Tax Court Disallows $714 Million Partnership Basis Deduction in Otay Project

The U.S. Tax Court ruled on February 23, 2026, that a San Diego-area real estate partnership improperly claimed a $713,759,615 tax deduction tied to a basis adjustment on the exit of one of its partners. The decision in Otay Project LP v. Commissioner, T.C. Memo. 2026-21, disallows the deduction on two independent grounds and offers a rare, fact-heavy look at how the IRS challenges partnership basis planning under Section 743(b).

What changed

Otay Project LP developed the 22,000-acre Otay Ranch master-planned community near Chula Vista, California, for brothers Al and Jim Baldwin. When the brothers split their joint real estate business, their advisors restructured the partnership so that a related entity's exit triggered a positive basis adjustment of more than $867 million, generating a claimed deduction exceeding $743 million on the partnership's 2012 return. The IRS disallowed all but a small fraction of that deduction, and the Tax Court agreed, finding both that the basis adjustment was miscalculated under the governing regulations and, independently, that the restructuring lacked economic substance and should be treated as a sham for tax purposes.

Who is affected

The ruling speaks directly to business owners and real estate partners who exit or restructure partnership interests, particularly in family-owned enterprises where related parties on both sides of a transaction share the same tax advisors. The court noted that Al and Jim retained a joint accounting firm and law firm to design the restructuring, and that despite the complexity of the resulting entities, the brothers kept their original 50/50 economic split of the underlying property throughout. That combination, an intricate structure built by shared advisors that leaves the parties' actual economic positions unchanged, is what the court found fatal to the claimed tax benefit.

The after-tax math

Example: a Section 743(b) basis step-up lets an incoming or remaining partner depreciate or amortize an increased share of partnership assets when another partner's interest is bought out or liquidated, effectively converting built-in gain into future deductions. In Otay Project, the court found the restructuring was designed to shelter roughly $921 million of income the partnership had deferred under the completed-contract method of accounting, income tied to public-bond-financed infrastructure the partnership had already spent. Losing the deduction means that deferred gain generally remains taxable to the partnership and its partners as land sales close out, rather than being offset by the disallowed basis write-off.

Penalties: a partial taxpayer win

The IRS also sought a 40% gross valuation misstatement penalty and a 20% negligence penalty on top of the disallowed deduction. The Tax Court declined to impose either, crediting the partnership's reasonable-cause defense: the brothers obtained written opinions from three separate advisory firms before and after the transactions, and the court found nothing in the record showing those advisors' opinions were knowingly false or that the taxpayers withheld material facts from them. The result is a split outcome common in complex partnership cases, the underlying deduction is gone, but the accuracy-related penalties are not, because seeking professional advice was treated as reasonable care even where the transaction itself failed.

Moves to discuss with your advisor

• Whether a partnership restructuring around a partner buyout or liquidation changes the parties' actual economic exposure, or only their tax positions.
• Whether using the same accounting and legal advisors on both sides of a related-party restructuring could undercut an economic-substance defense later.
• Whether retaining independent, contemporaneous written tax opinions, as the Baldwins did, is documented well enough to support a reasonable-cause defense if a position is later challenged.

What to watch

Under Tax Court Rule 155, the parties still must submit computations reflecting the court's findings before a final decision is entered, so the exact dollar amount of additional tax due has not yet been made public. The case is a reminder that the IRS continues to pursue large, decade-old partnership basis positions well after the original transactions closed, and that economic-substance and technical basis-calculation challenges can both apply to the same deduction.

After TAX is an independent publication. Articles are general information, not tax, legal or investment advice. Consult a licensed professional about your situation.