Section 754 Election: How Partnership Basis Step-Ups Work

This one will get a bit more technical, but it’s worth the doozy. 

Say an investor receives an offer from another party to sell their partnership interest. It’s a budding real estate interest and/or business. So, the current partner in the partnership wants cash. The new one wants the assets in the partnership. So they do the ole trade of cash for property, and that property, in this case, is partnership equity. 

And, there is this interesting provision that allows this new owner to potentially get brand-new bonus depreciation and other step-ups automatically.

It’s called the 754 election. 

Two Number Mismatch

When a partnership forms, it is easy to find and control. A partner contributes property, the partnership takes it with the contributing partner’s basis under §723, and that partner’s basis in the interest is built off the same number under §722. Inside basis and outside basis start life synchronized.

Then someone sells their interest.

Outside basis is what you paid for the partnership interest. Inside basis is your share of what the partnership paid for the buildings. Buy an interest for more than the seller’s share of asset basis and your outside basis jumps to what you paid. Your share of inside basis doesn’t move an inch.

Put numbers on it. Assume an unleveraged deal for simplicity. A partner contributed $250,000 in 2023. By 2026, the assets are worth $500,000, and you buy that interest for $500,000. Your outside basis is $500,000. Your share of inside basis is $250,000. Because §743(a) says no adjustment gets made without an election, you simply take the seller’s proportionate share of the partnership’s common adjusted basis. I like to call it ‘stepping into the shoes’ of the old partner. 

That $250,000 gap is money you have already paid. The ‘new’ FMV of the asset is $500,000. And so, absent an election, you cannot touch it until you sell your interest or the partnership liquidates. On a long-hold real estate deal, that’s ten years or more. 

Which is relatively unfair. Why? Because now a liquidation event is required to actually get the partner ‘whole’ for tax purposes. And that’s an unfair game, and now we will discuss why the § 754 election fixes this math. 

Another good question is, isn’t my capital account my outside basis? And the answer is no, they are not the same thing. 

Outside basis is most likely your capital account PLUS partnership debt (though there can be a few minor exceptions on this). 

But, we will talk later about how the § 754 election fixes this ‘stepping into the shoes’ of the capital account of the bought out partner. 

What the Election Actually Does

• 754 is a switch, which then makes you flip two other switches. 
• 743(b) applies when a partnership interest is sold or exchanged, or when a partner dies. It adjusts the transferee’s share of inside basis to match what that partner paid, or value at death.
• 734(b) applies when the partnership distributes property or cash: any distribution, not just a redemption. It adjusts the basis of what stays inside.

The two get mixed up constantly. The mnemonic I use, imprecise but directionally right: 743(b) is someone buying in from the outside. 734(b) is the entity itself handing something out.

One point investors consistently get wrong. A §743(b) adjustment is yours alone. Under Reg. §1.743-1(j), it affects only the transferee partner and makes no adjustment to the common basis of partnership property. 

Nobody else’s K-1 changes. Unless it’s the 734(b) adjustment. Then, the adjustment becomes the partnership’s, which in turn, becomes everyone’s. 

So What’s the Adjustment?

The adjustment doesn’t attach to the partnership as a lump sum. Now, through §755, you look into the partnership’s assets. You look between two classes, capital gain property and ordinary income property, and then among the assets inside each class.

So a $250,000 adjustment is not $250,000 of only new depreciation. If the partnership holds buildings, land, cash, and notes, the piece allocated to land does nothing for you until sale. Only the portion landing on depreciable property produces deductions, recovered as newly placed-in-service property under Reg. §1.743-1(j)(4).

Why Waiting Costs You More than Time

Investors hear “you get the basis eventually” and stop worrying. That framing is not entirely correct. 

With the adjustment, your step-up feeds depreciation. Depreciation offsets income otherwise taxed at ordinary rates, currently up to 37%, plus the 3.8% net investment income tax where it applies.

Without it, the difference sits in your outside basis and surfaces as reduced capital gain when you exit. Long-term capital gain tops out at 20%, plus the same 3.8%.

Now, the kicker is, the partnership does have to make the election. While it does belong to the partner, as mentioned before, the partnership has to ‘flip the switch,’ so to speak. And, once it turns on the switch, the switch can never get turned off. 

Death and the One Case That Isn’t Close

What if a partner dies holding an interest in a syndication? The interest gets a stepped-up basis under §1014, other than for items of income in respect of a decedent, which for most real estate funds is a small piece.

Outside basis steps up. Inside basis does not follow, unless a §754 election is in effect.

Say a 10% LP interest, $500,000 original contribution, $1.2 million value at death. Without the election, the heirs hold an interest carrying $1.2 million of outside basis while their share of inside basis still runs off the decedent’s old numbers. Every depreciation deduction and every future sale gets computed on stale basis. That’s phantom income, for the life of the deal.

With the election, a §743(b) adjustment picks up the spread and pushes it inside, subject to the same §755 allocation as everything else.

The §1014 step-up already happened. Skipping the election taxes an estate on appreciation already accounted for at death. And the heirs didn’t pick this deal. They inherited it, along with whatever the operating agreement did or didn’t say.

So Why Doesn’t Every Partnership Elect

Well, it’s effectively permanent. Reg. §1.754-1(c) allows revocation only with IRS consent, and consent won’t be approved where the purpose is primarily to avoid stepping down the basis of partnership assets. Once you’re in, you’re in for every future triggering event.

It cuts both ways. If asset values fall, the same machinery produces a step-down. Partners buying in below the partnership’s basis get less depreciation, not more, and the election stays on.

Tracking is real work. Every transferee gets a separate basis schedule for every asset. On an open-end fund running 60 to 120 transfers a year, that’s a compliance operation, and its cost comes out of returns.

Some adjustments are mandatory anyway. §743(d) forces one on a transfer where there’s a substantial built-in loss, and §734(d) forces one where downward adjustments on a distribution exceed $250,000. “We just won’t elect” doesn’t fully work.

A Question to Ask Before You Buy

“Is a §754 election in place? If not, will the partnership make one for my purchase?” Is a good question to ask when buying in. 

This answer generally sits in the operating agreement. Look for who decides, whether the GP is obligated to elect on a transfer or a death, and who bears the cost of the computation. It’s better to get ahead of the conversation than to try to talk through it before the return is filed. 

If you’re the GP, it’s good to know what your policy is. Most institutional funds elect and build the compliance cost into fund expenses. Whatever you choose, just know you’ll have to repeat it over and over to your investors. 

If a partner is being bought out, have the conversation while terms are still open. Whether the partnership distributes cash or property, and how §751 hot assets get handled, changes the §734(b) answer.

Then, we need to document it. The election is a written statement attached to a timely filed return, including extensions, under Reg. §1.754-1(b). Since T.D. 9963, it no longer needs a partner signature — just the partnership’s name and address and a declaration that it’s electing. The partnership also needs to be able to produce the §743(b) computation and the §755 allocation if anyone asks.

Miss the deadline, and it’s usually fixable. Reg. §301.9100-2(a)(2) gives an automatic 12-month extension for a §754 election: file an original or amended return with the statement and “FILED PURSUANT TO § 301.9100-2” at the top. No ruling request, no user fee. Past 12 months and you’re into discretionary relief under §301.9100-3, which means a private letter ruling and a real bill.

The Honest Version

Making the election is a judgment call with conditions attached.

The size of the adjustment, where §755 puts it, whether §469 lets you use it, and what the compliance work costs decide whether this is worth six figures or worth nothing.

Pull the operating agreement on your largest passive position and search it for “754.”

Or if you need to go over it with someone, call us! 

Schedule a discovery call today.