A Section 754 step-up in basis is the adjustment a partnership makes, under Internal Revenue Code Section 743(b), so that an incoming partner’s share of the partnership’s asset basis matches the price they actually paid for their interest. The step-up equals the difference between the new partner’s outside basis (purchase price plus assumed debt) and their share of the partnership’s existing inside basis, and it is then spread across the partnership’s assets under Section 755. It is personal to the new partner: it changes their depreciation deductions and their gain on future asset sales, without affecting the other partners’ tax positions.
Why the Step-Up Exists
Partnership taxation runs on two basis numbers that drift apart over time. Inside basis is the partnership’s own tax basis in its assets, cost minus depreciation. Outside basis is each partner’s basis in their partnership interest, starting at what they paid or contributed and moving with income, contributions, losses, and distributions.
When partnership assets have appreciated, a buyer’s outside basis is the purchase price, but their proportionate share of inside basis is still the partnership’s old, lower number. That gap is the problem. If the partnership later sells an appreciated asset, gain is measured against the old inside basis, and the new partner gets allocated their share of a gain that accrued before they arrived. The 743(b) adjustment closes the gap by giving the new partner a personal basis increase in the partnership’s assets equal to what they overpaid relative to inside basis.
Worked Example: Calculating the 743(b) Adjustment
Consider XYZ LLC, an equal three-member partnership (Partners X, Y, and Z) with two assets:
| Asset | Inside Basis | Fair Market Value | Unrealized Gain |
|---|---|---|---|
| Asset A (Land) | $150,000 | $300,000 | $150,000 |
| Asset B (Equipment) | $50,000 | $150,000 | $100,000 |
| Total | $200,000 | $450,000 | $250,000 |
Each partner’s share of inside basis is $66,667. Partner Z sells their entire one-third interest to a new partner, T, for $150,000. A Section 754 election is in effect.
Step 1: Total Adjustment
The 743(b) adjustment is the difference between the new partner’s outside basis and their share of the partnership’s inside basis.1Office of the Law Revision Counsel. 26 U.S.C. 743 – Special Rules Where Section 754 Election or Substantial Built-in Loss
- T’s outside basis: $150,000
- T’s share of inside basis: $66,667
- Total 743(b) adjustment: $83,333
That $83,333 is the pre-acquisition appreciation baked into what T paid. Without the adjustment, T would eventually be taxed on gains that accrued entirely during X, Y, and Z’s ownership.
Step 2: Allocate Between Asset Classes
Section 755 splits the adjustment between two classes: capital gain property (capital assets and Section 1231 property) and ordinary income property.2Office of the Law Revision Counsel. 26 U.S.C. 755 – Rules for Allocation of Basis Here, both the land and the equipment are capital gain property, so the entire $83,333 stays in that class. If the partnership held inventory or accounts receivable, a portion would be carved off for those ordinary income assets first.
Step 3: Allocate to Individual Assets
Within the capital gain class, the adjustment is spread among individual assets based on T’s share of the unrealized gain in each:
- Asset A (Land): one-third of $150,000 = $50,000 adjustment
- Asset B (Equipment): one-third of $100,000 = $33,333 adjustment
After the adjustment, T has a personal, or “special,” basis in each asset. T’s special basis in Asset A is $100,000 ($50,000 share of inside basis plus $50,000 adjustment). T’s special basis in Asset B is $50,000 ($16,667 share of inside basis plus $33,333 adjustment). The adjustment belongs to T alone and has no effect on how the partnership computes income for X and Y.3eCFR. 26 CFR 1.743-1 – Optional Adjustment to Basis of Partnership Property
Goodwill and the Residual Method
The example above uses only tangible assets. Many partnerships hold goodwill too. When partnership assets constitute a trade or business, the regulations require a residual method for valuing Section 197 intangibles: the partnership values its identifiable assets first, and any excess of total value over identifiable assets is assigned to goodwill and going concern value.4eCFR. 26 CFR 1.755-1 – Rules for Allocation of Basis The 743(b) adjustment allocated to goodwill is then amortized over 15 years, which is often a significant tax benefit for the incoming partner.
One trap: if goodwill was acquired from a related party, the anti-churning rules under Section 197(f)(9) can block amortization of the stepped-up portion. Those rules use a 20-percent ownership threshold rather than the usual 50 percent and apply to intangibles held during a specific transition period. Where they bite, the new partner gets the basis adjustment on paper but cannot deduct it through amortization.
How the Step-Up Pays Off on Future Returns
The 743(b) adjustment isn’t a paper figure. It changes the new partner’s tax liability every year through higher depreciation deductions and lower gain on asset sales, tracked by the partnership and reported on a statement attached to the K-1.
