ARTICLE | August 14, 2025
I. Introduction and Background
Section 754 elections can have far-reaching consequences for real estate partnerships, yet they often remain poorly understood by both general partners and limited partners. These elections come into play during key moments in a partnership’s lifecycle—when buying out a partner, inheriting a partnership interest, or transferring ownership interests. In each of these situations, Section 754 can align the purchasing or inheriting partner’s outside basis in the partnership with the partnership’s inside basis in its underlying assets. While that may sound technical, the outcome can be highly advantageous for reducing future taxes and maximizing depreciation and amortization deductions.
Through the lens of the Internal Revenue Code (IRC), Section 754 interacts closely with Sections 734(b) and 743(b), both of which govern the specific basis adjustments that come into play when partnership interests shift hands or property is distributed. With proper planning and a deep understanding of these rules, real estate partnerships can strategically use a basis “step-up” to benefit partners. However, practical issues also arise, including the irrevocable nature of the election, the complexity of tracking ongoing adjustments, and significant new regulations aimed at curbing abuses in basis shifting transactions. These factors should not be underestimated, particularly for larger real estate investment funds or tiered partnership structures incorporating multiple lower-tier partnerships.
Context and Relevance
Real estate partnerships regularly face situations where ownership changes. It might be a hedge fund acquiring a partner’s stake, or an inheritance event in which an estate hopes to leverage a step-up in basis to reduce taxes. Whatever the scenario, having a clear grasp of how Section 754 can either help or complicate matters is crucial for a partnership’s tax efficiency. By bridging the gap between a partner’s newly adjusted outside basis and the partnership’s inside basis, Section 754 offers a path to more equitable treatment of depreciation, amortization, and ultimately, any tax on capital gains. For both the general partner (who oversees decisions on the tax elections) and limited partners (who often stand to benefit from increased basis), it’s essential to understand how these elections may shape the partnership’s long-term strategy.
Overview of Section 754 within the IRC
Section 754, in conjunction with Sections 734(b) and 743(b), provides a mechanism for adjusting the tax basis of partnership property when there is a distribution or a transfer of a partnership interest. Under Section 734(b), if the partnership redeems an interest or distributes property in a taxable transaction, the partnership itself can adjust the basis of its remaining assets. Under Section 743(b), a transfer of partnership interests—by sale, exchange, or inheritance—can trigger a special basis adjustment that benefits only the incoming partner or the heir. Both these sections take their cues from whether there is a valid Section 754 election in place. If the partnership chooses to make this type of election, it must do so on a timely filed return for the year the event triggering the adjustment occurs, and then apply it going forward.
II. Key Concepts Underlying Section 754 Elections
Inside vs. Outside Basis
In any partnership, each partner has an “outside basis,” representing what that individual partner has invested in or paid for their partnership interest. Meanwhile, the partnership itself has an “inside basis” for the assets it owns, which reflects the tax basis of property on the partnership’s books. When you see these figures diverge—possibly because the fair market value of a property soared or a partner’s interest was increased through improvements—problems can arise at tax time, especially for a new or successor partner. The Section 754 election is a tool that helps reconcile the two values by stepping up (or stepping down) the inside basis of the partnership’s assets to match the outside basis of the new partner for tax purposes.
Adjustments Triggered by Section 754
Two main types of adjustments come under the umbrella of Section 754.
Section 734(b) Adjustments: In cases where a partnership redeems a partner or distributes property in a taxable transaction, the resulting basis changes get applied to the remaining assets in the partnership. These adjustments effectively reallocate the bases among existing partners.
Section 743(b) Adjustments: When a partnership interest changes hands—by a sale, an exchange, or the death of a partner—the new partner can benefit from an increased (or decreased) basis in the partnership assets they inherit. Unlike Section 734(b) adjustments, Section 743(b) basis changes typically affect only the new or incoming partner’s share of the partnership.
The Role of “Step-Up” in Basis
A step-up in basis can be a powerful tax strategy in real estate. Imagine a scenario where a partnership owns apartment buildings and one partner is buying out another partner’s interest for an amount far exceeding that partner’s original investment. A Section 754 election can bump up the inside basis of the real estate to reflect that higher purchase price. The result: the acquiring partner may enjoy larger depreciation or amortization deductions and potentially reduce the taxable gain when the property is eventually sold. This effect is particularly noticeable if the partnership also leverages cost segregation studies to identify short-life property components, which can accelerate depreciation for the new partner.
III. Strategic Impact for Real Estate Partnerships
Estate & Inheritance Considerations
A common trigger for basis adjustments is the death of a partner. From the estate’s perspective, inheriting a partnership interest in real estate can provide substantial tax benefits if there is a Section 754 election in place or if one is made in the year of the partner’s death. When the partner’s interest is stepped up to reflect fair market value, the beneficiary inherits the new, higher basis in that interest. If the partnership makes a Section 743(b) adjustment, the heir also enjoys a matching step-up in the underlying partnership assets, which can yield higher depreciation deductions going forward. In practice, ensuring that the property is appraised accurately at the time of the partner’s death is crucial, as this information underpins the proper calculation of basis adjustments on the partnership return.
