Key Takeaways:
- Section 754 allows optional basis adjustments for partnership assets
- Triggered by: Transfer of partnership interest OR distribution of property
- Section 743(b): Adjusts basis when partnership interest is transferred
- Section 734(b): Adjusts basis after property distributions
- Once made, election applies to all future transactions (unless revoked with IRS approval)
- Mandatory adjustment required for “substantial built-in loss” (exceeds FMV by >$250,000)
- Requires additional record-keeping and reporting
New partner buys in for $500,000. Their share of inside basis? $300,000.
Without Section 754, that new partner eventually pays tax on $200,000 of “phantom” appreciation already reflected in their purchase price. They bought the appreciation. Now they’re taxed on it again.
Section 754 exists to fix this. The election allows the partnership to adjust its inside basis when interests transfer or property distributes. Properly used, it prevents double taxation and aligns partner economics with tax consequences.
But the election isn’t automatic. Partnerships must choose to make it. Once made, it applies to all future transactions. And it creates administrative burden.
This guide explains when Section 754 elections make sense, how the mechanics work, and what partnerships need to maintain compliance.
Table of Contents
What Is a Section 754 Election?
Section 754 of the Internal Revenue Code allows a partnership to elect to adjust the basis of partnership property in two situations:
- Transfer of a partnership interest (Section 743(b) adjustment)
- Distribution of property to a partner (Section 734(b) adjustment)
Without the election, inside basis (partnership’s basis in assets) and outside basis (partner’s basis in partnership interest) can diverge significantly. This creates mismatches between economic reality and tax consequences.
The election tells the IRS: “When these events happen, we’ll adjust inside basis to align with the new partner’s investment or the distribution’s effect.”
Why It Matters
Example without Section 754:
- Partnership has land worth $1,000,000 with $400,000 inside basis
- Partner A sells 25% interest to Partner B for $250,000
- Partner B’s share of inside basis: $100,000 (25% of $400,000)
- Partner B paid $250,000 for something with $100,000 basis
- If land sells for $1,000,000, Partner B pays tax on $150,000 “gain” already reflected in their purchase price
With Section 754:
- Same facts
- Partnership makes Section 743(b) adjustment of $150,000 for Partner B
- Partner B’s adjusted share of basis: $250,000
- When land sells, Partner B’s taxable gain properly reflects only post-purchase appreciation
When to Make the Election
Scenarios Favoring Section 754 Election
1. Partner buys interest at premium When incoming partner pays more than their share of inside basis (because assets have appreciated), the 754 election provides stepped-up basis. This generates additional depreciation deductions and reduces future gain recognition.
2. Partnership has significant appreciated assets Real estate partnerships, in particular, often have substantial appreciation. New partners buying in benefit from basis step-up under 743(b).
3. Death of a partner Deceased partner’s estate or beneficiaries receive stepped-up basis in the partnership interest (IRC Section 1014). Without 754, that step-up doesn’t carry through to the partnership’s assets. With 754, the partnership can make Section 743(b) adjustment reflecting the stepped-up value.
4. Distributions in kind When appreciated property distributes to partners, the 754 election allows adjustments that can benefit remaining partners.
Scenarios Where 754 May Not Make Sense
1. Partner buys at discount If incoming partner pays less than their share of inside basis, 754 election creates a negative adjustment. This reduces their share of depreciation and potentially increases gain.
2. Partnership has depreciated assets Assets worth less than basis would create negative adjustments on transfer.
3. High administrative burden The election requires asset-by-asset basis tracking for each partner with an adjustment. Partnerships with frequent partner changes face significant compliance work.
4. Unexpected consequences Once made, the election applies to all future transactions. You can’t pick and choose. A beneficial adjustment for one partner might create complications later.
The Permanence Factor
Section 754 election is permanent once made. It applies to all subsequent transfers and distributions until formally revoked with IRS approval.
Think long-term. Consider:
- Expected partner turnover
- Anticipated asset appreciation/depreciation
- Administrative capacity
- Future transactions
Section 743(b) Adjustments: Transfer of Partnership Interest
When a partnership interest transfers (sale, exchange, gift, or death), Section 743(b) requires basis adjustment if a 754 election is in effect.
