What Is a Section 754 Election and When Does a Partnership Need One?
Sam's List Editorial | 2026-08-03
What Is a Section 754 Election and When Does a Partnership Need One? A Section 754 election lets a partnership adjust the tax basis of its own assets when a partnership interest changes hands, so an incoming partner is not taxed on gain that was already priced into what they paid. Without it, the new partner can buy an interest at full market value and still inherit the old partner's share of built-in gain, then pay tax on it a second time when the partnership sells the asset. It is one of the highest-stakes elections in partnership tax, and it is regularly missed by partnerships that had no idea it was available. Inside Basis and Outside Basis: The Gap That Creates the Problem Every partnership has two sets of basis numbers running in parallel. Outside basis is each partner's basis in their partnership interest. When you buy an interest, your outside basis is generally what you paid. Inside basis is the partnership's basis in the assets it owns. When an interest is sold, the partnership's asset basis does not change. The buyer and seller transacted with each other; the partnership itself did nothing. Normally the two stay in rough alignment. They come apart the moment an interest is sold or inherited at a value different from the seller's basis. Here is the mechanic, using illustrative numbers only. A partnership owns a building with a tax basis of $300,000 and a fair market value of $900,000. Three equal partners each have $100,000 of outside basis. One partner sells her one-third interest to a new partner for $300,000, and that buyer's outside basis is now $300,000. The partnership then sells the building for $900,000 and recognizes $600,000 of gain, one-third of which, $200,000, is allocated to the new partner. She pays tax on $200,000 of gain on an asset she effectively already paid full value for. She will eventually recover that through basis when she exits, but the timing damage is done, and in many cases the character is worse too. A Section 754 election is what closes that gap. What the Election Actually Does Section 754 is the switch. Once flipped, two other provisions do the work. Section 743(b) applies when a partnership interest is transferred by sale or exchange, or on the death of a partner. It adjusts the basis of partnership property with respect to the transferee partner only. In the example above, the new partner would receive a $200,000 positive adjustment to her share of the building's basis, and the gain on a later sale would net to zero for her. Section 734(b) applies to distributions of partnership property, adjusting the basis...
