Purpose of Substantial Built-in Loss Rules
Q1. What’s the purpose of the substantial built-in loss rules?
A1. The purpose of the substantial built-in loss rules is to prevent a double benefit of built-in losses that may result from the transfer of a partnership interest. The transferor partner recognized the built-in loss in the partnership property upon the sale or exchange of their interest. If the partnership doesn’t adjust partnership property with respect to the transferee partner, the transferee will benefit from the built-in loss associated with the partnership property such as through depreciation or loss on the sale of the property.
Substantial Built-in Loss Defined (Prior Law)
Q2. What is a “substantial built-in loss” under prior law (through December 31, 2017)?
A2. In general, a partnership doesn’t adjust the basis of partnership property following the transfer of a partnership interest unless it has a valid IRC Section 754 election to make basis adjustments or a substantial built-in loss immediately after the transfer. Under prior law, a substantial built-in loss exists if the partnership’s adjusted basis in its property exceeds by more than $250,000 the fair market value of the partnership property.
If the partnership has made an IRC Section 754 election, or has a substantial built-in loss immediately after the transfer, the partnership adjusts its bases in its partnership property with respect to the transferee partner.
These adjustments account for the difference between the transferee partner’s proportionate share of the adjusted basis of the partnership property and the transferee’s basis in its partnership interest. The adjustments approximate the result of a direct purchase of the partnership property by the transferee partner.
Q3. How was a substantial built-in loss determined under prior law?
A3. The substantial built-in loss rules used an aggregate approach. The partnership compared the fair market value (FMV) of all assets to its total adjusted tax bases. A substantial built-in loss existed if the adjusted basis of partnership assets exceeded the FMV of partnership assets by more than $250,000.
Changes to Substantial Built-in Loss Rules under the TCJA
Q4. What changes did TCJA make to IRC Section 743(d)?
A4. The TCJA changed the rules relating to the substantial built-in loss computation.
The new provision adds another definition for purposes of determining whether there is a substantial built-in loss at the time of the transfer of a partnership interest.
Now, the partnership has a substantial built-in loss when:
- the partnership's adjusted basis in partnership property exceeds the fair market value of such property by more than $250,000, or
- the transferee would be allocated a loss of more than $250,000 if the partnership sold assets for cash equal to their fair market value immediately after such transfer.
Q5. Example – Loss Allocated Exceeds $250,000
A5. Partnership ABC has three partners (partners A, B, and C) and has not made an election under IRC Section 754. The partnership has two assets. Asset G has a built-in gain of $2 million. Asset L has a built-in loss (BIL) of $1.8 million.
Under the terms of the partnership agreement, any gain on sale or exchange of Asset G is specially allocated to partner A.
Partners A, B and C share equally in all other partnership items, including the built-in loss in Asset L. Partners A, B and C’s share of the net built-in loss is $600,000 (one-third of the loss attributable to Asset L) allocable to their respective partnership interest.
Under prior law, the partnership would have a net built-in gain of $200,000 ($2 million gain in Asset G netted with the BIL of Asset L of $1.8 million). Because of no BIL, former law would have required no adjustment.
Under the TCJA, if Partner C sells his partnership interest to D after January 1, 2018, for $66,666 (one third of the net FMV of the partnership), the partnership would have a substantial built-in loss.
The test for a substantial built-in loss applies at both the partnership level and at the transferee partner level. Immediately after the transfer, the assets are treated as sold for cash equal to their fair market value. The partnership computes gain or loss on an asset-by-asset basis. Even with no overall loss, it’s possible that on an individual basis, some assets, if sold, would result in a loss. If the transferee partner under the partnership agreement would be allocated a loss of more than $250,000 from the sale of such assets, the partnership must adjust the basis of its assets to the transferee partner. The partnership must adjust the basis of the assets giving rise to the substantial built-in loss with respect to the transferee partner.
In this example, the partnership must adjust the basis of Asset L to partner D (or by $600,000).
This provision prevents a double deduction of losses associated with BIL partnership property. In this example, the BIL partnership property would have reduced the FMV paid to Partner C (effectively reducing their gain or increasing their loss). If not for this provision, transferee partner D would have been able to benefit from the BIL associated with Asset L.
Q7. When did the changes to IRC Section 743 become effective?
A7. The changes apply to sale or exchanges of partnership interests occurring after December 31, 2017.