What Is a Section 734 Basis Adjustment?

A Section 734 basis adjustment is a mechanism in partnership tax law that aligns a partnership’s accounting records with the economic results of distributing property to a partner. A distribution can create a disparity between the partnership’s tax basis for its assets, known as “inside basis,” and the partners’ collective tax basis in their partnership interests, their “outside basis.” This adjustment reconciles that difference.

The purpose is to prevent the distortion of future income or loss. Without it, remaining partners could be taxed on artificial gains or benefit from artificial losses that do not reflect the partnership’s actual economics. The adjustment under Internal Revenue Code (IRC) Section 734 steps up or down the basis of the partnership’s property to account for gain, loss, or basis changes recognized by the partner from the distribution.

The Section 754 Election Prerequisite

A partnership cannot make a Section 734 basis adjustment unless it has a valid Section 754 election in effect for the taxable year of the distribution. This election is made by the partnership, not individual partners, and is filed with the partnership’s timely tax return, Form 1065. The election must be in place for the year a distribution occurs to permit a corresponding basis adjustment.

Once made, the Section 754 election is binding for the year of the election and all subsequent tax years. It requires the partnership to adjust the basis of its property following both certain distributions to partners under Section 734 and transfers of partnership interests under Section 743. This dual applicability means a partnership must consider the administrative implications of tracking these adjustments for future transactions.

Revoking the election requires permission from the IRS. A partnership must file a request and demonstrate a valid reason for the revocation, such as a change in the business’s nature or a substantial increase in assets that makes compliance an administrative burden. An exception exists for distributions that trigger a “substantial basis reduction” of over $250,000, which mandates an adjustment even without an election.

Calculating the Basis Adjustment

The calculation of the Section 734(b) adjustment is triggered by specific outcomes of a property distribution. The total adjustment is the net result of two potential calculations, which can either increase or decrease the basis of the partnership’s remaining property.

Adjustment for Partner’s Recognized Gain or Loss

The first component of the calculation relates directly to any gain or loss a partner recognizes on the distribution. A partnership increases the basis of its property by the amount of any gain the distributee partner recognizes under Section 731. This occurs when a partner receives cash in excess of their outside basis in the partnership. For instance, if a partner with an outside basis of $40,000 receives a cash distribution of $50,000, the partner recognizes a $10,000 gain, and the partnership would then make a positive $10,000 basis adjustment.

Conversely, a partnership must decrease the basis of its property for any loss a partner recognizes. A loss can only be recognized in a liquidating distribution where the partner receives solely cash, unrealized receivables, and inventory, and the basis of the distributed property is less than the partner’s outside basis. The negative adjustment equals the amount of the recognized loss.

Adjustment for Basis Differences in Distributed Property

The second part of the calculation arises from a difference between the partnership’s basis in the distributed property and the basis the distributee partner takes in that property. In a non-liquidating distribution, if the partner’s outside basis is less than the partnership’s basis in the asset, the asset’s basis is “stepped down” in the partner’s hands, and the partnership can make a positive adjustment for the amount of that step-down.

In a liquidating distribution, the partner’s basis in the distributed property is determined by their outside basis in the partnership interest. If the partner’s outside basis exceeds the partnership’s basis in the distributed asset, the asset’s basis is “stepped up” for the partner. The partnership must then make a negative adjustment equal to the amount of this step-up.

Allocating the Adjustment to Partnership Assets

After calculating the total Section 734(b) adjustment, the partnership must allocate this amount among its remaining properties according to the rules of IRC Section 755. This process is designed to reduce the difference between the fair market value and the tax basis of the partnership’s assets. The allocation rules first require the partnership to separate all of its remaining property into two classes.

The first class of property consists of capital assets and Section 1231 property, which are assets used in a trade or business, such as buildings and equipment. The second class includes any other property, primarily ordinary income assets like inventory and accounts receivable. This segregation ensures the adjustment is applied to assets of a similar character to those that gave rise to it.

The allocation of the adjustment between the two classes depends on what triggered the adjustment. If the adjustment was caused by a partner recognizing a capital gain or by a basis difference related to a distributed capital asset, the entire adjustment must be allocated to the first class. Likewise, an adjustment triggered by ordinary income items must be allocated to the second class of assets.

Once the adjustment has been assigned to a class, it is then allocated within that class to specific assets. A positive adjustment can only be allocated to assets that have appreciated in value, and a negative adjustment can only be allocated to assets that have depreciated. This ensures the adjustment serves its purpose of aligning basis with economic value.

Reporting and Statement Requirements

When a partnership makes a basis adjustment under Section 734, it must attach a detailed statement to its Form 1065, U.S. Return of Partnership Income, for the taxable year in which the property distribution occurred. This statement serves as a formal record and justification for the adjustment, providing transparency to the IRS.

The required statement must contain the partnership’s name and employer identification number (EIN). The core of the statement is the computation of the basis adjustment, showing the specific calculations that led to the final adjustment amount.

The statement must also provide a schedule that details the allocation of the adjustment among the partnership’s remaining properties. This schedule must identify the specific assets whose bases were adjusted, the amount of the adjustment allocated to each asset, and how the allocation complies with the rules under Section 755.