Inherited Partnership or Fund Interest: Basis and 754 Election

An inherited partnership interest gets a new basis: its value at the date of death, plus the heir's share of the fund's debt, minus any part of the value that is income in respect of a decedent (Reg. 1.742-1; 26 USC 1014(c)). That step-up is automatic. The fund's basis in its own assets does not change unless the fund has a section 754 election in effect.

Three things make a case not simple: the fund has no 754 election, the decedent had large suspended passive losses, or the decedent held carried interest or a share of the management company. Each can move a large amount of tax between the final return, the estate and the heir. The heir's notice to a fund with a 754 election is due within one year of the death, so start with the checklist below.

What basis do I get in an inherited partnership interest?

The basis of an inherited fund interest is its fair market value at death (or at the alternate valuation date, generally six months after death, if the executor elects it on Form 706, which is allowed only when it lowers both the estate's value and its estate tax (26 USC 2032)), increased by the heir's share of fund liabilities on that date, and reduced by any value that comes from income in respect of a decedent (Reg. 1.742-1). The same rule steps basis down when value plus debt share is less than the decedent's adjusted basis.

• Value at death. For a fund interest, this is usually an appraised value of the interest itself, not simply the capital account. Restrictions on transfer and redemption can affect it. The appraisal belongs to the estate.
• Share of liabilities. The fund's K-1 shows each partner's share of fund debt. A fund that borrows, such as a leveraged real estate fund, can give a large debt share.
• Income in respect of a decedent. Value that is a right to income the decedent earned but had not yet been taxed on gets no step-up (26 USC 1014(c)). See the section on that below.
• Holding period. Capital gain on a later sale of the interest is long-term, however briefly you held it (Publication 559). Part of the gain can still be ordinary income from the fund's receivables or inventory (26 USC 751(a)); carry is covered below.
• Held with a spouse. If the interest was community property, the whole interest, including the surviving spouse's half, generally takes its value at death as basis, if at least half of it is included in the decedent's estate (Publication 555; 26 USC 1014(b)(6)). If spouses held it jointly outside community property, only the decedent's half steps up (Publication 551).

The Form 8971 limit. If including the interest in the estate increased the estate tax, the value in your basis cannot exceed the final estate tax value; your share of fund debt is added on top. The executor reports that value to you on Form 8971 Schedule A (26 USC 1014(f)). For deaths in this page's tax year, the basic exclusion is $15,000,000, reduced by lifetime taxable gifts. Where no estate tax is owed, this limit does not apply (IRS: What's new, estate and gift tax). Where it does apply, a basis above the Schedule A value can draw an accuracy-related penalty of 20%, or 40% if the basis you report is twice the correct amount or more (Form 8971 instructions; 26 USC 6662(b)(8)).

Does the fund's basis in its assets step up too?

The fund's basis in its own assets changes on a partner's death only if the fund has a section 754 election in effect (Reg. 1.743-1(a)). With the election, the fund records a special adjustment for the heir alone, equal to the gap between the heir's new basis and the heir's share of the fund's asset basis. That is a section 743(b) adjustment.

One exception runs the other way. If the fund has a substantial built-in loss right after the transfer, it must reduce basis even without an election. A substantial built-in loss means the fund's asset basis exceeds the assets' value by more than $250,000, or the heir would be allocated a loss of more than that amount in a sale of all assets (26 USC 743(d)). Some investment funds have elected a different regime that limits the heir's later losses instead (26 USC 743(e)). Ask the fund which applies.

Should the estate ask the fund for a section 754 election?

A 754 election matters most when the fund holds assets worth more than their tax basis, such as long-held real estate; a fund that turns over its holdings within a year has less such gain. Without an election, the heir is taxed on gains that built up before death as the fund sells those assets. The heir's higher basis in the interest gives that tax back only as a loss when the interest is sold or liquidated, which can be many years later.

