The §754 Election

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A partnership has two layers of basis. Each partner has an outside basis in the partnership interest; the partnership has an inside basis in each asset it owns. They start out equal and drift apart whenever an interest changes hands at a price other than its share of inside basis: a sale to a new partner, a death that steps up the interest under §1014, a distribution that shifts gain among partners. When they diverge, one partner is taxed on gain that economically belongs to someone else, or depreciates less than the price actually paid.

The §754 election tells the partnership to adjust inside basis to match, through §743(b) (transfers of interests) and §734(b) (distributions). It is a one-sentence statement on a timely return, it is permanent once made, and the recordkeeping it creates is why some preparers avoid it. The alternative, a buyer or an heir paying tax on the seller’s or the decedent’s appreciation, is worse. This is the procedure.

Step 1: The Two Bases

Outside basis (§705, §722, §742): what the partner paid or contributed, plus income allocated, less losses and distributions, plus the partner’s share of liabilities (§752). On a purchase, cost plus assumed liabilities. On death, fair market value at death (§1014) plus the share of liabilities, less the portion attributable to income in respect of a decedent (§1014(c); unrealized receivables and the decedent’s share of undistributed income don’t step up).

Inside basis (§723, §1012): the partnership’s basis in each asset, unaffected by who owns the interests. A building bought in 2008 for $1,000,000 and depreciated to $500,000 has an inside basis of $500,000 regardless of what the partners paid for their interests since.

The divergence shows up in three places: depreciation (the new partner depreciates her share of $500,000, not of the $2,000,000 the building is now worth), gain on sale of the asset (the new partner is allocated her share of $1,500,000 of gain, though she paid full value), and gain on a later sale of her interest (which produces an offsetting capital loss, years later, in the wrong character). The §754 election closes the gap for the transferee alone; the other partners are not affected.

It matters most in real estate LLCs with appreciated property and in family partnerships where interests pass by death. It matters least in a service partnership with no appreciated assets.

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Step 2: §743(b): Sale or Death

On a sale or exchange of an interest, or a transfer at death, with a §754 election in effect, the partnership adjusts the basis of its assets with respect to the transferee partner only, by the difference between the transferee’s outside basis and her share of inside basis (her share of the partnership’s “previously taxed capital” plus her share of liabilities, under Reg. §1.743-1(d)). A positive adjustment is a step-up; a negative one, a step-down. The adjustment is the transferee’s alone: separate depreciation, separate gain computation, shown as a separate line.

• Transferee’s outside basis: purchase price plus share of liabilities; or date-of-death FMV plus share of liabilities, less IRD items.
• Transferee’s share of inside basis: hypothetical liquidation computation under Reg. §1.743-1(d): the cash she would receive if the partnership sold everything for FMV and liquidated, plus her share of tax loss, minus her share of tax gain.
• Difference = §743(b) adjustment, allocated among assets under §755.
• Transfers that do not trigger §743(b): contributions to the partnership, gifts (carryover basis, no adjustment), and distributions (that is §734(b)).
• Partial interests: an adjustment for each transfer; a partner who bought in three times has three §743(b) layers.

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Step 3: §734(b): Distributions

When a distribution causes a partner to recognize gain (cash in excess of outside basis, §731(a)(1)) or loss (a liquidating distribution of only cash, unrealized receivables and inventory, §731(a)(2)), or when distributed property takes a basis in the partner’s hands different from its inside basis (§732), the remaining partners have been shifted gain or loss. With the election, the partnership adjusts the basis of its retained assets to compensate: up by the gain recognized and by any basis the distributee lost; down by the loss recognized and by any basis the distributee gained. Unlike §743(b), this adjustment is common to all remaining partners. It arises mostly in liquidating distributions and redemptions of a retiring partner, and it is the reason a redemption and a cross-purchase of the same interest produce different results for the people who stay.

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Step 4: Making the Election

• When: on a timely filed Form 1065 (including extensions) for the year in which the transfer or distribution occurs (Reg. §1.754-1(b)). A transfer on December 20, 2026 requires the election on the 2026 return, due March 15, 2027 or September 15 on extension. It cannot be made on an amended return outside the relief below.
• How: a written statement attached to the return: the partnership’s name and address, and a declaration that it elects under §754 to apply §734(b) and §743(b). T.D. 9963 (2022) removed the former signature requirement. Check the box on Form 1065 Schedule B as well (verify current line number).
• Late relief: automatic 12-month extension under Reg. §301.9100-2(a)(2)(vi) by filing an amended return with the statement and “FILED PURSUANT TO §301.9100-2” within 12 months of the original due date (excluding extensions). Beyond that, a §301.9100-3 private letter ruling with its user fee; granted routinely when the failure was inadvertent and the government’s interests aren’t prejudiced.
• Duration: permanent, for all subsequent transfers and distributions, including step-downs, until revoked with IRS consent (Reg. §1.754-1(c)), which is given only for a change in business, not for a bad year.
• Who decides: the partnership (the operating agreement often says the managing member may or must make it on a transferee’s request). A buyer should negotiate for it before closing; an estate should ask for it before the 1065 is filed.

