Here is a brief synopsis:
- In 2014, my spouse inherited 1/8 share of a 27 year old rental real estate business.
- Prior to 2014, the LLC had used ~$1M of depreciation.
- LLC's accountant did not file a 754 election to step-up the basis for the heirs.
- In 2021, the LLC paid a licensed commercial real estate appraiser to estimate the FMV at the time of inheritance.
- Valuation was $1.5M, using sales comparison and income capitalization approaches.
- The appraisal has verbiage to justify a step-up in basis to the IRS.
- The business and all property was sold in 2022, proceeds distributed, and the LLC was dissolved.
- All proceeds appear on the K-1, there is no other document from the accountant.
- Partner's basis can be stepped up by subtracting 1/8 share of the appraiser's FMV from the Section 1231 gain.
- What's odd to me is that Box 9c on my spouse's final K-1 shows unrecaptured Section 1250 gains = 1/8 of ALL depreciation that was ever taken by the LLC, going back to 1987.
- 90% of the LLC's historical depreciation was taken prior to inheritance.
My question is: are heirs responsible for ALL unrecaptured section 1250 gains over the life of a partnership?
- In my mind, the heir should only be responsible for their share of the LLC's depreciation taken AFTER the inheritance.
- And if I am correct, how to show this adjustment in TT?
Thanks in advance for your advice!
without the 754 election there is inside and outside tax basis that are different. all the years since death didn't the heirs report the income/loss based on the k-1 without the benefit of any step up. This is continued to do this in the final year.
however, don't think you'll be over reporting income because of no Section 754 election. what can't be done because of the lack of the election is to change the k-1 numbers unless you like corresponding with the IRS and a tax bill to boot.
you have outside basis. it is unclear whether that's $1.5 million or 1/8 of that.
anyway, you start with your outside basis on the date of death add partnership income or subtract partnership loss for all the intervening years per the k-1 subtract distributions for those intervening years except 2022.
you now have a tax basis which should be higher than the cash distributions during 2022. report the disposition of the partnership interest using the 2022 distributions as the selling price and the calculated tax basis which should produce a capital loss to offset the pre inheritance depreciation.
an over simplified example descendant's and heirs allocable shars
original cost $2.75 million.
deprecation taken through date of death $2 million.
leaving inside basis of $.75 million.
property sold for $1.5 million on date of death.
inside1250 gain $.75 million (k-1) treated as capital gain.
outside basis $1.5 million = FMV DOD.
k-1 gain $.75 million.
outside basis now $2.25 million.
distribution $1.5 million (sales price of interest)
outside capital loss $.75 million.
the outside capital loss offsets the inside capital gain.
@Mike9241 -- thanks for the info. The outside vs inside basis twists my brain into knots. To make sure that I understand what you're saying, I'll try your approach using data from the 1/8 partner share:
|start with your outside basis on the date of death (per appraisal)||195|
|add partnership income for all the intervening years per the k-1||535|
|subtract partnership loss for all the intervening years per the k-1||n/a|
|subtract distributions for those intervening years except 2022.||(130)|
|you now have a tax basis which should be higher than the cash distributions during 2022||600|
|report the disposition of the partnership interest using the 2022 distributions as the selling price (2022 K-1 box 19A)||410|
|less the calculated tax basis||(600)|
|which should produce a capital loss to offset the pre inheritance depreciation||(190)|
total depreciation shown on 2022 K-1 box 9c
|post inheritance depreciation (from actual 1065s)||10|
|pre inheritance depreciation (subtracting post- from total)||105|
i may have misled you on your situation by assuming that the 1.5 million was the valuation of the decedent's interest rather than the value of the real property (ie it does not include the value of other assets like cash net of liabilities such as a mortgage). if it was the decedent's interest than what I provided was correct as to outside basis but if it was the value of just the property then the starting amount is the decedent's capital account on the date of death plus the difference between the decedent's share of the appraised value of the property and the tax basis of the decedent's interest in the property IE what would have been the IRC sec 754 step-up.
decedent's share of appraised value of property $1,500.
tax basis of the decedent's share of property $300
difference $1200 (this would have been the 754 step-up had the election been made)
capital account on date of death (this would reflect any income for the part of the year before death) say $16 consisting of property of $300 less mortgage of $284
thus, in this example, the starting outside basis because 754 was not elected would be $1216.
if 754 had been elected and the building had been immediately sold for $1500 the k-1 would reflect no gain or any amount on line 10 or 9c after paying of the mortgage of $284 there would be $1216 left to distribute which equals the capital account
now say the property was sold at year end for the $1500. depreciation taken post death and the loss for the remainder of the year was $20 (including the depreciation). line 2 would reflect a loss of $20 (depreciation) while line 9c and 10 would reflect a profit of $20 (selling price of $1500 less tax basis of $1480). mortgage payoff as above.
tax basis to start $1216 less line 2 loss of $20 plus line 10 income of $20 (line 9c is included in line 10) = $1216. notice that the pre death depreciation is gone. I cannot tell you why the election was not made.
