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Section 754 Election: Inside Basis Step-Up on Partner Transfer, How to File, Section 743(b) Adjustments

By chrisomo

A section 754 election is the mechanism a partnership uses to step up (or step down) the inside basis of its assets when a partner sells an interest, dies, or receives a distribution. The election is made under Internal Revenue Code section 754 and triggers two operative adjustments: section 743(b) on transfers of partnership interests and section 734(b) on distributions of property. Once filed, the election is irrevocable without IRS consent under Treasury Regulation section 1.754-1(c).

What is a section 754 election?

A section 754 election is a partnership-level tax election that allows the partnership to adjust the basis of its assets to reflect the price a new or successor partner paid (or the value a partner received in a distribution). Without the election, a partner who buys an interest at fair market value is stuck recovering basis only through the partnership’s historical depreciation schedule, even though that partner paid current market price. The election is authorized under IRC section 754 and operationalized through two companion sections: section 743(b) and section 734(b).

The election is partnership-level, not partner-level. A single statement, signed by a partner authorized to sign the partnership return, is attached to Form 1065. Treasury Regulation section 1.754-1(b)(1) sets out the formal contents: a declaration that the partnership elects under section 754 to apply the provisions of sections 734(b) and 743(b), the name and address of the partnership, and the signature of any partner. The election is binding for the year filed and all subsequent years.

Why the section 754 election matters

The election matters because partnership taxation defaults to aggregate-and-entity treatment that almost guarantees a mismatch between inside basis and outside basis after any non-pro-rata event. A purchaser of a partnership interest pays current value but inherits the partnership’s stale inside basis. Without the section 754 election, the purchaser is over-taxed: they pay for built-in gains and then pay tax on those same gains a second time when the partnership sells or depreciates the underlying assets.

Consider a typical M&A scenario. A private-equity buyer acquires a 100% interest in a partnership target through a unit purchase agreement. The target owns equipment with an inside basis of $2 million and fair market value of $10 million. Without a section 754 election, the buyer takes a $10 million outside basis but the partnership keeps $2 million of inside basis on the equipment. The buyer would pay tax on $8 million of phantom depreciation recapture or gain that economically belongs to the seller. The election removes the mismatch by triggering a section 743(b) adjustment that increases the buyer’s share of inside basis by $8 million, giving them additional depreciation deductions and reducing future gain on sale.

For an introduction to how basis adjustments interact with M&A due diligence, see our quality of earnings report guide and the broader transaction playbook.

How the section 754 election works (mechanics)

The election itself is a one-page attachment. The substantive work is in the two adjustments that follow.

Section 743(b) on transfers

Section 743(b) is triggered by a sale, exchange, or death of a partner. The adjustment equals the difference between (a) the transferee partner’s outside basis in the partnership interest, and (b) the transferee’s proportionate share of the partnership’s adjusted basis in partnership property. The adjustment is allocated among the partnership’s assets under section 755 in a manner that reflects the relative built-in gain or loss on each asset, with the allocation rules in Reg section 1.755-1.

The section 743(b) adjustment is personal to the transferee. The partnership maintains a separate set of basis records for that partner. The historical partners continue to use the partnership’s original inside basis. This personalization is why the partnership must track section 743(b) adjustments on a partner-by-partner basis on Schedule K-1 in the supplemental information.

Section 734(b) on distributions

Section 734(b) is triggered when a partner receives a distribution that creates an inside basis distortion. Two situations trigger the adjustment under section 734(b): (1) a partner recognizes gain or loss on the distribution (typically when cash distributed exceeds outside basis), or (2) the partner’s basis in the distributed property is different from the partnership’s basis in that property immediately before the distribution. The adjustment is to the basis of the partnership’s remaining property and benefits all remaining partners.

Mandatory basis adjustments without an election

Two provisions, added by the American Jobs Creation Act of 2004, require basis adjustments even when the partnership has not made a section 754 election. Section 743(d) requires a mandatory downward adjustment on transfer if the partnership has a “substantial built-in loss” (built-in loss exceeding $250,000). Section 734(d) requires a mandatory adjustment on distribution if there is a “substantial basis reduction” (a downward adjustment that would exceed $250,000). These mandatory rules cannot be avoided by skipping the election.

Section 754, 743(b), and 734(b): how they compare

Worked example

ABC Partnership has three equal partners (A, B, C), each with $1 million outside basis. The partnership owns one asset: a manufacturing building with $3 million inside basis and $9 million fair market value. There is no depreciation recapture (assume the building has been fully depreciated against the inside basis already).

On January 1, 2026, partner A sells her one-third interest to D for $3 million cash (one-third of $9 million fair market value). D’s outside basis is $3 million. The partnership has a valid section 754 election in place.

Section 743(b) adjustment calculation:

• D’s outside basis: $3,000,000
• D’s proportionate share of inside basis: $1,000,000 (one-third of $3,000,000)
• Section 743(b) positive adjustment: $2,000,000

The $2 million adjustment is allocated to the manufacturing building (the only asset), under section 755. The partnership now maintains two parallel basis schedules for the building: a $3 million common-pool basis used by B and C, and a $5 million basis used by D (their original $1 million proportionate share plus the $2 million 743(b) step-up). Depreciation expense, future gain on sale, and section 1245/1250 recapture are computed separately for D.

Future depreciation impact for D: If the building had 25 years of remaining MACRS recovery, D would receive an additional $80,000 in annual depreciation deductions ($2,000,000 / 25) attributable only to her share. B and C continue to use the original depreciation schedule.

