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What Is a 754 Election?

Section 754 of the Internal Revenue Code (IRC) deals with complex issues that often arise in connection with assets owned by a partnership. Under Section 754, a partnership may adjust the basis of partnership property when the property is distributed or when a partnership interest is transferred. Section 754 also allows new partners to reconcile the outside basis of their partnership interest with the inside basis of property allocated to them, as well as enjoy the benefits of depreciation and amortization that might not happen if the election was not made.

Inside Cost Basis vs. Outside Cost Basis

To determine each partner’s share of profits or losses and tax liability, each member of the partnership must calculate their adjusted cost basis, which is calculated using the inside cost basis and outside cost basis. These are defined as follows:

Inside Cost Basis

This is the basis of an asset owned by a partnership, or the price paid for an asset at the time of acquisition. For example, if five partners each contributed $100,000 to purchase a property for $500,000, each partner’s inside basis in that property would be $100,000.

Outside Cost Basis

This refers to the basis of each partner in their partnership interest. New members of the partnership will have a different outside cost basis depending on the basis of assets each new partner contributes to the partnership.

When a partnership is formed, the inside cost basis and outside cost basis for an asset are usually the same. For example, in forming a partnership, if five partners each contribute $100,000 to purchase a property for $500,000, the inside cost basis of each partner would be $100,000, and each partner’s outside cost basis would be $100,000.

Applying a 754 Election

When a 754 election is made, the partnership steps up the inside cost basis — but only for the new partner. This balances the inside cost basis and outside cost basis and reduces capital gains tax when a property that has appreciated is sold.

Consider the following scenario. Five partners contributed $100,000 each to purchase a property for $500,000. The property now has a market value of $1,000,000. Each partner’s inside cost basis is still $100,000, and their outside cost basis is still $100,000 each. Now, one of the partners sells their ownership interest for $200,000 and is taxed on the $100,000 gain.

Without making a 754 election, the asset’s inside cost basis would be transferred to the new partner with no adjustment. The new partner would have an inside cost basis of $100,000 and outside cost basis of $200,000. If the partnership decided to sell the property for $1,000,000, each partner would have a taxable gain of $100,000 — including the new partner.

By making a 754 election at the time of ownership transfer, the new partner’s inside basis would be increased to $200,000. With an inside basis of $200,000, if the partnership decided to sell the property, the new partner wouldn’t experience a taxable event.

Stay Current on Today’s Tax Laws with CCH® CPELink

Every partnership is different, and choosing to make a 754 election is not always the right decision. When considering tax strategies for clients, it is important to remain up to date and utilize the best resources. At CCH CPELink, we are focused on helping CPAs and financial professionals stay current on changes in their industries. Among our self-study offerings, we offer courses that cover Section 754 in-depth, including Planning for the Death of the Majority Shareholder.