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Step 5: When It Isn’t Optional

Two situations force the adjustment with or without an election, both aimed at loss duplication:

• Substantial built-in loss on a transfer (§743(d)): the partnership’s adjusted basis in all its property exceeds FMV by more than $250,000, or (since 2018) the transferee would be allocated a net loss of more than $250,000 on a hypothetical sale of all assets at FMV. The §743(b) step-down is mandatory.
• Substantial basis reduction on a distribution (§734(d)): the downward adjustment that would be made under §734(b) exceeds $250,000. Mandatory.

An electing investment partnership and a securitization partnership are excepted. For the ordinary client these rules bite in a partnership holding property that has fallen in value, where a new partner buys in cheaply and would otherwise inherit the old partners’ loss.

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Step 6: Allocating the Adjustment

Reg. §1.755-1. The total adjustment is split between two classes, then among assets within each class.

• Class 1: ordinary income property (inventory, unrealized receivables, depreciation recapture to the extent of recapture). Class 2: capital gain property (everything else, including §1231 property and goodwill).
• For a §743(b) adjustment, allocate to each asset the amount that would eliminate the transferee’s share of built-in gain or loss in that asset on the hypothetical sale; the result can be positive for some assets and negative for others within the same total.
• Goodwill and going-concern value take the residual when the price exceeds the FMV of identifiable assets (the residual method of §1060, incorporated by §755(b)).
• Land takes its share and is not depreciable; the building’s share is depreciated as newly purchased property placed in service on the transfer date (Reg. §1.743-1(j)(4)(i)(B)): 27.5 or 39 years straight-line from that date, with bonus depreciation available for qualifying property in a purchase (not at death) (verify treatment of §743(b) adjustments for bonus under the 2025 act’s 100% restoration).
• A negative §743(b) adjustment on depreciable property reduces the transferee’s depreciation over the asset’s remaining life.
• Keep a schedule per transferee: adjustment by asset, depreciation taken on the adjustment, remaining adjustment. When the partnership sells the asset, the transferee’s gain is reduced (or increased) by the remaining adjustment on that asset.

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Step 7: Reporting

• Form 1065: the election statement in the year made; Schedule B question answered; the §743(b) adjustment computed and attached as a statement showing the computation and allocation (Reg. §1.743-1(k)(1) requires the partnership to attach it to the return for the year of transfer).
• The transferee must notify the partnership of the transfer within 30 days (purchase) or the estate within one year of death (Reg. §1.743-1(k)(2)); without notice, the partnership is not required to make the adjustment and may report as if none exists.
• Schedule K-1: the transferee’s depreciation on the step-up and the gain/loss effect are reported as separately stated items; box 20 code U reports the §743(b) adjustment information; box 13 code V or the depreciation lines carry the additional depreciation (verify current K-1 codes for 2026). The partnership’s own books (Schedule L, M-2 capital accounts) are not adjusted; §743(b) is off-book, partner-specific.
• §734(b) adjustments, by contrast, go into the partnership’s books and depreciation schedules for everyone.
• The transferee’s tax-basis capital account on K-1 item L excludes the §743(b) adjustment (2020 instructions forward); outside basis includes it. Keep both.

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A Worked Example

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Why There Is No S Corporation Version

S corporations have no inside-basis adjustment mechanism. An heir’s stock steps up under §1014; the corporation’s assets don’t, and when the corporation sells the building the gain passes through to the heir, who gets a basis increase and an offsetting capital loss on liquidation. The gain is ordinary or §1231 at the corporate level and the loss is capital, so the character mismatch is real money. This is the strongest argument for holding appreciated real estate in an LLC taxed as a partnership rather than in an S corporation, and it is why our business-entities page says so. For an existing S corporation holding appreciated property, the planning options are limited: a §338(h)(10) or §336(e) election on a sale of the whole company, or simply holding the asset until it is sold and accepting the mismatch.

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Questions at the desk

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Written for the Tax Shop desk; figures are for the 2026 tax year as currently published. Items marked (verify) are to be confirmed against primary sources before the figures freeze in December. Last updated October 16, 2026.