Section 754 Step-Up in Basis: An Illustrated Example

A Section 754 election is an optional tax code provision that allows a partnership to adjust the basis of its assets. This adjustment occurs when a new partner joins or an existing partner’s interest changes hands. The goal is to align the new partner’s investment cost, known as their “outside basis,” with their proportional share of the partnership’s asset values, or “inside basis.” Without this election, a disparity can arise, creating an inequitable tax situation for the incoming partner.

The election is made by the partnership itself, not the individual partners. Once made, it remains in effect for all future transactions unless the IRS consents to a revocation, meaning the decision requires careful consideration of its long-term consequences.

Triggering Events for a Section 754 Election

A partnership can make a Section 754 election in response to events that alter its ownership structure. One common trigger is the sale or exchange of a partnership interest. When an existing partner sells their stake, the purchase price paid by the buyer often exceeds the seller’s share of the partnership’s tax basis in its assets, creating a mismatch the election can rectify.

The death of a partner is another event that can prompt a Section 754 election. Upon a partner’s death, the person who inherits the interest receives it with a new basis, which is the fair market value of the interest on the date of death. This “stepped-up” outside basis is often higher than the heir’s share of the partnership’s inside basis, and the election allows the partnership to adjust the inside basis to match.

Information Required for the Basis Adjustment Calculation

Before a partnership can calculate the basis adjustment, it must gather key financial information. The first is the new partner’s outside basis. In a sale, this is the total amount the new partner paid for the partnership interest, while if acquired through inheritance, the outside basis is the fair market value of that interest as determined for estate tax purposes.

Next, the partnership must determine the new partner’s share of the partnership’s inside basis. This figure represents the incoming partner’s proportional claim on the partnership’s collective tax basis in all of its assets. It includes their share of the partnership’s liabilities, as partners are permitted to include their share of partnership debt in their basis.

Finally, the current fair market value (FMV) of all the partnership’s underlying assets is required. The FMV is necessary to properly allocate the total basis adjustment among the various assets held by the partnership, ensuring the step-up is applied accurately where appreciation has occurred.

The Step-Up Calculation Illustrated

To understand the calculation, consider a real estate partnership, “ABC Properties,” with two equal partners, Alex and Ben. The partnership owns a building with a tax basis of $400,000 but a current fair market value of $1,000,000. The partnership has no liabilities, and Alex and Ben each have a capital account and an outside basis of $200,000.

Alex passes away, and his 50% interest is inherited by his daughter, Chloe. The fair market value of this interest is $500,000 (50% of the $1,000,000 building value). Chloe’s outside basis in her inherited interest is therefore $500,000, and the partnership makes a Section 754 election.

The calculation for the total basis adjustment is the new partner’s outside basis minus their share of the partnership’s inside basis. Chloe’s outside basis is $500,000, and her share of the inside basis is $200,000 (50% of the building’s $400,000 tax basis). The total adjustment is $300,000 ($500,000 – $200,000), which is a special basis adjustment available exclusively to Chloe.

This $300,000 adjustment is allocated directly to the building. For tax purposes, Ben’s basis remains his 50% share of the original $400,000, which is $200,000. For Chloe, her share of the basis is her inherited portion of $200,000 plus her special $300,000 adjustment, for a total inside basis of $500,000 that matches her outside basis.

Post-Adjustment Tax Implications

The benefit of the basis step-up becomes clear when considering future tax deductions. Continuing the example, assume the building is depreciable over a 39-year period. Without the Section 754 election, Chloe’s annual depreciation deduction would be based on her share of the old tax basis ($200,000 / 39 years = $5,128). With the election, her depreciation is calculated on her new stepped-up basis of $500,000, giving her a larger annual deduction ($500,000 / 39 years = $12,821).

The advantage is also apparent if the partnership decides to sell the asset. Suppose ABC Properties sells the building for its fair market value of $1,000,000. The total taxable gain on the sale is $600,000 ($1,000,000 sale price – $400,000 partnership basis). Without the election, this gain would be split equally, and Chloe would face a $300,000 taxable gain.

With the Section 754 election in place, the outcome for Chloe is different. The partnership’s gain is still $600,000, and Ben is allocated his 50% share, resulting in a $300,000 taxable gain. Chloe is also allocated a $300,000 gain, but she can use her special basis adjustment of $300,000 to offset it. As a result, Chloe’s net taxable gain from the sale is zero.