How the election works:

• Who makes it. The fund, not the heir. It files a written statement with its timely filed return, including extensions, for the year of the death (Reg. 1.754-1(b)). A fund that missed the deadline may still get relief (Instructions for Form 1065).
• Why a fund may say no. The election binds the fund for every later transfer and distribution, for all partners, and the fund cannot revoke it without IRS approval (Reg. 1.754-1(a) and (c)). A fund with frequent investor changes may decline for that reason.
• Your notice. If an election is in effect, the heir must give the fund a written notice, signed under penalties of perjury, within one year of the death. It must include the names, addresses and taxpayer identification numbers of the decedent and the heir, how the two are related, the date of death, the date you became the owner, the value of the interest at death and how that value was determined (Reg. 1.743-1(k)(2)(ii)). The fund is not required to make the adjustment until it is notified.

If the fund declines, the heir cannot make the 754 election alone. One exception: if the fund distributes property other than cash, such as securities, to the heir within two years of the transfer, the heir can elect to give that property the basis it would have had with the election (26 USC 732(d)). The heir attaches the election to the heir's own return for the year of the distribution if the property is depreciable, otherwise no later than the first year its basis affects the heir's tax. In some cases the same rule applies without an election, at any time, such as when the fund's assets were worth more than 110% of their basis at the transfer (Reg. 1.732-1(d)). Otherwise the gap between your basis in the interest and your share of the fund's asset basis stays until the interest ends. How the fund computes and tracks a 743(b) adjustment is covered in selling or redeeming a fund interest.

Who reports the K-1 in the year of death?

The decedent's final Form 1040 reports the fund items up to the date of death; the estate, or whoever received the interest at death, reports the rest of the year. Death closes the fund's tax year for the deceased partner, but not for the other partners (Reg. 1.706-1(c)(2); Publication 559, Partnership Income).

• The fund works out the decedent's share as if its year ended on the date of death. It may close its books or prorate the full-year amounts (Publication 559). Ask the fund which method it used, so the two K-1 periods add up.
• The final Form 1040 is due on the date it would have been due had the decedent lived, April 15 of the year after the year of death for a calendar-year taxpayer (Publication 559). Fund K-1s often arrive late, so an extension is common.
• A late return without an extension can cost 5% of the unpaid tax for each month or part of a month, up to 25%.
• After death, the K-1 goes to the estate if the interest passed through it. If the interest passed directly, for example to a trust or a surviving joint owner, the new owner reports it.

What happens to suspended passive losses at death?

Suspended passive losses on an inherited interest are deductible on the final return only to the extent they exceed the basis step-up. The part equal to the step-up is lost for good (26 USC 469(g)(2); Publication 925, Dispositions by death).

The step-up here is the heir's new basis minus the decedent's adjusted basis right before death. So an interest that rose in value usually wipes out its suspended losses; one that barely grew may release them on the final return, where they can offset any income. The decedent's last Form 8582 shows the losses for each fund. What those losses could do while the decedent was alive is covered in suspended passive losses from fund investments.

Is any fund income "income in respect of a decedent"?

Some of it is, and that part gets no step-up. Income in respect of a decedent is income the decedent had a right to but had not yet been taxed on. The person who receives it reports it when received (26 USC 691(a)), and the heir's basis in the interest is reduced by its value (Reg. 1.742-1).

• Named by the rules. Payments a partnership makes to a deceased partner's successor under section 736(a), such as payments for a share of future income in a buyout, are income in respect of a decedent (26 USC 753; Reg. 1.753-1(a)). So are payments by a third person for the right to those future payments.
• Not named. For other fund items, such as an incentive allocation earned before death but not yet allocated, or unrealized gain in a carried interest, no rule speaks directly to funds. The treatment is unsettled. The deciding facts are whether the right was fixed at death, what the fund or management company agreement says, and how the estate valued the interest.
• Estate tax offset. If the estate paid estate tax, whoever reports income in respect of a decedent may deduct the estate tax that the item caused (26 USC 691(c)).

My parent held carried interest or a management company share: what changes?

An interest in a fund's carry vehicle is an applicable partnership interest, and once an interest is one, it stays one (Reg. 1.1061-2(a)(1)(i)). The regulations say a carried interest given to a child as a gift remains one in the child's hands (Reg. 1.1061-5(f)). They do not address a transfer at death directly. So how the three-year holding rule applies to an heir, and how it interacts with the basis step-up and a 743(b) adjustment, is unsettled. The rule itself is covered in the carried interest three-year rule.

