A Section 754 step-up in basis is the adjustment a partnership makes, under Section 743(b) of the Internal Revenue Code, to align an incoming partner’s share of the partnership’s asset basis with what that partner actually paid for their interest. Without it, a buyer who pays fair market value for a stake in a partnership holding appreciated assets ends up taxed on gains that built up before they ever joined. The election is made by the partnership, not the partner, and once filed it applies to every future transfer and distribution.1Office of the Law Revision Counsel. 26 U.S.C. 754 – Manner of Electing Optional Adjustment to Basis of Partnership Property
Why the Step-Up Exists
Partnership taxation runs on two basis numbers that drift apart over time. Inside basis is the partnership’s own tax basis in its assets: original cost minus depreciation. Outside basis is each partner’s tax basis in their partnership interest, which starts at what they paid or contributed and then moves with income, contributions, distributions, and losses.
When partnership assets appreciate, a new buyer’s outside basis (the purchase price) sits above their proportionate share of inside basis. If the partnership later sells an appreciated asset, it computes gain using the old, lower inside basis. Without a 754 election, the new partner takes a full share of that gain even though the appreciation happened before they bought in. The Section 743(b) adjustment closes the gap by giving the new partner a personal basis bump in the partnership’s assets equal to the difference between what they paid and their share of inside basis.
A Worked Example of the 743(b) Adjustment
Consider XYZ LLC, an equal three-member partnership (Partners X, Y, and Z) holding two assets:
| Asset | Inside Basis | Fair Market Value | Unrealized Gain |
|---|---|---|---|
| Asset A (Land) | $150,000 | $300,000 | $150,000 |
| Asset B (Equipment) | $50,000 | $150,000 | $100,000 |
| Total | $200,000 | $450,000 | $250,000 |
Each partner’s share of inside basis is $66,667 (one-third of $200,000). Partner Z sells the full one-third interest to a new partner, T, for $150,000. XYZ has a Section 754 election in effect.
Step 1: Total Adjustment
The 743(b) adjustment equals the difference between T’s outside basis and T’s share of inside basis.2Office of the Law Revision Counsel. 26 U.S.C. 743 – Special Rules Where Section 754 Election or Substantial Built-in Loss
- T’s outside basis: $150,000
- T’s share of inside basis: $66,667
- Total 743(b) adjustment: $83,333
That $83,333 is the pre-acquisition appreciation baked into T’s purchase price.
Step 2: Allocate Between Asset Classes
Section 755 splits the adjustment between two classes: capital gain property (capital assets and Section 1231 property) and ordinary income property (everything else).3Office of the Law Revision Counsel. 26 U.S.C. 755 – Rules for Allocation of Basis Both the land and the equipment here are capital gain property, so the full $83,333 stays in that class. If XYZ held inventory or receivables, a portion would be carved off for the ordinary income class first.
Step 3: Allocate to Individual Assets
Within the capital gain class, the adjustment is spread by T’s share of each asset’s unrealized gain:
- Asset A (Land): one-third of $150,000 = $50,000 adjustment
- Asset B (Equipment): one-third of $100,000 = $33,333 adjustment
T now has a personal basis in each asset that differs from the partnership’s common basis. T’s special basis in Asset A is $100,000 ($50,000 share of inside basis plus the $50,000 adjustment). T’s special basis in Asset B is $50,000 ($16,667 share of inside basis plus the $33,333 adjustment). The adjustment is personal to T and has no effect on how the partnership computes income for X and Y.4eCFR. 26 CFR 1.743-1 – Optional Adjustment to Basis of Partnership Property
Goodwill and the Residual Method
Many partnerships hold significant goodwill. When the partnership’s assets make up a trade or business, the regulations require a residual method to value Section 197 intangibles. The partnership values its identifiable assets first; any excess of total partnership value over those identifiable assets goes to goodwill and going concern value.5eCFR. 26 CFR 1.755-1 – Rules for Allocation of Basis The 743(b) adjustment allocated to goodwill is amortized over 15 years, often a meaningful benefit for the incoming partner.
How the Step-Up Pays Off in Later Years
The 743(b) adjustment isn’t just a number on a worksheet. It changes T’s actual tax liability every year through larger depreciation deductions and smaller taxable gain when assets are sold. The partnership tracks these adjustments separately and reports them on an attached statement to T’s Schedule K-1.
