What you paid vs. what the building's books say.
In Part 1 I said the building inside an LLC keeps the seller's old tax basis, and a 754 election is the fix. Here's what that looks like in dollars.
Same setup as before: an LLC that files as a partnership and has at least two owners after closing. On our deal, the deal side, counsel, and escrow got it closed. My seat was tax. The election went into the purchase agreement. The numbers below are not from that deal.
Made-up numbers
Two buyers each buy 50% of an LLC from its old owners. The LLC owns one commercial building and nothing else.
- The LLC bought it years ago for $1.6 million: $400,000 land, $1.2 million building.
- It has taken $500,000 of depreciation since. The building's tax basis is now $700,000.
- Today it's worth $3 million: $900,000 land, $2.1 million building.
- The LLC owes $1.8 million on its loan.
- The buyers pay $1.2 million cash, $600,000 each.
Two different numbers
Your basis in your LLC interest is what you paid, including your closing costs, plus your share of the company's debt. Each buyer, before closing costs: $600,000 cash plus $900,000 of the loan is $1.5 million. Together, $3 million. Who guaranteed the loan can change how the debt gets split, so check that.
The LLC's own books say something else. Land at $400,000 plus building at $700,000 is $1.1 million. Your share of that is $550,000 each.
That's a $1.9 million gap. Your basis says $3 million. The LLC's tax books say $1.1 million.
What the election does
With a 754 election, the company steps up the basis for you to close that gap. The step-up belongs to each buyer and gets tracked separately.
The step-up gets split between land and building. The split is mostly based on how far each one's value sits above its tax basis. Land is at $900,000 against a $400,000 basis, so it gets $500,000. The building is at $2.1 million against $700,000, so it gets $1.4 million. Land doesn't depreciate. The building piece does, on its own new 39-year clock starting at closing. (39 years is the schedule for commercial property. Apartments use 27.5.)
| Made-up numbers | Both buyers | Each buyer |
|---|---|---|
| Cash paid | $1,200,000 | $600,000 |
| Share of the loan | $1,800,000 | $900,000 |
| Basis in the LLC interest | $3,000,000 | $1,500,000 |
| Share of the LLC's tax basis | $1,100,000 | $550,000 |
| Step-up with the election | $1,900,000 | $950,000 |
| Goes to land (no depreciation) | $500,000 | $250,000 |
| Goes to building (39 years) | $1,400,000 | $700,000 |
| Extra depreciation, full year | $35,897 | $17,949 |
The old basis keeps depreciating on the old schedule, about $30,800 a year, until it runs out. So with the election, the buyers write off about $66,700 a year together instead of $30,800. Year one is partial. The clock starts in the middle of the closing month.
At a made-up 35% combined tax rate, that extra $35,900 is worth about $12,600 a year. Usually that's tax put off, not erased. Depreciation you take now generally comes back as gain when you sell. The federal rate on that part tops out at 25%, before surtax and state tax. And whether you can use the write-off now depends on your own return, including the passive loss rules.
The land and building split drives all of this. Get an appraisal that splits them. A sloppy split costs you depreciation, or invites a fight with the IRS.
Without the election
The $1.9 million doesn't vanish. It sits in your LLC interest. You mostly get it back when you sell that interest or the company winds up. Until then, you depreciate off the seller's old numbers and report more taxable income each year than you would with it.
It gets worse if the company sells the building. Say it sells for $3 million and keeps operating. On its books, that's a $1.9 million gain, and it flows to you even though you just paid full price. The matching loss usually waits until you sell your interest or the company winds up. With the election, that same sale shows about zero gain for you.
The fine print
- The company has to show the step-up math on its return for the year you bought in. Each buyer has to tell the company about the purchase in writing within 30 days.
- A cost segregation study can move parts of the building step-up to shorter lives. Those parts may qualify for 100% bonus depreciation on the federal return. Faster write-offs can come back as ordinary income when you sell. That's its own article. See our cost segregation page.
- California generally follows the same partnership rules, and a federal election generally counts for California. But California doesn't allow bonus depreciation. See California and bonus depreciation.
- If the property is worth less than the LLC's tax basis, the same math runs in reverse. That's a step-down, and past a $250,000 built-in loss it can apply even without the election.
Coming next
- Part 3: Prop 13 and transfer taxes when you buy a company instead of a deed.
Buying an LLC? Get the election in the contract, and get the appraisal before the return is due.
Shawn Lavi, CPA · LaviCPA · lavicpa.com. General information, not tax or legal advice. The example uses made-up numbers. Every deal is different. Talk to your own CPA and attorney before you act.