A share of the management company is often bought back under the owners' agreement. Payments that fall under section 736(a) are income in respect of a decedent, taxed to the recipient as received (26 USC 753). Which payments fall there depends on how the agreement is written and on whether the company earns its income mainly from people's work rather than from capital (26 USC 736(b)(3)). Reading and changing the agreement is a lawyer's job.

When do the K-1s switch from the estate to me?

The K-1s switch to the heir when the estate distributes the interest and the fund records the transfer. Until then they go to the estate. Ask the fund what it needs to admit you, often a transfer form and proof of the executor's authority, and from which date it will treat you as the partner. If the estate redeems the interest instead, its gain or loss is measured against the same stepped-up basis (Reg. 1.742-1), so a redemption soon after death at about the date-of-death value usually produces little gain or loss.

Fund K-1s can also require state returns in each state where the fund does business. That is covered in state returns for fund investors.

What should the executor get from the fund?

Ask the fund for these items soon after the death:

1. The value of the interest at the date of death and the capital statement as of that date.
2. The partner's share of fund liabilities at the date of death.
3. Whether a section 754 election is in effect, and if not, a written request that the fund make one for the year of death.
4. How the fund will split the year-of-death K-1 (closing of the books or proration).
5. The decedent's K-1s for prior years and the decedent's Forms 8582 with the suspended losses for each fund.
6. Any carried interest, incentive allocation or management company documents, including buyout terms.
7. The fund's transfer requirements for moving the interest to the heir.

If the estate is required to file Form 706, the executor also files Form 8971 and sends each beneficiary who received property a Schedule A, whether or not estate tax is owed. They are due 30 days after the earlier of the Form 706 due date (with extensions) or the date it is filed (Form 8971 instructions).

Pay the decedent's and the estate's taxes before handing the interest to the heir. An executor who pays other debts or distributes property first is personally liable for unpaid federal tax up to the amount paid (31 USC 3713(b)). An heir who received the interest is personally liable for unpaid estate tax up to its value at death (26 USC 6324(a)(2)), and as a transferee can be assessed for the decedent's unpaid income tax until one year after the IRS's time to assess the decedent runs out (26 USC 6901).

Example

These figures are illustrative and in US dollars.

A real estate fund interest that rose in value

A father dies on June 30 holding a real estate fund limited partner interest worth $900,000. His share of fund debt is $150,000. His adjusted basis in the interest, including that debt share, is $350,000. He has $120,000 of suspended passive losses from the fund.

• Heir's basis: $900,000 + $150,000 = $1,050,000.
• Step-up: $1,050,000 − $350,000 = $700,000.
• The $120,000 of losses is less than the $700,000 step-up, so none of it is deductible on the final return. It is lost.
• The final Form 1040 reports the fund's items from January 1 to June 30.

The same fund with less growth

Now the father's adjusted basis was $1,000,000. The step-up is $1,050,000 − $1,000,000 = $50,000. The losses exceed it by $120,000 − $50,000 = $70,000, so $70,000 is deductible on the final return and $50,000 is lost.

With and without a 754 election

Go back to the first case. A year later the fund sells its only asset, a building, for the same value it had at death. Assume the heir's share of the fund's asset basis is $350,000, all in the building. The heir's share of the fund's gain is $700,000.

• No election: the heir reports a $700,000 gain. The heir's basis in the interest rises by the same $700,000, which comes back only as a loss when the interest is sold or liquidated, usually a capital loss, which may not offset the earlier gain in the same year or at the same rate.
• Election in effect: the 743(b) adjustment of $700,000 offsets the gain, so the heir reports no gain on that sale.

Different for you?

• The fund will not make a 754 election, or the decedent held carry or a management company share: these need judgment on timing and character. Get help through hedge fund and alternative fund tax services.
• You need the final Form 1040, the estate's Form 1041 or Form 706, or your own return with inherited K-1s: see hedge fund and alternative fund tax services or individual tax services.
• The fund sold its last asset and sent a final K-1: see final fund tax form.
• You inherited from family abroad: see gifts and inheritances from abroad.
• You live outside the US and inherited a US fund interest: see foreign investor in a US fund.
• The decedent was a US citizen living in Canada: see final returns when a US citizen dies in Canada.
• You inherited Delaware statutory trust interests: see Delaware statutory trust tax reporting.
• You want to know which state returns the K-1s require: see state returns for fund investors.