners’ capital accounts in the same way as gain or loss would have been allocated if the partnership had disposed of its properties in a taxable transaction at FMV on the date that the capital accounts are revalued. Any future allocations of depreciation, amortization, gain and loss, as calculated for book purposes, must be allocated for tax purposes under the 704(c) rules. The foregoing illustrates the importance of maintaining tax basis and fair market value (IRC Section 704(b)) capital accounts. It is likely that most partnership operating agreements address such revaluations. Without the adjustment at a “revaluation event” or any 704(c) transaction, capital accounts become disproportionate to the true economics of a partnership.
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