Certain Partnership Transactions May Benefit from a “Hidden Bonus” in Bonus Depreciation

Bonus depreciation is a powerful tool businesses can use to accelerate tax deductions on qualifying property. Its application in the context of certain partnership transactions — specifically, a subset of transactions resulting in Sec. 743(b) basis adjustments — raises nuanced questions and can be an easily missed opportunity.

This article explores the eligibility of Sec. 743(b) adjustments for bonus depreciation, the regulatory framework permitting its limited usage and practical considerations for taking advantage of this opportunity.

Bonus Depreciation Basics

Bonus depreciation allows taxpayers to immediately deduct some or all of the cost of qualifying property. Qualifying property eligible for bonus depreciation must generally:

1. Have a recovery period of 20 years or less (for example, machinery, equipment, furniture and fixtures, and land improvements);
2. Be placed in service within an allowable time period;
3. Be acquired within an allowable time period; and
4. Be either original use property or used property acquired by purchase.

Read “One Big Beautiful Bill Up Close: Tax Impact for Real Estate” for more on bonus depreciation, which was restored and made permanent in the OBBBA.

The Intersection of Section 743(b) Adjustments and Bonus Depreciation

When a partnership has a Sec. 754 election in effect, the purchase of an existing partner’s interest in the partnership triggers a Sec. 743(b) adjustment. This adjustment allows the incoming partner to step up (or down) its share of the partnership’s inside basis in partnership assets to reflect the consideration paid for the partnership interest. The goal of such an adjustment is to align a partner’s inside and outside tax basis in his or her partnership interest. The amount of adjustment is allocated among partnership assets as additional basis proportionate to their fair market value, and the additional basis may be depreciated or amortized, depending on the type of asset to which the adjustment is allocated.

The question then becomes whether a Sec. 743(b) basis adjustment qualifies for bonus depreciation. As stated above, property must meet four requirements to be eligible for bonus. Typically, the first three requirements are easy to identify and determine. The fourth requirement, specifically “used property acquired by purchase,” requires additional analysis.

Regulation Sec. 1.168(k)-2, which addresses bonus depreciation for property acquired and placed in service after September 27, 2017 (this date references the effective date of the Tax Cuts and Jobs Act), provides our answer. It states a Sec. 743(b) adjustment is treated as an acquisition of used property if:

• The transferee partner did not have a prior depreciable interest in the portion of the property being acquired,
• The transfer of the partnership interest is by purchase (not by inheritance or like-kind exchange) and results in a new cost basis, and
• The transferor and transferee are not related under rules described in Sec. 179 (this reference defines “related” via reference to Secs. 267 and 707(b), which are frequently referenced rules in the Internal Revenue Code regarding definitions of related parties).

If all of the above requirements are met, the additional basis created by the Sec. 743(b) adjustment can be treated as used property acquired from a third party. Further, if the other three requirements (class life, acquisition date, and in-service date) that cause the property to be eligible for bonus depreciation treatment are met, the additional basis is automatically eligible for bonus depreciation treatment.

Qualified Improvement Property (QIP) and Sec. 743(b) Adjustments

A common area of confusion is the treatment of depreciation on Sec. 743(b) adjustments allocated to Qualified Improvement Property (QIP). QIP is defined as:

• Any improvement to the interior portion of nonresidential real property;
• Placed in service after the building’s initial service date; and
• Not attributable to a building’s enlargement, elevators, escalators or internal structural framework.

Property that meets the above definitions has a 15-year MACRS straight line recovery period, making it eligible for bonus depreciation.

Importantly, to qualify as QIP, the original use of the property must be with the taxpayer. There is no “used property” exception for QIP. Therefore, a Sec. 743(b) adjustment allocated to a partnership’s QIP assets, if they exist, does not qualify for QIP treatment. The adjustment is therefore ineligible for bonus depreciation and is treated as 39-year nonresidential real property for depreciation purposes.

Other Opportunities and Pitfalls

Partnerships and partners may elect out of bonus depreciation for any property addition, including property basis created by Sec. 743(b) adjustments. This is done on a class-by-class basis (e.g., all 5-year property, all 7-year property, etc.), and the election is made on the partnership’s tax return. Importantly, Sec. 743(b) adjustments are considered a separate class from fixed asset additions acquired by purchase, so if a taxpayer is electing out of bonus depreciation, the taxpayer must carefully identify each separate class of property for which it is electing out. This nuance creates an additional planning opportunity for the partnership and the transferee partner, whereby bonus depreciation can be taken or not taken on any combination of classes of regular fixed asset additions and Sec. 743(b) adjustments.

If a taxpayer fails to take bonus depreciation on Sec. 743(b) adjustments and did not properly elect out of bonus depreciation, the normal “use it or lose it” rules apply when property is disposed of. In other words, if a taxpayer does not deduct depreciation it is entitled to, the taxpayer must still reduce basis in its assets by the allowable depreciation expense when disposing of property and calculating taxable gain or loss on the transaction. Not identifying this issue can result in missed tax deductions.

Taxpayers should also be aware that Sec. 734(b) adjustments, which apply when a partner is redeemed from a partnership by the partnership, are specifically identified by the regulation as ineligible for bonus depreciation treatment.

Below is a Summary Table of 743(b) Adjustments and Bonus Depreciation

The intersection of bonus depreciation and Sec. 743(b) basis adjustments is a technical but critical area for partnership tax planning. Understanding the eligibility rules, especially for used property and QIP, can unlock significant tax benefits and prevent costly errors. Always consult the latest regulations and consider seeking expert advice for complex transactions.

Contact Mike McGivney or a member of your service team to discuss this topic further.

In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.