754 Basis Adjustment Upon Purchase of Membership Interest

Question: I am buying a minority interest in a three member limited liability company which owns appreciated real estate.  If the property is sold, will I be taxed on the appreciation that occurred prior to my purchase?

Answer:  There are various tax issues that arise in connection with purchases and sales of interests in limited liability companies (“LLCs”) taxed as partnerships.  One concern relates to the purchase of a LLC membership interest which holds property which has appreciated in value. The purchase price you are paying is no doubt based on the underlying fair market value of the LLC’s real estate property. As with any purchaser, you do not want to be saddled with a tax burden attributable to asset appreciation which occurred prior to your purchase.  Absent any special planning, you, like the other LLC members, will be taxed on the gain from any eventual sale of the real estate property.

To negate the harshness of this result, the Internal Revenue Code allows a special election, a Section 754 election, to be made when a party purchases a membership interest from a LLC member.  A 754 election allows the LLC to increase the basis of LLC property to fair market value with respect to the purchasing party. The higher basis often results in larger depreciation deductions for the purchasing party. Equally important, the higher basis can either reduce the gain or increase the loss the purchaser must report when the real estate is sold, depending upon the increase or decrease in the value of the LLC’s assets following the membership interest purchase.

As the purchasing party, you should consider whether the LLC has a 754 election in place which allows for this basis adjustment.  If not, you should review the LLC’s Operating Agreement to determine which member or members have the right to cause the LLC to make this election and whether the election will be made as a result of your purchase. If no 754 election is in effect and no such election will be made following your purchase, you should consider negotiating a lower purchase price with the seller of your membership interest to account for the increased tax burden you may bear in the future due to the appreciation in the LLC’s real estate property.

754 elections are not always advantageous.  Assets do not always appreciate in value and, once a 754 election is made, downward adjustments in the basis of an LLC’s assets are required for assets which have decreased in value. After a 754 election is made, it can only be revoked with the consent of the Internal Revenue Service which is generally not readily obtainable.Your situation is just one of the circumstances where a 754 election should be considered. Basis adjustments for a 754 election are also permitted upon the death of a LLC member and upon the distribution of LLC property to members. While there are various factors to consider in determining whether or not a 754 election should be made, in a situation such as yours where you are purchasing a membership interest in a LLC which holds appreciated property, a 754 election is recommended.

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.