What Is a Section 754 Election and How Does It Work?

Section 754 of the Internal Revenue Code allows a partnership to adjust the tax basis of its assets following certain events, such as distributions of partnership property or transfers of partnership interests. This election reconciles disparities between a partner’s tax basis in their partnership interest and their share of the partnership’s asset basis. It aims to align the tax basis of partnership property with its fair market value for affected partners.

Purpose of Section 754

Section 754 addresses a challenge in partnership taxation: the potential divergence between a partner’s “outside basis” and their share of the partnership’s “inside basis.” A partner’s outside basis is their individual tax basis in their ownership interest. This typically includes the amount paid for the interest, plus their share of partnership liabilities, adjusted for contributions, distributions, and their share of income or losses.

The partnership’s inside basis is its collective tax basis in all assets it owns. While generally equal at formation, inside and outside bases can diverge due to various transactions. For example, if a partner sells their interest for more than their share of the partnership’s asset basis, the incoming partner’s outside basis would be higher than their share of the inside basis. Without an adjustment, this new partner might be taxed on gains that occurred before they acquired their interest.

The Section 754 election provides a mechanism for the partnership to adjust the basis of its assets, correcting these disparities. This adjustment ensures a new partner’s share of the partnership’s asset basis aligns with the amount they paid for their interest or its inherited value. For instance, if a new partner acquires an interest when assets have appreciated, a Section 754 election can “step up” the basis of those assets for that specific partner. This step-up prevents the new partner from being taxed on pre-acquisition appreciation when assets are sold or depreciated.

The election is a choice the partnership makes, not an automatic process. It ensures the new partner or a partner receiving a property distribution receives correct tax treatment for future depreciation deductions and gain or loss calculations upon asset disposition. This prevents inequities where a partner might recognize artificial gains or be denied legitimate tax benefits. The election can also lead to increased depreciation deductions for the affected partner, reducing their taxable income.

Events Requiring Adjustment

A Section 754 election becomes relevant in two scenarios that can create a disconnect between a partner’s outside basis and their share of the partnership’s inside basis: a transfer of a partnership interest or a distribution of partnership property. The election allows for specific adjustments, known as Section 743 adjustments for transfers and Section 734 adjustments for distributions, to rectify these disparities.

Transfer of a Partnership Interest

One common event triggering the need for a Section 754 election is the transfer of a partnership interest. This includes sales or exchanges between existing partners or to a new partner, and the death of a partner where their interest is inherited. When an interest is transferred, the new partner’s cost basis in their partnership interest (outside basis) often differs from their proportionate share of the partnership’s historical asset basis (inside basis). For instance, if a new partner buys an interest in an appreciated partnership, their purchase price reflects current value, while the partnership’s books show lower historical cost.

Without a Section 754 election, this new partner would inherit the selling partner’s low inside basis. This could lead to the new partner being taxed on gains that accrued before they acquired their interest, or not receiving depreciation deductions commensurate with their investment. The Section 743 adjustment, enabled by a Section 754 election, allows the partnership to increase or decrease the basis of its assets specifically for the acquiring partner. This aligns their share of the inside basis with their outside basis, ensuring the new partner’s future tax implications are based on their actual cost of acquiring the interest.

Distribution of Partnership Property

The second event necessitating a Section 754 election is a distribution of partnership property to a partner. When a partnership distributes property, the basis of that property in the hands of the distributee partner, or the basis of the remaining partnership property, can become misaligned. For example, if a partnership distributes property and its basis in that property differs significantly from the amount by which the partner’s interest basis is reduced, an imbalance can occur.

A Section 734 adjustment, enabled by the Section 754 election, addresses these imbalances. This adjustment modifies the basis of the partnership’s remaining assets or, in some cases, the distributed property itself. This prevents artificial gains or losses for continuing partners or the distributee partner, ensuring tax consequences are fairly allocated and the overall tax basis remains appropriate following the distribution.

Electing Section 754

The decision to make a Section 754 election rests solely with the partnership, not individual partners. This election is made by attaching a written statement to the partnership’s income tax return, Form 1065, for the taxable year of the transfer of interest or property distribution. The statement must indicate the partnership is electing to apply Section 754 and include the partnership’s name and address.

The election must be made with a timely filed tax return for the first taxable year it applies, including any filing extensions. If not made with the initial return for the year of the triggering event, it generally cannot be made retroactively.

Once a Section 754 election is made, it is generally binding for all future taxable years. The partnership must apply the basis adjustment rules for all subsequent transfers of partnership interests and distributions of partnership property, even if future adjustments result in a basis decrease. While largely irrevocable, it can be revoked only with Internal Revenue Service (IRS) approval.

The IRS typically grants permission for revocation under specific circumstances, such as a change in business nature, a substantial increase in assets, or increased frequency of partner interest transfers or retirements that create an undue administrative burden. However, revocation will not be approved if its primary purpose is to avoid a reduction in partnership asset basis. The binding nature of the election highlights the importance of careful consideration, as it creates ongoing compliance requirements.

Consequences of the Election

The primary consequence of a Section 754 election is the adjustment of partnership property’s tax basis, which affects individual partners. These basis adjustments are specific to the partner whose interest was transferred or who received a property distribution, rather than affecting the overall basis for all partners. The partnership maintains a common basis for its assets, but tracks separate “special basis adjustments” for the affected partner.

An upward adjustment, or “step-up,” provides tax advantages for the affected partner. For instance, if a new partner acquires an interest in a partnership with appreciated depreciable assets, a Section 754 election increases the basis of those assets for that partner. This increased basis translates into larger depreciation or amortization deductions, reducing their taxable income from the partnership. Conversely, a downward adjustment, or “step-down,” reduces these deductions.

The election also impacts the affected partner’s gain or loss calculation when the partnership sells the adjusted asset. With a step-up in basis, the affected partner’s share of the gain on a subsequent sale will be reduced, or their share of a loss increased, reflecting their higher effective cost. This prevents the partner from paying tax on appreciation that occurred before they acquired their interest. Without the election, the partner would be taxed on their share of the partnership’s lower historical basis, despite paying more for their interest.

While tax benefits for affected partners can be substantial, a Section 754 election introduces considerable administrative complexity. The partnership must maintain detailed records for each special basis adjustment, tracking it for each affected asset and partner. This requires additional accounting and tax reporting efforts, as the partnership’s tax return (Form 1065) must reflect these specific adjustments. This added burden is a factor partnerships consider before making the election, especially in partnerships with frequent transfers or numerous assets.