Section 754 election valuation error on partnership tax return - need correction options

Thanks for the detailed response. I'm leaning toward the prior period adjustment approach since it seems cleaner than filing Form 3115. Do you think there's any risk the IRS would challenge this correction given that the Section 754 election itself isn't changing, just the valuation used? Also, on the depreciation point - since these are limited partnership interests rather than direct real estate holdings, my understanding was that we don't depreciate the Section 754 step-up basis. Is that correct?

The IRS could certainly question the adjustment, but your risk is mitigated by several factors. Since you're only correcting the valuation (not the election itself) and have clear evidence from the recent sale supporting the correction, you have a reasonable position. Make sure your disclosure is thorough, explaining the valuation method used originally and why it resulted in an undervaluation. You're correct about the depreciation. For limited partnership interests, the Section 754 step-up is typically allocated to the underlying assets, but since you don't directly own or depreciate those assets, the partnership interest itself isn't subject to depreciation. The partnership might be taking depreciation on the underlying real estate, but that's separate from your basis adjustment in the partnership interest.

Did they actually help with the Section 754 calculation itself or just provide general advice? I'm dealing with a similar issue but need someone who really understands the technical valuation aspects. How detailed was their analysis?

I'm skeptical about online tax services for something this complex. Section 754 elections involve serious partnership tax law. Did you have any issues with the IRS after using their guidance? I'd be worried about taking advice that isn't from a professional who specializes in partnership taxation.

They provided detailed analysis of the Section 754 calculations, not just general advice. They have tax professionals who review the documentation and point out specific issues with valuations. In my case, they identified that our income approach used incorrectly low cap rates and provided guidance on more appropriate valuation methods that still worked within IRS guidelines. We haven't had any issues with the IRS. Their advice was actually quite conservative and well-documented. They're not replacing an accountant - they're providing specialized analysis that most general CPAs don't have deep expertise in. My accountant was actually grateful for the detailed guidance since Section 754 elections aren't something they deal with regularly.

How does this service actually work? I've been trying to reach the IRS about a K-1 issue for weeks. Do they just call the same number I would call, or do they have some special access?

Sorry, but I don't buy it. I worked at a Big 4 accounting firm, and even we couldn't get specialized IRS agents on demand. The IRS is severely understaffed. I seriously doubt any service can magically get you to partnership tax specialists. Sounds like you just got lucky or they connected you with a general agent who happened to know something about partnerships.

They don't have a special number, but they use technology that navigates the IRS phone system and waits on hold for you. When an agent finally answers, they immediately connect you. It works because they understand the optimal times to call and which prompts to select to reach specific departments. The key difference is they're persistent and efficient. When I finally got connected, I specifically asked for someone who handles partnership tax issues, and they transferred me to a more specialized department. It's not magic - it's just leveraging their system and being very clear about needing someone with partnership taxation expertise. They won't guarantee a specialist, but they dramatically increase your chances of reaching someone helpful by getting you through the initial bottleneck.

That's excellent advice about the documentation. If we go the prior period adjustment route, would you suggest having an independent appraiser prepare a retroactive valuation report for the date of death value, or would our internal calculation with market comparables be sufficient if well-documented?

An independent appraisal would provide the strongest support, but it might be overkill depending on the overall size of the partnership and adjustment. A well-documented internal calculation using market comparables from the date of death period can be sufficient if you can demonstrate a reasonable methodology. One approach I've seen work well is to use the current sale as a benchmark, then work backward using industry-standard appreciation rates for that type of commercial property in that location. Include local market data from 2022 that supports your revised valuation. Also gather any information about comparable property sales from that time period to strengthen your position.

Good point! Adjusting the Section 754 election value would increase their capital accounts, which could affect profit/loss allocations depending on how the partnership agreement is structured. It might also impact any special allocations or preferred returns if those are based on capital percentages.

This is really helpful advice about timing the correction before the pending sale. I hadn't considered the state filing requirements - we're in California, so I'll need to check if there are any additional notifications required for significant partnership capital adjustments. Your point about reviewing the partnership agreement is spot on. I just pulled it and there's actually a clause about how basis adjustments from deaths or transfers should be allocated, which I think supports our correction approach. It specifies that Section 754 adjustments should reflect "fair market value at the time of the triggering event." The side-by-side comparison idea is excellent. I'm thinking of structuring it to show: 1) Original income approach with the actual rent rolls from 2022, 2) Market rent analysis showing what comparable properties were getting, and 3) The corrected valuation using market rents. This should clearly demonstrate that the undervaluation was due to below-market lease rates rather than any error in methodology. Do you think it would be worth getting a brief letter from a local commercial real estate broker familiar with that market to support the rent comparisons, or is that overkill for documentation purposes?

A broker letter would actually be very valuable documentation, especially if they can provide specific comparable lease rates from 2022. It doesn't need to be a formal appraisal - just a brief market analysis showing what similar properties were leasing for during that time period. This third-party validation of your rent comparison analysis could be crucial if the IRS ever questions the adjustment. Since you're in California, definitely check with your tax advisor about state requirements. California can be particularly strict about partnership reporting, and you may need to file an amended state return even if you don't amend the federal return. Your approach with the clause about "fair market value at the time of the triggering event" is perfect - that language essentially requires you to make this correction to comply with your own partnership agreement. Make sure to reference that specific provision in your disclosure statement when you make the prior period adjustment. One more suggestion: consider getting your current accountant to review and sign off on the corrected valuation methodology before you make the adjustment. Having their professional endorsement of the correction approach could provide additional protection if there are any future questions about the change.