How does a §754 election step up basis when a partner dies? (worked example)

The rule When a partner dies, the partnership's basis in its property is not adjusted unless a §754 election is in effect or the partnership has a substantial built-in loss immediately after the transfer (26 U.S.C. § 743(a)). With the election, the partnership increases the basis of its property by the excess of the heir's basis in the interest over the heir's share of the partnership's basis in its property, or decreases it by the reverse excess. The adjustment is to partnership property "with respect to the transferee partner only" (§ 743(b)).

Step 1: the heir's basis in the interest (outside basis) Generally, the fair market value of the interest at the date of death (or the alternate valuation date), plus the heir's share of partnership liabilities on that date, less the part of the value that is income in respect of a decedent (Treas. Reg. § 1.742-1(a)).

Step 2: the heir's share of the partnership's basis (inside basis) The heir's share of previously taxed capital plus its share of partnership liabilities. Previously taxed capital is the cash the heir would get if the partnership sold everything for its fair market value and liquidated, increased by the tax loss and decreased by the tax gain that sale would allocate to the heir (Treas. Reg. § 1.743-1(d)(1)).

Step 3: the adjustment Step 1 less Step 2. A positive figure is a step-up, a negative one a step-down (§ 743(b)).

Step 4: spreading it among the assets The adjustment is split between ordinary income property and capital gain property. The ordinary income class gets the income, gain or loss the heir would be allocated from a sale of that class at fair market value; the capital gain class gets the rest. Within each class, each item gets the heir's share of its gain or loss in that sale (Treas. Reg. § 1.755-1(b)(2)-(3)). No part of the adjustment goes to assets that are income in respect of a decedent, such as a cash-method partnership's unrealized receivables (Treas. Reg. § 1.755-1(b)(4)).

Worked example (illustrative figures) A, B and C are equal partners. The partnership has no liabilities, no contributed property, no income in respect of a decedent, and a §754 election in effect. A dies, and A's one-third interest passes to A's daughter, D. The interest is worth $30,000 at A's death.

	Partnership's basis	Fair market value	D's one-third of the gain
Land (capital gain property)	$18,000	$60,000	$14,000
Inventory (ordinary income property)	$12,000	$30,000	$6,000
Total	$30,000	$90,000	$20,000

• Step 1, D's outside basis: $30,000 (value at death; no liabilities or income in respect of a decedent).
• Step 2, D's share of inside basis: $30,000 of cash on a hypothetical liquidation, less the $20,000 of gain D would be allocated = $10,000.
• Step 3, the step-up: $30,000 − $10,000 = $20,000.
• Step 4, allocation: inventory (ordinary income property) gets $6,000, D's ordinary income from the hypothetical sale; land (capital gain property) gets the rest, $20,000 − $6,000 = $14,000.

If the partnership later sells the land for $60,000, its $42,000 gain is allocated $14,000 to each partner, and D's $14,000 adjustment offsets her share: D reports $0, while B and C report $14,000 each. The same happens with the inventory's $6,000 of ordinary income.

Without the election, D would be taxed on the $14,000 and $6,000 even though her basis in the interest already reflects their value. Her basis in the interest would rise by the income she reports (§ 705(a)(1)), so she would recover it only as a loss when she sells or liquidates the interest.

When the adjustment is mandatory Even without an election, the partnership must adjust (downward) if it has a substantial built-in loss immediately after the transfer: its basis in its property exceeds the property's fair market value by more than $250,000, or the heir would be allocated a loss of more than $250,000 if the partnership sold everything at fair market value (§ 743(d)(1)).

Making the election Attach a written statement to the partnership's return for the year of the death. The statement gives the partnership's name and address and declares that the partnership elects under §754 to apply §734(b) and §743(b). The return must be filed by its due date, including extensions (Treas. Reg. § 1.754-1(b)(1)). The election covers distributions (§734(b)) as well as transfers, and applies to that year and all later years (§ 754; Treas. Reg. § 1.754-1(a)). If a valid election is already in effect, no new one is needed. Our §754 election statement template has the wording.

If the election was missed A §754 election gets an automatic 12-month extension from the return's due date (extended due date if an extension was obtained), with no letter ruling and no user fee. The partnership files an original or amended return for the year of the death with the election statement, marked "FILED PURSUANT TO § 301.9100-2" at the top (Treas. Reg. § 301.9100-2(a)(2)(vi), (c), (d)). After 12 months, relief needs a ruling request showing the partnership acted reasonably and in good faith (Treas. Reg. § 301.9100-3(a)).

Notices and statements

• The heir must notify the partnership in writing within one year of the death, signed under penalties of perjury, giving among other things the names and taxpayer identification numbers of the deceased partner and the heir, the date of death and the interest's fair market value (Treas. Reg. § 1.743-1(k)(2)(ii)).
• The partnership attaches a statement to its return for the year of the transfer with the heir's name and taxpayer identification number, the computation of the adjustment and the properties it was allocated to (Treas. Reg. § 1.743-1(k)(1)(i)).