Extra Depreciation Deductions
For Asset B, T depreciates two layers. The first is T’s $16,667 share of the partnership’s original inside basis, which continues over the asset’s remaining recovery period. The second is the $33,333 basis adjustment, which the regulations treat as a separate depreciable asset.4eCFR. 26 CFR 1.743-1 – Optional Adjustment to Basis of Partnership Property Together, T recovers the full $50,000 economic investment in Asset B through depreciation, which reduces T’s share of ordinary income from the partnership each year.
One trap: if partnership goodwill was acquired from a related party, the anti-churning rules under Section 197(f)(9) can block amortization of the stepped-up portion. The rules apply when buyer and seller are related (using a 20 percent ownership threshold instead of the usual 50 percent) and the intangible was held during a specific transition period. When these rules apply, the new partner gets the basis adjustment on paper but cannot deduct it through amortization.
Reduced Gain on Asset Sales
If XYZ sells Asset A for its $300,000 fair market value, the partnership recognizes $150,000 of total gain. X and Y each report their $50,000 share in full. T’s $50,000 share is offset by T’s $50,000 basis adjustment in Asset A, producing zero taxable gain.6eCFR. 26 CFR 1.743-1 – Optional Adjustment to Partnership Property That is the point: T paid fair market value and should not owe tax on gains that existed before the purchase.
Step-Up at the Death of a Partner
Buying out a departing partner isn’t the only trigger. Section 743(b) also applies when a partnership interest transfers because of a partner’s death.2Office of the Law Revision Counsel. 26 U.S.C. 743 – Special Rules Where Section 754 Election or Substantial Built-in Loss Under Section 1014, a deceased partner’s interest generally takes a stepped-up basis to its fair market value at the date of death. If the partnership has a 754 election in place, or makes one for the year of death, the inside basis of partnership assets adjusts to reflect the heir’s new, higher outside basis.
Without the election, the heir inherits a stepped-up outside basis but a share of the partnership’s old, low inside basis. Every future depreciation deduction and capital gain calculation ignores the step-up. Partnerships that anticipate ownership transitions at death, including family limited partnerships, often treat the election as close to mandatory for this reason.
The Downside: Negative Adjustments and Permanence
The election cuts both ways. When someone buys a partnership interest for less than their proportionate share of inside basis, the election forces a downward adjustment that reduces the new partner’s depreciable basis in partnership assets.2Office of the Law Revision Counsel. 26 U.S.C. 743 – Special Rules Where Section 754 Election or Substantial Built-in Loss That can happen when assets have declined in value, when partnership liabilities inflate inside basis above market value, or when a seller simply accepts a discount.
Because the election is permanent, a partnership that elected during a period of appreciation remains locked in when values later fall. A new partner entering at a discount gets a negative 743(b) adjustment, meaning lower depreciation deductions and more taxable gain when assets are eventually sold. This is the main reason some partnerships hesitate to elect at all.
Making, Missing, and Revoking the Election
The election requires a written statement attached to the partnership’s Form 1065 for the year the triggering transfer or distribution occurs. The statement must give the partnership’s name and address, be signed by a partner, and explicitly declare that the partnership elects under Section 754 to apply the provisions of Sections 734(b) and 743(b). The return must be filed by its due date, including extensions.7GovInfo. 26 CFR 1.754-1 – Manner and Time of Making Election
Missed the deadline? An automatic 12-month extension is available under Treasury Regulation Section 301.9100-2. After 12 months, the partnership can still request relief, but it needs IRS Commissioner approval under Treasury Regulation Section 301.9100-3, which requires demonstrating reasonable cause.8Internal Revenue Service. FAQs for Internal Revenue Code (IRC) Sec. 754 Election and Revocation Hit the 12-month window if you can.
Revocation also requires IRS permission. The partnership files Form 15254 no later than 30 days after the close of the tax year for which the revocation should take effect. The IRS considers approval when the election has become administratively burdensome due to changes like a substantial increase in assets, a shift in the character of partnership property, or a jump in how often interests change hands.8Internal Revenue Service. FAQs for Internal Revenue Code (IRC) Sec. 754 Election and Revocation The IRS will not approve a revocation whose primary purpose is to dodge a downward basis adjustment.
Once the election is in place, the partnership must track the remaining balance of each incoming partner’s 743(b) adjustment for every asset, reducing it each year for depreciation recovery and adjusting it when assets are sold. Those results flow through an attached statement to the partner’s Schedule K-1, which must reflect the adjusted share of income, deductions, gains, and losses after the special basis adjustment.4eCFR. 26 CFR 1.743-1 – Optional Adjustment to Basis of Partnership Property That asset-by-asset tracking is the real cost of a 754 election, and for partnerships with frequent ownership changes it can get expensive to maintain.