The Calculation
743(b) adjustment = Transferee’s outside basis – Share of partnership’s inside basis
The adjustment applies only to the transferee partner. Other partners’ allocations aren’t affected.
Step-by-Step Example
Facts:
- Partnership ABC has three equal partners
- Partnership assets: equipment with $600,000 inside basis, $900,000 FMV
- Partner A sells interest to Partner D for $300,000
Calculation:
- Partner D’s outside basis: $300,000 (purchase price)
- Partner D’s share of inside basis: $200,000 (1/3 of $600,000)
- 743(b) adjustment: $100,000 positive
Effect: Partner D is allocated $100,000 additional depreciation basis. When the partnership sells equipment or takes depreciation, Partner D’s tax allocations reflect their $300,000 investment, not the historic $200,000 inside basis.
Negative Adjustments
If transferee pays less than their share of inside basis:
Example:
- Partner D pays $150,000 for interest
- Share of inside basis: $200,000
- 743(b) adjustment: ($50,000) negative
Partner D has reduced basis for depreciation and gain calculations. This is why 754 elections may not benefit all transfers.
Allocation Among Assets
The 743(b) adjustment allocates among partnership assets following Section 755 rules:
- First allocation: Between ordinary income property (inventory, receivables) and capital/Section 1231 property
- Within each category: Based on relative FMV
This creates asset-specific adjustments the partnership must track.
Section 734(b) Adjustments: Property Distributions
When the partnership distributes property to a partner, Section 734(b) allows basis adjustments if a 754 election is in effect.
When 734(b) Applies
Adjustments occur when distributions cause:
- Gain recognition by distributee partner (excess cash over basis)
- Basis adjustment in distributed property (partner’s basis differs from partnership’s basis)
Types of Adjustments
Positive adjustment when:
- Partner recognizes gain on distribution (cash exceeds basis)
- Partner takes lower basis in distributed property than partnership’s inside basis
Negative adjustment when:
- Partner recognizes loss on liquidating distribution
- Partner takes higher basis in distributed property than partnership’s inside basis
Example: Gain on Distribution
Facts:
- Partner X has $100,000 outside basis
- Partnership distributes $150,000 cash to Partner X
- Partner X recognizes $50,000 gain
734(b) adjustment: Partnership increases inside basis of remaining assets by $50,000. This reflects that Partner X recognized gain the remaining partners won’t have to recognize when assets sell.
Example: Basis Adjustment in Property
Facts:
- Partner Y has $80,000 outside basis
- Partnership distributes property with $120,000 inside basis
- Partner Y takes $80,000 basis in property (limited to outside basis)
734(b) adjustment: Partnership decreases inside basis of remaining assets by $40,000. The distributed property left the partnership with $120,000 basis, but Partner Y only took $80,000 basis.
How to Make the Election
Filing Requirements
Attach a written statement to a timely filed Form 1065 (including extensions).
Required Statement Content
The statement must include:
- Partnership name
- Partnership EIN
- Tax year
- A statement that the partnership elects under Section 754 to adjust basis of partnership property
Sample Language
“[Partnership Name], EIN [XX-XXXXXXX], hereby elects under Internal Revenue Code Section 754 to adjust the basis of partnership property for the taxable year ending [date] and for all subsequent taxable years.”
Late Election Relief
Missed the deadline? Relief may be available.
Rev. Proc. 2024-1 relief: Partnerships can request automatic 12-month extension if they:
- File within 12 months of original deadline
- Attach required statement
- Include explanation of reasonable cause
Rev. Proc. 2024-48 relief: Broader relief for partnership elections with reasonable cause showing.
Substantial Built-in Loss: Mandatory Adjustments
Section 754 election is optional. But in certain situations, adjustments are mandatory regardless of election.
When Mandatory Adjustments Apply
If a partnership interest transfer would result in a substantial built-in loss, the partnership must make a Section 743(b) adjustment. No election required.
Substantial built-in loss defined: Partnership’s adjusted basis in its assets exceeds the fair market value by more than $250,000.