Future sale impact for D: If the partnership later sells the building for $9 million, the partnership recognizes $6 million of gain ($9M sale price minus $3M common-pool inside basis). B and C are each allocated $2 million of that gain. D’s allocated $2 million of gain is reduced by her $2 million section 743(b) adjustment, so D effectively recognizes $0 of gain on the sale. This is the intended result: D already paid for her share of the appreciation when she bought the interest from A.

Recent changes (OBBBA and TCJA carryover)

The Tax Cuts and Jobs Act of 2017 did not change the operative mechanics of section 754, but the section 199A qualified business income deduction and the TCJA depreciation regime (bonus depreciation, section 179) interact with section 743(b) adjustments. Section 743(b) step-up basis is generally eligible for bonus depreciation only to the extent the underlying asset is bonus-eligible new property in the hands of the partnership, which is rarely the case for stepped-up basis on used property. This was clarified in Reg section 1.168(k)-2(b)(3)(iv).

The One Big Beautiful Bill Act (OBBBA), signed in 2025, restored 100% bonus depreciation through 2029 and made the section 199A QBI deduction permanent. Neither change altered section 754 election mechanics, but both increase the value of a section 743(b) step-up for buyers of partnership interests holding qualifying property placed in service after January 19, 2025. Practitioners should pay close attention to the OBBBA placed-in-service rules: stepped-up basis on used property generally fails the original-use requirement and is not bonus-eligible.

For deeper analysis of OBBBA’s impact on partnership planning, see the Ledgerism learn library.

Common pitfalls

• Missing the filing deadline. The election must be made on a timely-filed Form 1065 (including extensions) for the year of the triggering event, per Reg section 1.754-1(b)(1). A late election requires an automatic 12-month extension request under Reg section 301.9100-2 or a private letter ruling under Reg section 301.9100-3, the latter of which costs a user fee of $43,700 per Rev. Proc. 2026-1.
• Forgetting to track section 743(b) adjustments per partner. Each transferee partner has a unique adjustment. Failing to track separately leads to wrong K-1 allocations and IRS adjustments under section 6231.
• Misallocating the adjustment under section 755. The section 755 rules require allocation by class (capital gain property vs. ordinary income property) and then by built-in gain or loss within each class. Allocating to the wrong asset distorts both depreciation and future gain recognition.
• Assuming the election can be undone. The election is irrevocable without IRS consent under Reg section 1.754-1(c). Reasons accepted by the IRS are limited: a change in the nature of the partnership business, a substantial change in partners, or substantial administrative burden.
• Ignoring the mandatory adjustment rules. Section 743(d) and section 734(d) require downward adjustments even without an election when the substantial built-in loss or substantial basis reduction thresholds (over $250,000) are exceeded.
• Misreading the death-of-partner rule. Death of a partner is a transfer for section 743(b) purposes even though no sale occurs. The successor (typically the estate) receives a section 1014 outside-basis step-up, and if a section 754 election is in place, that step-up flows through to inside basis on the deceased partner’s share.
• Forgetting the K-1 reporting code. Positive section 743(b) adjustments report on Schedule K-1 box 13 with code V (effective for 2024 forward). Negative adjustments report on box 11 with code F. Reporting on the wrong line creates IRS matching problems.

Frequently asked questions

Who signs the section 754 election?

Any partner authorized to sign the partnership return under Reg section 1.6063-1 can sign the election statement. For an LLC taxed as a partnership, this is typically the managing member or a designated tax matters partner (now called the partnership representative under the BBA centralized audit regime).

Can a partnership revoke a section 754 election?

Yes, but only with IRS consent under Reg section 1.754-1(c)(2). The application is made to the Service Center where the partnership files its return within 30 days after the close of the partnership taxable year for which the revocation is to take effect. The IRS accepts revocation requests for limited reasons including a change in partnership business, a substantial change in partners, or a substantial increase in administrative burden.

Does a section 754 election affect book accounting?

No. The election affects only the tax basis of partnership assets. Book basis for GAAP or other financial reporting is not changed by a section 754 election. The result is a permanent book-tax difference that flows through Schedule M-3 reconciliation.

How does a section 754 election interact with section 704(c)?

Section 704(c) governs allocations of built-in gain or loss on contributed property. A section 743(b) adjustment is layered on top of section 704(c) and section 704(b) book allocations. The interaction is complex; the partnership must maintain section 704(c) capital accounts, section 704(b) book capital accounts, and tax capital accounts separately for accurate reporting.

What if the partnership has multiple section 754 events in one year?

A single election covers all triggering events in the year filed and in subsequent years. The partnership does not file multiple elections. Each section 743(b) and section 734(b) adjustment is computed and tracked separately.

Is a section 754 election required for an estate to get an inside basis step-up?

Yes, unless the partnership has a substantial built-in loss requiring a mandatory section 743(d) adjustment. The decedent’s estate gets an outside-basis step-up under section 1014 automatically, but that step-up does not flow to inside basis without a section 754 election. The estate’s tax planning team should request the election from the partnership immediately after death.

Can a tiered partnership push a section 754 election up or down the chain?

Each partnership in a tiered structure must make its own election. An upper-tier partnership’s section 754 election does not automatically cause a step-up at the lower-tier level. Both partnerships must file separate statements to fully step up basis on the underlying operating assets.

What is the section 743(e) electing investment partnership exception?

An electing investment partnership (a fund-of-funds or similar entity that meets specific criteria under section 743(e)) is exempt from the mandatory section 743(d) adjustment on substantial built-in loss. Instead, the partner who would otherwise receive the adjustment recognizes a loss limitation at the partner level. The exception is narrowly drawn and rarely available outside large investment partnerships.