This article will focus on how to maximize an increase of a Unadjusted Basis Immediately After Acquisition (“UBIA”) where a member or partner of an LLC or LP interest is below the estate tax exclusion amount of $11,400,000 ($22,800,000 for a married couple) under the 2017 Tax Cuts and Jobs Act (“TCJA”). Please see the comments below about revising either an LLC or LP agreements to change the valuation of a partner’s interest from the typical “fair market value” formula (“FMV”) to the “net asset value” formula (“NAV”).
On January 18, 2019, the Internal Revenue Service (“IRS”) issued final regulations and three related pieces of guidance, implementing the new qualified business income (“QBI”) deduction (“Section 199A deduction”). On February 4, 2019, the IRS issued revised final regulations to correct and provide additional guidance about QBI and the UBIA dealing with the sale of a partnership interest or the transfer by inheritance.
For real estate owners of rental property there are two main issues that will impact your tax deduction. One is the threshold amount of your taxable income (single person with taxable income more than $157,000 and married couple 315,000). The other is whether or not you purchased the real property within the last 10 years, and also the 2.5% cost on all qualified property tests (building) for depreciation.
If you have already depreciated your rental property and you are above the threshold amount, your Section 199A deduction will be limited because of the 2.5% test. However, if property is inherited and immediately placed in service by the heir, the UBIA in the property will generally be its fair market value at the time of the decedent’s death.
Property owned by a partnership will also receive a step-up in basis upon the death of a partner, as the Regulations state that basis adjustments under Sections 734(b) and 743(b) (when a 754 election is in effect for the partnership). This was not the case in August 2018, when the IRS issued proposed regulations that would disallow the 754 election on death for the Section 199A deduction only.
The standard formula used in most LLC and LP agreements is the FMV formula for purposes of creating discounts on either the LLC or LP interest for gift or estate tax purposes. A typical transfer of either an LLC or LP interest can be between 30 to 40%. If an LLC or LP interest had a NAV of $100,000 with a 30% discount the FMV would be $70,000. This a very favorable result if the LLC or LP interest was subject to the 40% estate tax rate under TCJA. The UBIA would then be $70,000 for depreciation purposes.
If your estate is below the estate tax exclusion amount of $11,400,000 ($22,800,000 for a married couple) you would want to use the NAV formula in order to increase your UBIA to $100,000 for income tax purposes. This change to the NAV formula gives you an additional $30,000 for depreciation on your income tax return!
The initial basis of a member or partner who acquires an LLC or LP interest by inheritance is the fair market value of the LLC interest, IRC §§742 and 1014(a). Under the IRC §§742, 1014(a) and its regulations it is the gross value of the property reduced by its debt. Gross value is the price at which the property would change hands between an unrelated willing buyer and willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of all relevant facts. Generally, with respect to trade or business assets, going concern value should be used as it will provide the most accurate reflection of such a price.