Internal Revenue Code Section 742 is a short statute that answers one question: when you acquire a partnership interest by any means other than contributing property to the partnership, what is your starting basis? The answer is that you use the general basis rules for property found in Part II of Subchapter O of the Code.1Office of the Law Revision Counsel. 26 U.S. Code 742 – Basis of Transferee Partner’s Interest In plain terms, a purchased interest starts at cost, an inherited interest starts at fair market value on the date of death, and a gifted interest carries over the donor’s basis. That opening figure then gets adjusted for your share of the partnership’s liabilities and updated every year for income, losses, distributions, and contributions.
What the Statute Actually Says
The statutory text is one sentence. It sends you to Section 1011 and the provisions that follow it, which is where the Code houses cost basis, basis of property acquired from a decedent, basis of property acquired by gift, and the rest. Section 742 does not create a special partnership basis rule. It confirms that a partnership interest, when you didn’t contribute property to get it, is treated like any other piece of property for basis purposes.
One boundary is worth pinning down at the start. If you acquired your interest by contributing cash or property directly to the partnership, Section 742 does not apply to you. Section 722 does, and it generally gives you a basis equal to the basis of what you contributed. Section 742 is the rule for transferee partners: people who bought, inherited, or were gifted an interest, or received one for services.
Basis When You Buy a Partnership Interest
A purchased interest takes a cost basis under Section 1012.2Office of the Law Revision Counsel. 26 U.S. Code 1012 – Basis of Property; Cost Cost means the total you paid in cash or other property, plus capitalizable acquisition expenses such as legal and accounting fees tied to closing the deal. Pay $500,000 for a 25% interest and spend $10,000 on professional fees, and your initial cost basis is $510,000.
Your holding period begins the day after the acquisition date.3eCFR. 26 CFR 1.1223-3 – Rules Relating to the Holding Periods of Partnership Interests Hold the interest more than a year and gain attributable to the partnership’s capital assets qualifies for long-term capital gain treatment when you sell.
One point that catches buyers off guard: if the partnership holds unrealized receivables or inventory items, sometimes called hot assets, a portion of your gain on a later sale of the interest is taxed as ordinary income regardless of your holding period.4Internal Revenue Service. Sale of a Partnership Interest – Practice Unit Hot assets don’t change your starting basis, but they change the character of your gain at exit.
Basis When You Inherit a Partnership Interest
An interest acquired from a decedent gets a basis equal to its fair market value on the date of death under Section 1014.5Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent The unrealized appreciation the decedent held during life is wiped out. An interest the decedent bought for $50,000 that was worth $400,000 at death gives the heir a $400,000 basis, and the $350,000 of lifetime appreciation is never taxed as capital gain.
Alternate Valuation Date
The executor may elect to value estate property as of six months after the date of death rather than the date of death itself.6Office of the Law Revision Counsel. 26 U.S. Code 2032 – Alternate Valuation If property is sold or distributed within that window, it’s valued as of the disposition date. The election is only available when it reduces both the gross estate and the estate tax owed. When it’s made, the heir’s basis is the alternate valuation figure.
Consistency With the Estate Tax Return
Section 1014(f) caps the heir’s basis at the final estate tax value of the interest. That consistency rule applies only to property whose inclusion in the estate actually increased the estate tax liability. If the estate owed no estate tax because it fell below the exemption, the cap doesn’t apply.
Income in Respect of a Decedent
Not everything steps up. The decedent’s share of accrued but untaxed partnership income earned through the date of death is income in respect of a decedent, or IRD.7eCFR. 26 CFR 1.753-1 – Partner Receiving Income in Respect of Decedent IRD keeps its original character and receives no basis step-up. The heir or estate reports it when received. Payments to the estate under Section 736(a), including the decedent’s distributive share for the portion of the year before death, are treated as IRD.
Basis When You Receive a Partnership Interest as a Gift
A gifted interest carries over the donor’s adjusted basis immediately before the transfer under Section 1015.8Office of the Law Revision Counsel. 26 U.S. Code 1015 – Basis of Property Acquired by Gifts and Transfers in Trust The donor’s built-in gain follows the interest to you. If the donor had $200,000 of basis and the interest was worth $500,000 at the gift, you take $200,000 and owe tax on $300,000 of gain when you sell at that value.
The Split-Basis Rule for Loss Property
If fair market value at the time of the gift is lower than the donor’s adjusted basis, you end up with two basis figures for the same interest. For measuring a future gain, use the donor’s higher basis. For measuring a future loss, use the lower fair market value at the time of the gift. Sell at a price between those two numbers and you recognize neither gain nor loss. The rule keeps donors from shifting unrealized losses to donees.
Add-On for Gift Tax Paid
If the donor paid gift tax on the transfer, you can increase your carryover basis by a portion of that tax. The increase equals the gift tax multiplied by the ratio of net appreciation (fair market value over the donor’s basis) to the total gift value, and the resulting basis cannot exceed fair market value at the time of the gift.9eCFR. 26 CFR 1.1015-5 – Increased Basis for Gift Tax Paid Donor basis of $100,000, interest worth $300,000, gift tax paid of $40,000: the increase is $40,000 times ($200,000 ÷ $300,000), roughly $26,667, for a total basis of about $126,667.
