Inheriting a Partnership Interest: The Section 754 Election and Basis Step-Ups

Somewhere in the months after a death in the family, an heir opens a piece of mail that looks like homework: a Schedule K-1 from a partnership they now own a slice of. Real estate deals, a family LLC, a private fund: the wrapper varies. The first question I ask is always the same, and it's one most families have never heard: is there a section 754 election in effect?

The step-up you get without asking

Inherited assets generally get a fresh start for tax purposes. Your basis in what you inherit (a partnership interest included) resets to fair market value at the date of death rather than what the person who left it to you paid, so decades of appreciation fall out of the future capital-gain math. (Narrow exceptions exist, mainly for income the deceased had earned but not yet collected.) California adds a generous twist: property a married couple holds as community property can reset in full at the first spouse's death, both halves.

The mismatch nobody mentions

That reset applies to your outside basis: your basis in the partnership interest itself. Inside the partnership, nothing moved. The building bought in 1998 still carries its 1998 basis, and your share of depreciation and gain is still computed from it. If the partnership sells that building next year, your K-1 can hand you taxable gain on appreciation that happened long before you inherited. The mismatch does wash out eventually, often not until the partnership winds down, and the wait is rarely in your favor.

What a section 754 election fixes

The fix belongs to the partnership, not to you: an election under section 754 of the tax code. With one in effect, a transfer of an interest, whether by sale or by death, triggers what's called a 743(b) adjustment, stepping your share of the partnership's inside basis up to match your outside basis. It's personal to you. The other partners' numbers don't move, and the benefit rides along on your K-1 from then on, often as extra depreciation deductions each year or less gain when assets sell.

The practical part

• The election goes on the partnership's timely filed return for the year of the transfer, extensions included. That's the window. Ask the general partner or fund manager about it before that return goes out; afterward is usually too late.
• Once made, it sticks for every later transfer and distribution until the IRS consents to a revocation. Many established partnerships already have one in effect, so the job is just confirming it.
• It cuts both ways. If assets are worth less than their basis, the adjustment steps down, and once the partnership's built-in loss tops $250,000, a write-down is mandatory whether anyone elected or not.
• Tiered structures need extra care. One partnership's election doesn't automatically reach assets held by partnerships underneath it; each layer is its own question.
• The math starts from date-of-death value, so the estate's appraisal does double duty. Sloppy valuations become sloppy adjustments.