The last couple of years has produced a great change in our political atmosphere, and as a result of this we are hearing and seeing more for potential tax law changes that could impact how limited partners plan their estates. Notably, the elimination of step-up in basis has been brought up and more recently directly addressed by Treasury Secretary Janet Yellen. This article is going to briefly cover what the step-up in basis is, how limited partners benefit from this, and what the proposed changes could mean moving forward.
Before we move forward, it is important to note that for the last 15 years our team at LP Equity has helped hundreds of limited partners sell their illiquid interests and we frequently work with estate scenarios that are benefitting from the step-up in basis. As a result, we are well versed in how this mechanism works particularly for real estate limited partnerships. Despite our depth of knowledge on this subject, we are not licensed tax professionals, so any limited partner or heir considering their position should consult their tax professional before making any kind of decision.
What is Step-Up in Basis?
The step-up in basis provision allows for the cost basis of an inherited asset, such as a limited partnership interest, to be adjusted to the fair market value. This occurs when it is passed on to an heir or estate, after death. The “step-up” eliminates the capital gain that occurred between when the asset was originally purchased and when it was inherited. As a result, an heir benefiting from a step-up in basis will significantly reduce or eliminate their tax liability. It should be noted that the step-up in basis provision benefits are greater for individuals, as opposed to trusts or corporate entities holding an individual limited partnership interest.
How Do Limited Partners Benefit From Step-Up in Basis?
Due to the structure and passive nature, many wealthy investors and high-earners have historically utilized limited partnerships as a tax shelter vehicle. The Tax Reform Act of 1986 overhauled limited partnerships and their viability as tax shelters. Notably, the recapture of the previous tax benefits upon disposal created substantial tax liability for many investors. The recapture tax liability can be determined from the capital account balance that appears on a limited partner’s IRS form 1065 K-1.
In some cases the recapture tax liability of a limited partnership interest can be greater than the fair market value of that investment. The step-up in basis provision allows the estate or heir of a limited partner to benefit by significantly reducing or entirely eliminating the recapture tax liability. This means that for many of the investors that have large recapture tax liability, it can make more sense to hold on to these assets until death so that the estate can benefit from the step-up in cost basis and then sell.
What Do the Proposed Changes Mean for Limited Partners?
The Biden administration has proposed that either capital gains taxes be applied upon death, or if no taxation is imposed upon death then the heir/estate would also inherit the cost basis for that asset. This means that the recapture tax liability will exist through death and potentially impact the estate that would have previously benefited from a step-up in cost basis.
The elimination of step-up in basis, paired with more aggressive capital gains tax rates, poses considerations for investors to consult with their financial advisors and tax professionals for estate planning purposes.
Given the proposed tax law reforms and evolving political atmosphere combined with the heated real estate market, there has never been a better time to consider how your limited partnership interest is being held. We strongly advise that you consult with your financial advisor to discuss how well positioned you are to take advantage of the step-up in basis, whether your investment is being held in a trust, corporation or jointly owned with a spouse. These factors can help to determine the validity of the step-up in basis for your estate planning purposes.
Our team at LP Equity is here to be a resource for limited partners looking to explore the value of their individual partnership interests and how these traditionally illiquid assets can be turned into cash. We are here to help, call our team today to discuss how we can help with your limited partnership interest.