Additional Depreciation
For Asset B, T depreciates two layers. The first is T’s $16,667 share of the partnership’s original inside basis, which continues over the asset’s remaining recovery period. The second is the $33,333 basis adjustment, which the regulations treat as a separate depreciable asset.3eCFR. 26 CFR 1.743-1 – Optional Adjustment to Basis of Partnership Property Between the two layers, T recovers the full $50,000 economic investment in Asset B, and the added depreciation reduces T’s share of ordinary income each year.
Reduced Gain on Sale
Suppose XYZ LLC sells Asset A for its $300,000 fair market value. The partnership recognizes $150,000 of gain. Partners X and Y each report their $50,000 share in full. T’s share is different: T’s $50,000 allocation is offset by T’s $50,000 basis adjustment in Asset A, leaving zero taxable gain.3eCFR. 26 CFR 1.743-1 – Optional Adjustment to Basis of Partnership Property That is the whole point. T paid fair market value and should not owe tax on gains that existed before the purchase.
Making the Section 754 Election
The partnership makes the election, not the individual partner. Once filed, it applies to every transfer of a partnership interest and every distribution of partnership property, for that year and every year after.5Office of the Law Revision Counsel. 26 U.S.C. 754 – Manner of Electing Optional Adjustment to Basis of Partnership Property Permanence matters here: this is not something you switch on for one transaction.
The election is a written statement attached to the partnership’s Form 1065 for the year the triggering transfer or distribution occurs. It must include the partnership’s name and address, be signed by a partner, and declare that the partnership elects under Section 754 to apply Sections 734(b) and 743(b). The return must be filed by its due date, including extensions.6GovInfo. 26 CFR 1.754-1 – Manner and Time of Making Election
If the deadline is missed, an automatic 12-month extension is available under Treasury Regulation Section 301.9100-2. Beyond 12 months, relief requires approval from the IRS Commissioner under Section 301.9100-3 and a showing of reasonable cause.7Internal Revenue Service. FAQs for Internal Revenue Code (IRC) Sec. 754 Election and Revocation The 12-month window is the one to hit.
Revocation requires IRS permission. The partnership files Form 15254 no later than 30 days after the close of the tax year for which the revocation should take effect. The IRS will consider revocation when the election has become administratively burdensome due to a substantial increase in assets, a shift in the character of partnership property, or a jump in how frequently partnership interests change hands.7Internal Revenue Service. FAQs for Internal Revenue Code (IRC) Sec. 754 Election and Revocation The IRS will not approve a revocation whose primary purpose is to dodge a basis reduction on a transfer or distribution.
When the Step-Up Cuts the Other Way
The election does not only create upward adjustments. When someone buys a partnership interest for less than their share of inside basis, the same rules force a downward adjustment that reduces the new partner’s depreciable basis in partnership assets.1Office of the Law Revision Counsel. 26 U.S.C. 743 – Special Rules Where Section 754 Election or Substantial Built-in Loss This can happen when assets have declined, when partnership liabilities have inflated inside basis above market value, or simply because the seller took a discount.
Because the election is permanent, a partnership that elected during appreciating years is stuck with it in later years when assets may have lost value. A discounted buy-in produces a negative 743(b) adjustment, meaning lower depreciation and more taxable gain when assets are sold. This is the main reason some partnerships hesitate to elect. And revocation, as noted, requires IRS approval and cannot be motivated primarily by a wish to avoid downward adjustments.
When the Adjustment Is Required Anyway
In some situations, the partnership must adjust basis whether or not a 754 election exists. Since 2004, a partnership with a “substantial built-in loss” immediately after a transfer of an interest must adjust basis as though a 754 election were in effect. A substantial built-in loss exists when total inside basis exceeds total fair market value of partnership assets by more than $250,000.1Office of the Law Revision Counsel. 26 U.S.C. 743 – Special Rules Where Section 754 Election or Substantial Built-in Loss A second test also applies: the adjustment is required if the incoming partner would be allocated a loss exceeding $250,000 on a hypothetical sale of all partnership assets at fair market value immediately after the transfer.
A parallel rule applies to distributions. When a distribution triggers basis decreases (because the distributed property’s basis to the partner exceeds what it was to the partnership) totaling more than $250,000, the partnership must reduce the basis of remaining assets even without a 754 election.8Office of the Law Revision Counsel. 26 U.S.C. 734 – Adjustment to Basis of Undistributed Partnership Property These mandatory rules exist to prevent partnerships from using loss-laden assets to shift tax benefits to incoming partners or to distribute overstated basis to exiting ones without a corresponding adjustment to what remains.