Private Equity & Fund Structures
While the concept of basis step-ups can seem straightforward, it becomes more complicated—and sometimes burdensome—when dealing with large, multifaceted real estate funds. These funds often have multiple investors entering or exiting, often at different times. A Section 754 election, once made, cannot be reversed except under highly limited circumstances with the IRS’s permission. This irrevocability can create ongoing administrative tasks, especially if the fund invests in multiple lower-tier partnerships where each tier might need to coordinate or replicate the election. Fund managers must therefore balance the prospective tax savings for partners against the additional cost, labor, and complexity of applying the election each time interests are transferred.
Implications for Cost Segregation and Depreciation Planning
Cost segregation studies can play a central role in maximizing the benefit of a stepped-up basis within a real estate partnership. By breaking a building’s components into categories with different recovery periods—such as personal property, land improvements, or fixtures—partnerships can accelerate depreciation for the newly stepped-up portion. For instance, certain fixtures might be eligible for bonus depreciation, creating a significant immediate deduction that wouldn’t be possible without the Section 754 step-up. This can be particularly appealing in the first year that a new partner acquires their interest—or inherits it—since that initial bump can translate into notable tax savings.
IV. Compliance and Regulatory Concerns
Irrevocability and Ongoing Obligations
Deciding to make a Section 754 election isn’t a one-time formality. Once the partnership elects to step up or step down its asset basis in a given tax year, that election usually sticks for all subsequent years. Because this choice is typically irrevocable, the partnership must be ready to calculate and track basis adjustments each time a partner departs or enters—an administrative challenge that grows with the size and complexity of the partnership. This administrative work involves updating depreciation schedules, maintaining records of each partner’s share of the adjustments, and ensuring all relevant forms and statements are attached to the annual tax return.
New Basis Shifting Regulations
The government has been paying closer attention to partnerships that appear to abuse basis adjustments, especially in transactions among related parties where there is minimal real economic substance. Recent final regulations, set to take full effect in 2025, classify certain partnership-related basis adjustments as “transactions of interest.” Once a transaction is tagged, it carries special disclosure requirements and heightened potential penalties if disclosures are not made properly. The threshold for these basis increases has been raised from $5 million to $25 million, and the lookback period for examining previous transactions is now six years. Partnerships and material advisors must be aware of these rules; failing to comply can have costly ramifications, including penalties for non-disclosure.
Complexity in Tiered Partnerships
In tiered partnerships, a Section 754 election at the top level will not automatically carry over to lower-tier partnerships. Each lower-tier partnership that holds the underlying real estate or related assets would also need to make its own election to achieve the same basis step-up effect. This coordination challenge can be substantial for funds that may own interests in numerous partnerships jointly. It underscores the importance of meticulous planning and communication among all stakeholders, including general partners, outside accountants, and tax lawyers managing each moving part.
V. Practical Steps for Implementation
Review Organizational Agreements
A critical first step is ensuring the partnership’s (or the fund’s) operating agreement, limited partnership agreement, or other governing documents address Section 754 elections. Partnerships often include provisions granting the managing partner or general partner the authority to make these elections on behalf of the partnership. It’s wise to clarify in advance whether the partnership intends to make a Section 754 election if major acquisitions, buyouts, or inheritance events arise. Having a roadmap in place can forestall conflicts later, particularly when timing is tight to file necessary forms with the IRS.
Conduct Cost-Benefit Analysis
Before the partnership opts to make (or decline) a Section 754 election, it should evaluate the potential tax benefits for the partner or partners involved. This evaluation estimates possible short- and long-term advantages, such as increased depreciation benefits or reduced recognition of capital gains upon sale. However, potential benefits must be weighed against higher compliance costs—both in terms of accounting fees and the partnership’s administrative load. For smaller interest transfers or when the fund is near the end of its lifecycle, the resulting benefits may be outweighed by the costs of record-keeping and reporting.
Coordinate Among CPAs, Legal Advisors, and Valuation Experts
Successfully implementing a Section 754 election often demands input and coordination among several professionals. CPAs can help run the numbers and gauge potential tax savings and administrative costs. Attorneys ensure the election complies with partnership agreements and IRS requirements. Meanwhile, valuation professionals play a pivotal role in accurately determining the fair market value of properties, especially when a partner’s death triggers a basis adjustment. By bringing these parties together early in the process, a partnership can avoid costly missteps and ensure that it remains compliant with all requirements.
VI. Conclusion
Summary of Strategic Advantages
Section 754 provides real estate partnerships a unique way to harmonize inside and outside basis, often delivering significant tax benefits. When used wisely—which frequently means conducting cost segregation analyses and making effective use of step-ups in basis—partners can enjoy accelerated depreciation, meaningful tax deductions, and reduced capital gains. This election can be especially appealing in scenarios involving inherited properties or where a partner is purchasing someone else’s interest for substantially more than that person originally advanced.
Forward-Looking Considerations
While Section 754 can confer powerful advantages, partnerships must proceed cautiously. The irrevocable nature of the election, evolving IRS guidance on basis shifting transactions, and increased reporting requirements all demand vigilant oversight. With the right planning and professional guidance, Section 754 can remain a cornerstone of a well-designed tax strategy for real estate partnerships. Still, each partnership’s circumstances are unique, and ongoing monitoring of regulatory changes is vital. Whether you’re managing a single-asset partnership or a complex multi-tiered real estate fund, it’s wise to consult with qualified advisors to tailor a solution that maximizes benefits while keeping you compliant.