Interests Received for Services
Section 742 also picks up interests received in exchange for services, but the treatment splits based on what kind of interest you get. A capital interest would entitle you to a share of existing partnership assets on immediate liquidation. A profits interest entitles you only to a share of future profits and appreciation.
A capital interest received for services is taxable. You include the fair market value of the interest in gross income, and that amount is your starting basis.10Internal Revenue Service. Revenue Procedure 2001-43 If the interest vests over time, Section 83 governs the timing, and you can file a Section 83(b) election to accelerate income to the grant date.
A profits interest is treated more gently. Under Rev. Proc. 93-27, the IRS does not treat receipt of a profits interest as a taxable event, provided the interest is not tied to a substantially certain and predictable stream of income, you don’t dispose of it within two years, and it isn’t a limited partnership interest in a publicly traded partnership. Because nothing is included in income, the initial basis in a qualifying profits interest is essentially zero, before any share of liabilities gets added.
Adding Your Share of Partnership Liabilities
Once you’ve set the starting figure under Section 742, you adjust it for your share of the partnership’s liabilities. Section 752(a) treats an increase in your share of partnership debt as a deemed cash contribution that increases outside basis, and a decrease as a deemed cash distribution that reduces it.11Office of the Law Revision Counsel. 26 U.S.C. 752 – Treatment of Certain Liabilities
How much of the debt gets allocated to you depends on whether it’s recourse or nonrecourse. Recourse debt goes to the partner or partners who actually bear the economic risk of loss on default. Nonrecourse debt, where no partner is personally exposed, is allocated under a separate set of regulations that generally follow partnership profits.12eCFR. 26 CFR 1.752-3 – Partner’s Share of Nonrecourse Liabilities Buy an interest for $100,000 and pick up a $50,000 allocation of recourse debt, and your outside basis is $150,000. That extra $50,000 affects how much loss you can deduct, whether a distribution triggers gain, and your gain or loss on eventual sale.
Adjusting the Basis After Acquisition
Section 742 sets the number on day one. Section 705 keeps the number current for the life of the investment.13Office of the Law Revision Counsel. 26 U.S.C. 705 – Determination of Basis of Partner’s Interest Every year, outside basis increases by your distributive share of the partnership’s taxable income and tax-exempt income. It decreases (but not below zero) by distributions, your share of partnership losses, and nondeductible, noncapital expenditures such as penalties.
These adjustments compound. Start the year at $150,000, get allocated $30,000 of income, and take a $20,000 distribution, and you end at $160,000. Failing to track them tends to surface at the worst possible moment, usually when the partner sells or the partnership winds down.
Basis and Loss Deductions
Outside basis is the first ceiling on loss deductions. Under Section 704(d), you can deduct partnership losses only up to your adjusted basis at the end of the partnership’s tax year.14Office of the Law Revision Counsel. 26 U.S.C. 704 – Partner’s Distributive Share Excess losses carry forward until you have enough basis to absorb them. Losses that clear the basis hurdle still have to pass the at-risk rules under Section 465 and the passive activity rules under Section 469 before you can deduct them.15Internal Revenue Service. New Limits on Partners’ Shares of Partnership Losses Frequently Asked Questions Nonrecourse debt that lifts your outside basis often doesn’t lift your at-risk amount, which is where partners in real estate deals typically get tripped up.
When Outside Basis Doesn’t Match Inside Basis
Your outside basis under Section 742 can diverge sharply from your proportionate share of the partnership’s basis in its assets. Pay $500,000 for a 25% interest in a partnership whose total asset basis is $1,200,000, and your outside basis of $500,000 exceeds your $300,000 share of inside basis by $200,000. Without an adjustment, you could later be taxed on $200,000 of gain that was already built into your purchase price.
A Section 754 election lets the partnership adjust the basis of its assets, under Section 743(b), to close that gap for the incoming partner only.16Office of the Law Revision Counsel. 26 U.S. Code 754 – Manner of Electing Optional Adjustment to Basis of Partnership Property Once made, the election applies to all future transfers and distributions until revoked. The adjustment becomes mandatory, even without an election, when the partnership has a substantial built-in loss immediately after the transfer, meaning either total asset basis exceeds fair market value by more than $250,000, or the transferee would be allocated more than $250,000 of loss on a hypothetical sale of all assets.17Office of the Law Revision Counsel. 26 U.S. Code 743 – Special Rules Where Section 754 Election or Substantial Built-In Loss
Reporting After a Transfer
A partner who sells or exchanges an interest involving unrealized receivables or inventory (a Section 751(a) exchange) must notify the partnership in writing within 30 days of the exchange, or by January 15 of the following calendar year, whichever comes first.18Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) The notice must include names, addresses, taxpayer identification numbers, and the date of the exchange. Failure to notify can trigger penalties absent reasonable cause.
The partnership, once notified, files Form 8308 as an attachment to its Form 1065 for the tax year that includes the exchange and furnishes copies to both parties by January 31 of the following year.19Internal Revenue Service. Instructions for Form 8308 (Rev. November 2025) Form 8308 is not required for pure gifts or for transactions where a broker files Form 1099-B.
Partners who receive property distributions other than money or marketable securities treated as money must file Form 7217 for each distribution date during the tax year. The form, required beginning in 2024, helps the IRS track distributed property and verify that you adjusted outside basis correctly.