Consequences of a Section 754 Election

When your partnership makes—or already has in place—a Section 754 election, it unlocks powerful flexibility but also important responsibilities. Specifically, the partnership must adjust the basis of its property under IRC § 734(b) and IRC § 743(b) according to Section 754 regulations. In simpler terms, whenever there’s a significant event—such as a distribution of property or a transfer of a partnership interest—the partnership steps up or steps down the tax basis of its assets.

A Section 754 election isn’t limited to one transaction. It applies to all property distributions and transfers of partnership interests within the tax year for which the election is made, and it continues automatically for future years unless formally revoked. Importantly, revoking this election is challenging; the IRS generally approves a revocation only if the main motive is not to avoid reducing—“stepping down”—the basis of your partnership assets.

Because the Section 754 election is difficult to undo, increases your partnership’s administrative requirements, and applies to both partnership asset distributions and interest transfers, it’s crucial for your partnership and its partners to weigh the decision carefully before proceeding.

When a partnership distributes property, disparities can arise between a partner’s outside basis (their investment in the partnership) and the inside basis (the partnership’s basis in the assets it owns). These differences often result when the distributee partner recognizes gain or loss, or when the distributed property’s basis to the partner diverges from the partnership’s inside basis. With a Section 754 election, these discrepancies are corrected through adjustments to the inside basis under IRC § 734(b). Notably, a step-down (negative adjustment) to the partnership’s inside basis only results from a liquidating distribution.

Here's how the Section 734(b) adjustment works:

The partnership increases the basis of its remaining property by:
- Any gain recognized by the distributee partner, and
- The amount by which the adjusted basis of the property distributed (prior to distribution) exceeds the property’s basis to the partner after the distribution (IRC § 734(b)(1)).
Conversely, for a liquidating distribution, the partnership decreases the basis of its remaining property by:
- Any loss recognized by the distributee partner, and
- The amount by which the distributee’s basis in the property distributed exceeds the partnership’s adjusted basis prior to distribution (IRC § 734(b)(2)).

When calculating a Section 734(b) adjustment, any previous special basis adjustments under IRC § 743(b) and IRC § 732(d) must be considered—these are already included in the partnership’s basis before the distribution.

Section 734(b) adjustments—whether an increase or decrease—are then allocated among the partnership’s remaining assets per IRC § 755. The adjustment is first allocated to properties of the same character (capital gain or ordinary income), and then within each class based on unrealized gain or loss. Reductions in basis cannot lower any property’s basis below zero. For depreciable properties, the regulations treat any basis increase as if the property were newly acquired for depreciation purposes, while any decrease is allocated over the property’s remaining recovery period, beginning the period the decrease is made.

When a partnership interest changes hands, if a Section 754 election is in force, IRC § 743(b) provides for a special basis adjustment—but this adjustment is unique to the transferee partner and does not affect the basis of partnership property for the continuing partners.

Because the buyer of a partnership interest steps in with a “cost basis” (the amount they paid for the interest) but takes over the seller’s capital account and share of the partnership’s inside basis, a mismatch almost always exists. The Section 743(b) adjustment is designed to eliminate this disparity. The adjustment equals the difference between the transferee’s outside basis and their share of the inside basis of partnership property. Regulations instruct on determining this share using a deemed-sale approach, and IRC § 755 and its regulations clarify how to allocate the adjustment among the assets. Critically, all of this affects only the transferee partner—other partners’ allocations and the overall partnership basis remain unchanged. If the transferee later sells the interest, any new basis adjustment is computed independently of any prior Section 743(b) adjustment.

Simply put, a Section 754 election is a powerful tax planning tool, but it comes with ongoing administrative complexity and the need for careful, tailored evaluation. Considering its long-term implications for both the partnership and its partners, a thoughtful analysis is strongly recommended before making this commitment.

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