Tax professionals may have the unique experience of seeing major tax reform legislation pushed through Congress twice within five years. For partnership-focused tax professionals, the recent draft legislation submitted by the Senate Finance Committee chair, if enacted, could drastically change major provisions of partnership taxation as we know it. In particular, section 704(c), already one of the more critical and complex code provisions, could become even more critical and complex.
It is imperative to recognize that this is only a draft discussion, and it is difficult to anticipate whether it will become legislation. However, real estate partnerships should take note of these ideas. While some proposals, such as dramatic changes to the debt allocation rules, may create an immediate cash tax impact, others will greatly complicate an already difficult compliance process and further emphasize the need for tax technology:
1. Mandating revaluations and the use of the remedial method under section 704(c)
What can cause a revaluation, and why do they matter?
Generally, a revaluation can occur when there is a contribution of money or other property to the partnership by a new or existing partner for an interest in the partnership, distributions of cash or other property to a partner in redemption of an interest in the partnership, and grants of partnership interests both compensatory and noncompensatory in nature to partners. Electing to revalue your assets requires the partnership to recognize its unrealized gains and losses for economic purposes and allocate underlying tax items like cost recovery deductions and realized gain or loss in accordance with the principles of section 704(c).
Currently, partnerships have flexibility regarding whether to revalue their assets and are permitted to use any “reasonable” method to compute the underlying section 704(c) gain and cost recovery allocations. The current regulations describe three methods for making section 704(c) allocations that are deemed to be reasonable: the traditional method, the traditional method with curative allocations and the remedial method. The draft legislation would require mandatory revaluations and mandatory use of the remedial method for section 704(c) computations.
2. Mandating sections 734 and 743 basis adjustments
What can cause basis adjustments, and why do they matter?
Generally, basis adjustments under sections 734 and 743 may occur upon recognition of a gain by a partner as a result of a distribution in excess of their tax basis or upon the sale or exchange of an interest in the partnership. These basis adjustments are generally attributable to partnership assets with significant unrealized gains and losses at the time of the transaction and recovered over the life of the underlying assets.
Only a partnership with a valid section 754 election may adjust the basis of partnership property in the case of a distribution of property or transfer of a partnership interest under sections 734 and 743 respectively. Generally, these basis adjustments are required when the partnership has "substantial" unrecognized losses and are attributed to partnership assets with significant unrealized gains and losses. The draft legislation will make these adjustments mandatory for all fact patterns and not simply when substantial unrecognized losses are present or if a valid section 754 election is in place.
MIDDLE MARKET REAL ESTATE INSIGHT
The draft legislation would drastically change the approach to partnership tax compliance across all industries. Real estate partnerships are particularly high risk for a major overhaul in the tax compliance process, as unrealized gains and losses are spread across high volume real estate portfolios. Only the bravest of real estate partnerships tackle the optional computations detailed above, for which the norm is to use myriad Excel spreadsheets. With the draft legislation, these would become mandatory for all and stretch the limits of current methods.
How tax technology implementation can help
A technology solution such as RSM PartnerSight can simplify the performance of large-scale complex partnership calculations, including those detailed above. The system performs those calculations accurately and efficiently, replacing the overwhelming Excel-based processes adopted by so many partnerships.
Now is the time to start discussions with your tax provider and stress the importance of implementing tax technology to handle upcoming legislative changes efficiently and avoid the consequences of maintaining current approaches with an ever-changing tax landscape.