Example
Facts:
- Partnership assets: FMV $800,000, inside basis $1,200,000
- Built-in loss: $400,000
- Exceeds $250,000 threshold
- Partner B purchases 50% interest
Result: Mandatory 743(b) adjustment applies. Partner B receives basis reduction reflecting their share of the built-in loss. Partnership doesn’t need 754 election on file.
This prevents partners from transferring interests and claiming the partnership’s unrealized losses.
Reporting Requirements
Partnerships must check for substantial built-in loss on any partnership interest transfer. Form 1065 Schedule B asks about this.
Record-Keeping Requirements
The 754 election significantly increases administrative burden.
Partnership Must Maintain
Asset-by-asset basis schedules Track inside basis of each asset, plus each partner’s Section 743(b) or 734(b) adjustments to that asset.
Partner-specific adjustments Each transferee partner has their own adjustment. If three partners entered at different times with different adjustments, the partnership tracks three separate basis layers.
Depreciation schedules Section 743(b) adjustments often relate to depreciable property. Track adjustment depreciation separately.
Annual adjustment calculations As assets sell or depreciate, adjustments reduce. Update records annually.
Partner Must Receive
Schedule K-1 must show partner’s specific Section 743(b) or 734(b) adjustments and related depreciation.
Revoking a Section 754 Election
Once made, the election is permanent. But IRS may grant revocation.
Requirements for Revocation
Application to IRS:
- Request in writing before end of tax year for which revocation effective
- Show good cause why revocation is needed
- Cannot simply be because election causes unfavorable results
Good cause examples:
- Significant change in partnership’s nature
- Original election made by prior general partner
- Administrative burden substantially changed
After Revocation
If IRS grants revocation, the partnership cannot make a new Section 754 election for five years without IRS consent.
Planning Considerations
Before Making the Election
Analyze current partner composition: Will existing partners transfer interests soon? At premium or discount?
Evaluate asset profile: Appreciated or depreciated assets? What’s the adjustment likely to be?
Assess administrative capacity: Can the partnership handle detailed basis tracking?
Consider future transactions: Frequent partner turnover increases both benefit and burden.
Alternatives to Partnership-Wide Election
Transferee election for mandatory adjustments: Where substantial built-in loss applies, adjustments happen automatically. No partnership-level election needed.
Entity structuring: Some partnerships use holding structures where transfers happen at different levels, potentially avoiding need for 754 election at operating partnership.
Frequently Asked Questions
What does a Section 754 election do?
It allows the partnership to adjust the basis of its assets when a partnership interest is transferred or when property is distributed. This prevents “phantom” gain or loss for incoming partners and aligns tax basis with economic investment.
Is a Section 754 election mandatory?
It’s optional unless the partnership has a “substantial built-in loss” (basis exceeds FMV by more than $250,000). In that case, Section 743(b) adjustments are mandatory regardless of election.
Can I revoke a Section 754 election?
Only with IRS approval and good cause shown. Once revoked, a new election cannot be made for five years without IRS consent.
Who benefits from a Section 754 election?
Primarily incoming partners who pay more than their share of inside basis. The step-up provides additional depreciation deductions and prevents taxation of appreciation already reflected in purchase price.
What’s the downside of a Section 754 election?
Increased administrative burden. The partnership must track basis adjustments asset-by-asset for each partner. The election applies to all future transactions, even unfavorable ones.
How do I make a Section 754 election?
Attach a written statement to a timely filed Form 1065 (including extensions). The statement must include partnership name, EIN, tax year, and language electing under Section 754.
Make the Right Call on Section 754
The 754 election isn’t right for every partnership. But for partnerships with appreciated assets, expected partner turnover, or complex ownership transitions, it prevents significant tax distortions.
The decision requires analysis: What’s the current inside/outside basis spread? Who’s likely to transfer interests? Can the partnership handle the compliance requirements?
Getting this wrong creates either unnecessary administrative burden or unexpected tax consequences for partners.
SDO CPA helps partnerships evaluate and implement Section 754 elections. We analyze your specific asset profile, partner dynamics, and administrative capacity to recommend the right approach. Contact us to discuss your partnership structure.