Inside Basis

A limited partner's outside (tax) basis is $25,000 and her at-risk amount is $16,000. The partnership distributes $20,000 of cash to her during the year. What is the tax character of the consequence to her, given that the distribution exceeds her at-risk amount but not her outside basis? (Figures are illustrative only.)

1. A.The full $20,000 distribution is capital gain, because any distribution exceeding at-risk amount is treated as gain from selling the partnership interest.Wrong. Capital gain is triggered only by a distribution that exceeds outside basis, not by exceeding at-risk amount.
2. B.Nothing is currently taxable, because the distribution is fully covered by her $25,000 outside basis.Wrong. Staying within outside basis avoids capital gain, but a separate ordinary-income recapture rule applies once the distribution exceeds at-risk amount.
3. C.$4,000, the amount by which the $20,000 distribution exceeds her $16,000 at-risk amount, is recaptured as ordinary income; because the full distribution still stays within her $25,000 outside basis, none of it is capital gain.Correct. The $4,000 excess over at-risk amount is ordinary income recapture, and no capital gain arises because the distribution does not exceed outside basis.
4. D.$9,000 is ordinary income, measured against her at-risk amount before this year's distribution reduced it.Wrong. This miscalculates the recapture amount; the recapture is measured as the distribution in excess of the at-risk amount, which is $4,000, not $9,000.

Why: Basis and at-risk amount trigger two separate consequences at two separate thresholds: exceeding at-risk amount, even while staying inside basis, recaptures the excess as ordinary income, and only exceeding outside basis itself produces capital gain.

An investor purchases a limited partnership interest on the secondary market for a price well above the seller's own outside basis in that interest, reflecting substantial appreciation in the partnership's underlying real estate since it was originally acquired. Without any special election, the buyer's share of the partnership's inside asset basis remains the old, lower historical figure, mismatched with the higher price she actually paid. What election is available to align the partnership's inside asset basis with what the buyer actually paid?

1. A.No such election exists; a transferee partner is permanently bound to compute her share of depreciation and gain using the same historical inside basis figures as the seller, regardless of what she paid.Wrong. A Section 754 election exists precisely to address this mismatch; the buyer is not permanently bound to the seller's historical figures.
2. B.The buyer can unilaterally elect on her own personal tax return to use a higher inside basis figure for the partnership's assets, without any action required by the partnership itself.Wrong. The Section 754 election is made by the partnership, not unilaterally by an individual transferee partner.
3. C.The mismatch resolves itself automatically after five years, at which point the partnership's inside basis in its assets is deemed to equal what each partner individually paid for her interest.Wrong. There is no automatic multi-year reset; a Section 754 election is required to make any inside basis adjustment.
4. D.The partnership can make a Section 754 election, which allows an optional step-up (or step-down) of the partnership's inside basis in its assets, specifically for the transferee partner, to better reflect the price she actually paid for her interest.Correct. A Section 754 election allows an optional inside basis adjustment for the transferee partner.

Why: The partnership can make a Section 754 election, which allows an optional step-up (or step-down) of the partnership's inside basis in its assets, specifically for the transferee partner, to better reflect the price she actually paid for her interest.