Section 754 Election

In a partnership, two kinds of basis matter. Outside basis is what a partner paid for her interest. Inside basis is the partnership's own cost basis in its underlying assets. Ordinarily these can diverge over time — sometimes dramatically — so a new partner may inherit tax gain or loss that economically belonged to a prior owner.

A Section 754 election (named for the section of the U.S. Internal Revenue Code that authorizes it) allows the partnership to step up or step down its inside basis in assets when a partnership interest is transferred by sale or by death. The result is that the incoming partner's share of inside basis is realigned to reflect what she actually paid, avoiding phantom gain on assets she never owned at a lower cost.

Consider a hypothetical: a family limited partnership holds appreciated real estate with a very low historical cost basis. A son inherits a partnership interest at death. Without a 754 election in place, he could later be taxed on gain that accrued before he ever held the interest. With the election, the partnership can adjust his allocable share of inside basis upward, reducing that future tax exposure.

A common confusion is treating the election as automatic — it is not. The partnership must affirmatively make it, and once made it generally applies to all future transfers. The election also creates administrative complexity. A qualified CPA and tax attorney must evaluate whether it is appropriate for any particular partnership's circumstances.