The Section 754 Election: A Step-Up in Basis, in One Example

Here's a scenario that catches people every year. You buy into a partnership, or you inherit a stake in the family LLC, and a year or two later a Schedule K-1 shows up with a big gain on it, from a sale of property that appreciated long before you ever arrived. You paid full price for your share. You never pocketed that gain. And you're taxed on it anyway. Closing that gap is the whole job of a Section 754 election, and the fix it delivers is a step-up in basis.

Two kinds of basis, and the gap between them

Every partnership runs on two separate basis numbers. There's inside basis, the partnership's basis in its own assets, and outside basis, your basis in your partnership interest. At the start, they line up. The trouble begins when an interest changes hands, because one of those numbers moves and the other sits still.

Buy a partnership interest and your outside basis becomes what you paid. Inherit one and your outside basis generally steps up to its value on the date of death under §1014, the same rule that resets the basis of inherited stock. Either way, your outside basis now reflects today's value. The partnership's inside basis in its assets doesn't move an inch; it stays at the old, low number on the books. You own a piece of the assets the partnership is still carrying as if the appreciation never happened.

A simple example

Say a partnership has three equal partners and a single asset: a parcel of land it bought years ago for $300,000 that's worth $900,000 today. No debt, to keep the math clean. Each partner's share of the inside basis is $100,000, and each third is worth $300,000.

One partner sells her third to you for its full price, $300,000. Your outside basis is now $300,000. Real cash, out the door. But on the inside you stepped into her shoes: your share of the partnership's basis in that land is still just $100,000.

A year later the partnership sells the land for $900,000 and reports a $600,000 gain. Your cut is a third of it, $200,000, and it lands on your K-1. Look at what happened. You paid $300,000 for something worth $300,000, the value never moved while you owned it, and you're taxed on $200,000 of gain regardless. That's phantom gain. The appreciation was already baked in the day you bought, taxed to you as if it were yours.

One honest wrinkle before the fix: that $200,000 isn't gone forever. The gain you report gets added to your outside basis, lifting it from $300,000 to $500,000, and whenever you finally sell your interest or the partnership winds down, the extra basis comes back to you, usually as a capital loss. The catch is the wait. Without a 754 election that recovery is your only relief, and a loss fifteen years from now is cold comfort for a tax bill due next April. What the missing election really costs you is timing, and sometimes the character of the income, rather than a doubled tax.

What the Section 754 election changes

If the partnership has a §754 election in place, it makes a second adjustment, a §743(b) adjustment, for you alone. It sets your $300,000 outside basis against your $100,000 share of inside basis and steps up the $200,000 difference: extra basis in that land, personal to you, invisible to the other two partners.

Now run the sale again. The partnership still reports its $600,000 gain, but your $200,000 step-up cancels the $200,000 that would otherwise land on your K-1. You report zero this year, which is the honest answer, because you had no real gain, and you get there now instead of waiting years to claw it back through basis. The other two partners, who actually watched the land climb from $300,000 to $900,000, still report $200,000 each. No tax disappeared here. The $600,000 just got assigned to the people who actually rode the land up, $200,000 at a time.

Land doesn't depreciate, so here your step-up pays off in one shot, on the sale. Most partnerships worth buying into own more than a patch of dirt, and that is where the election turns into real money.

Now add depreciation: land, building, and equipment

Now make the numbers bigger and the assets messier. Say a later buy-in hands you a $1,000,000 step-up in a partnership that owns a building and the operating business inside it. Section 755 decides where that million goes, spreading it across the assets in proportion to where the built-in gain lives. A common split:

• Land (20%): $200,000. No depreciation. It waits for a sale, just like the first example.
• Building (35%): $350,000. Recovered as extra depreciation over 39 years, on the order of $9,000 a year against your share of the income.
• Equipment and other personal property (35%): $350,000. Recovered much faster, over 5 to 7 years, and when the conditions line up, a big piece of it can land in year one through bonus depreciation under §168(k).
• Land improvements (10%): $100,000. Recovered over 15 years.

Add it up and $800,000 of your $1,000,000 step-up sits in property that depreciates. With the election, that becomes deductions that flow to you, and only you, on your K-1 over the next several years, quietly lowering the income you are taxed on. Without it, none of that happens: the whole $1,000,000 stays locked in your outside basis, doing nothing until the day you sell your interest. Same economics, very different timing, and timing is the whole game.

The bonus piece carries fine print of its own, and it moves real dollars. Bonus only attaches when the step-up comes from buying the interest, and buying it from an unrelated party at that. Buy out your parent or your sibling and the related-party rules shut it off. Inherit the interest and it's shut off too: a basis reset at death comes from §1014, not from a purchase, so those slices depreciate on the normal schedule instead. And some real estate partnerships gave bonus away on their building-type property when they elected out of the §163(j) business-interest limits, though equipment and land improvements generally keep it. None of this kills the step-up. It only sets the speed.

Where the election really earns its keep: inheritance

The purchase case is the easier one to picture. Death is the one that actually fills my inbox. When you inherit a partnership interest, §1014 resets your outside basis to date-of-death value on its own, no election needed. But that reset stops at the partnership's door. Inside, the assets still carry the decedent's decades-old cost, and their phantom gain passes to you right along with the interest.

With the election in place, the partnership carries that step-up inside, onto your share of the assets. On real estate held for decades, that is often the difference between a painful gain on the next sale and almost none, or years of extra depreciation you'd otherwise never collect. When a new client brings in a K-1 from an inherited LLC, "did the partnership make a 754 election?" is the first thing I want to know.

The catch nobody mentions

Every partnership could carry this election, and plenty refuse. Their reasons hold up. The election is a one-way door: the partnership files it, not the partner who wanted it, and it binds every transfer and distribution that comes afterward, whether the next one brings a step-up or a painful step-down. Revoking takes IRS consent, and a change of heart doesn't count as a reason.

That step-down possibility deserves numbers. Say a partnership paid $3,000,000 for equipment that's now worth $2,600,000, and you buy in mid-slide. Your share of inside basis lands above what you paid, so the adjustment runs downward: less basis and smaller depreciation deductions for as long as the partnership holds the gear. And because the gap here is $400,000, wider than the $250,000 line §743(d) draws for a substantial built-in loss, the write-down would hit you even if no election existed. Congress drew that line in 2004 and tightened it in 2017, after watching built-in losses get deducted twice, once by the seller on the way out and again inside the partnership.

Then there's the bookkeeping, which no one warns you about. Each adjustment is personal to one partner, so ten transfers over the years means ten separate layers riding on the partnership's books, every one carrying its own depreciation schedule for as long as its partner stays in. I've seen an election look brilliant the year it's made and turn into an annual chore nobody remembered signing up for.