If a partnership files a Section 754 election (or already has one in place), the basis of partnership property has to be adjusted under IRC § 734(b) and IRC § 743(b) in accordance with the Section 754 regulations. In other words, the partnership will step up (or step down) its basis in partnership property when a specific event—a property distribution or the transfer of a partnership interest—occurs. A Section 754 election applies to all property distributions and transfers of partnership interests during the partnership tax year for which the election is made, plus for all later tax years, unless revoked. Under the Section 754 regulations, however, an application to revoke the election will not be approved if the revocation’s primary purpose is to avoid stepping down the basis of partnership assets.
Since a Section 754 election is difficult to revoke, tends to increase the partnership’s administrative burdens, and applies on a mandatory basis to both distributions of partnership assets and transfers of partnership interests, the partnership (and partners) should thoroughly analyze the situation before making the election.
Partnership distributions of property can create disparities between a partner’s outside basis and the partnership’s inside basis when the distributee partner (1) recognizes gain or loss or (2) takes a basis in the distributed property that is different from the partnership’s inside basis. When there is a Section 754 election, these disparities are corrected by adjusting the partnership’s inside basis under IRC § 734(b). Note, however, that a reduction to the inside basis of partnership assets (i.e., a negative Section 734(b) adjustment) occurs only from a liquidating distribution.
The Section 734(b) adjustment is determined by:
- increasing the adjusted basis of partnership property by
- the amount of gain recognized by the distributee partner, and
- the excess of the adjusted basis of the distributed property to the partnership immediately before the distribution over the basis of the distributed property to the distributee (IRC § 734(b)(1)), or
- decreasing (only in the case of a liquidating distribution) the adjusted basis of partnership property by
- the amount of loss recognized by the distributee partner, and
- the excess of the basis of the distributed property to the distributee over the adjusted basis of the distributed property to the partnership immediately before the distribution (IRC § 734(b)(2)).
In calculating the Section 734(b) adjustment, any prior special basis adjustments under IRC § 743(b) and IRC § 732(d) have to be taken into account (i.e., any special basis adjustments are considered part of the partnership’s basis in the distributed property before the distribution).
The Section 734(b) adjustment (increase or decrease) is allocated among the partnership’s remaining assets under IRC § 755 (IRC § 734(c)). Thus, the adjustment is first allocated to property held by the partnership of like character (capital gain property or ordinary income property), then the adjustment is allocated within the class of property according to unrealized appreciation or depreciation. However, an allocation of basis reduction cannot reduce a property’s basis below zero. If the partnership property is depreciable, the Section 734 regulations (1) treat any basis increase as newly-purchased property for Section 168 purposes and (2) account for any basis decrease over the property’s remaining recovery period, starting with the period during which the basis is decreased.
As to a transfer of a partnership interest, the basis of partnership property is adjusted in accordance with IRC § 743(b) if the partnership makes a Section 754 election or already has one in place. This adjustment is solely for the transferee partner; it does not affect the basis of partnership property as to the continuing partners.
Since the purchaser of a partnership interest takes a cost basis in that interest but inherits the selling partner’s capital accounts (tax and book) and the seller’s share of inside basis, there is almost always a disparity between the transferee’s outside basis and share of inside basis; the Section 743(b) adjustment is intended to eliminate this disparity.
The amount of the Section 743(b) adjustment is equal to the difference between the transferee’s outside basis and their share of the inside basis of partnership property. The Section 743(b) regulations direct how to calculate the transferee’s share of inside basis by adopting a deemed-sale approach, and IRC § 755 (and its regulations) direct how to allocate the adjustment among the partnership’s assets. Since the adjustments made by the partnership apply only to the transferee partner, they have no effect on future allocations of income, deduction, gain or loss to the other partners, and no adjustment is made to the common basis of partnership property. Further, if the transferee later transfers their partnership interest, any basis adjustment for the subsequent transferee is determined independently from the prior Section 743(b) basis adjustment.
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