Buying Out Your Real Estate Partner

By Jason Watson, CPA
Posted Monday, August 5 2024

You and two partners buy a $600,000 rental property together by contributing $200,000 each. Some time goes by, and one of your partners wants out. The rental property is now worth $750,000 so you pay them $250,000 (the increase in value was $150,000 or $50,000 per partner plus the partner’s original contribution).

However, per the general rule, the inside basis of the rental property is transferred to you without any adjustment. Yuck. In other words, your inside basis is $400,000 and the other partner’s basis is $200,000 for a total of $600,000 (let’s assume no depreciation). What is inside basis?

“Inside” basis is the total equity the partnership has in its assets, whereas “outside” basis is each partner’s tax basis in their share of the ownership. At the formation of a partnership inside and outside basis are usually equal (there are times when appreciated property is contributed, such as real estate, where the contributing partner’s outside basis is less than the inside basis which would be fair market value of the real estate).

Sidebar: The IRS requires that you track outside basis, and while your capital account might be negative, your outside basis generally cannot.

Should the partnership entity in our example sell the rental property outright for $750,000, the entity would have a taxable gain of $750,000 less $600,000, or $150,000, with your portion being 2/3 or $100,000. The problem is that you paid or contributed a total of $450,000 (your original $200,000 plus the $250,000 to buy out one of the original partners).

Your taxable gain should be $750,000 x 2/3 or $500,000 less $450,000, or $50,000. However, according to the books, your taxable gain would be $750,000 x 2/3 less $400,000, or $100,000 since the inside basis does not automatically adjust upon transfer from the departing partner to you.

What can be done is an IRC Section 754 election to increase your inside basis in the underlying asset by the additional amount paid to the departing partner. In our example this was $50,000.

Here is a table to highlight Fred buying out Shaggy.

Without a 754 election, the step-up portion column would not exist, and Fred’s inside basis would be $400,000 with a gain of $100,000. Also, keep in mind that we not considering depreciation matters including downstream depreciation recapture. Those issues can get tricky. Our intent was to highlight the basics of an IRC Section 754 election.