this thread may help clarify what the election would have done
the difference is that with depreciable property prior depreciation would be eliminated but the post death depreciation would be higher and the net income because of the higher depreciation would be lower.
what i gave was an example. you results differ but the 190 loss is mathematically correct. you report the numbers on the k-1 for tax purposes. the 190 loss offsets the 1250 gain on 9c of 115
and did part II schedule L of the k-1 show zero as ending capital?
it would seem that the difference between the FMV and tax basis on date of death was $190
that's because if you start with a $5 capital a/c on date of death
add the $535 income post date of death the total is $540
distributions post date of death of $130 excluding 2022 reduces basis to $410
which equals the final distribution of $410
which zero's out capital account which is what's supposed to happen.
this assumes the descendant was a partner/member from day 1 of the entity.
if the $190 is far off you may need a tax pro to review the k-1's starting with the year of death.
the 1231 gain reported on line 10 includes the 1250 recapture reported on line 9c
put another way line 10 on the k-1 shows up on line 11 of schedule D while 9c on the k-1 shows up on line 19 of schedule D.
@Mike9241 -- indeed, the K-1 Part II Box L shows Ending capital account = $0. And the $190 difference is on target. Everything you laid out above is correct. But my original question is a little more subtle, here it is again in a slightly expanded version:
My question is: are heirs responsible for their share of ALL unrecaptured section 1250 gains over the life of a partnership (in this case, $115)? In my mind, the heir should only be responsible for their share of the LLC's depreciation taken AFTER the inheritance ($10).
The killer for me is that the K-1 Box 9c shows $115. I don't know of a way to separate the pre-inheritance chunk ($105) from the post-inheritance one ($10). Entering $10 for K-1 Box 9c in TT does the trick, but that discrepancy will likely raise a flag at the IRS.
So -- unless I am missing something -- the bottomline is that the entire $115 portion of the overall gain is taxed at a higher rate than 'regular' capital gain rate of 15%. If the partnership had filed a 754 election, then Box 9c would = $10 and only that amount would be taxed at the higher rate.
I appreciate your time and effort replying to my question, @Mike9241
you don't say what's on line 10 which is the total capital gain nor what the 754 adjustment would have been. it would have been the fair market value of all the partnership assets less liabilities less their tax basis times the descendant's ownership interest.
in part the line 9c amount will be offset by the capital loss on disposition
assuming no other capital gains or losses if line 10 were 200 then the 190 loss would reduce the overall gain to $10 and only the 10 would be recaptured as 1250 gain, if line 10 were 300 then the overall gain would be $110 all taxed as 1250 gain
if 754 had been elected then line 10 would go down by the 754 step up but up by the additional depreciation that would have been taken on the 754 adjustment and post death depreciation, so line 9c would be higher than the $10.
to give an example, the depreciable portion of the property seems to have been almost fully depreciated so assume it was since it was a 27-year-old business back in 2014. if the land was valued at 292 the building would have been valued at 1208. 1/8 pf that would be 151. on that an additional ~5.50 in depreciation would have been taken each full year (151/27.5) since it was about 8 years between death and the sale the maximum amount subject to 1250 recapture would have been about 44. now say the property was sold for a net of 2000. 1/8 of that is 250. so gain = 250 (sales price) - 151(tax basis building including step-up) +44 (depreciation) - 36.5 (1/8 of the 292 in land). if my math is correct line 10 would be 106.5 and line 9c would be 44. also, to take into account is that each k-1 over the intervening years would report less profit due to the additional depreciation. whether the passive loss rules would come into play is unknown. still not as good if 754 had been elected.
maybe the accountant was unaware of 754 but then why didn't the executor raise the issue when the k-1's came out without it. there may have been a chance for a late 754 election.
This is my understanding of how the tax laws apply in your situation. I no longer actively prepare tax returns. You are free to consult with an outside tax lawyer or other tax pro to see if they can offer some sort of relief. I would warn against not reporting what is on the k-1's since this could generate a notice from the IRS and potentially result in substantial penalties.
- I will ABSOLUTELY use the K-1 numbers on my return
- 9c=$115, 10=$370.
- executor of the decedent's estate didn't question accuracy of the LLC's1065 + K-1s when the LLC share was inherited (2014). Neither did I.
- IRS rules say that a 754 election had to happen within 1st two partnership tax filings. But it didn't.
- LLC accountant passed away in 2016.
- LLC's tax prep has been handled by a different CPA since then.
- I'll talk with a tax pro to ensure my TT return is correct.
I really appreciate all of your time and effort on this thread!
One thing to keep in mind, is that Unrecaptured Section 1250 depreciation is NOT gain. This is used in determining the tax rate on the gain.
Unrecaptured Section 1250 gain is taxed at 25%.
Since these types of questions are difficult to address without the history and understanding of what occurred post inheritance, even if this figure is not gain, it could tax some of your gain at a higher rate if not properly reported.
Also keep in mind the date of replies, as tax law changes.
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