Section 754 election: Overview, definition, and example
What is a Section 754 election?
A Section 754 election is a tax election made by a partnership under the U.S. Internal Revenue Code that allows the partnership to adjust the basis of its property when certain events occur, such as when a partner buys or sells a partnership interest or when there is a transfer of partnership property. This election helps to equalize the tax basis of a partner’s share of the partnership's assets, reflecting the fair market value of the assets at the time of the transaction.
For example, if a partner sells their interest in a partnership, the Section 754 election allows the partnership to adjust the value of the underlying property to reflect the selling partner’s share of the sale proceeds, which can help prevent tax distortions.
Why is a Section 754 election important?
A Section 754 election is important because it allows partnerships to adjust the tax basis of their assets in a way that reflects the actual economic transaction between partners. This can help avoid unfavorable tax consequences for both the partnership and its partners, particularly in cases where there are changes in ownership or the value of the partnership’s assets has significantly shifted.
For partners, making a Section 754 election can reduce potential tax liabilities related to the transfer of partnership interests, ensuring that the capital gains taxes are aligned with the real economic value of the assets involved. It can also facilitate better planning for future asset sales, providing more favorable tax treatment.
Understanding Section 754 election through an example
Suppose a partner, Alice, sells her 50% interest in a real estate partnership to Bob. Under the Section 754 election, the partnership would adjust the tax basis of the property it owns to reflect the fair market value at the time of the sale. This helps ensure that Bob’s tax basis in the property reflects the price he paid for Alice's interest, rather than the historical cost basis of the property. As a result, Bob can potentially claim depreciation deductions that are aligned with the actual value of the assets.
In another example, if the partnership had purchased a building for $1 million, and over time, the building appreciated to $1.5 million, a Section 754 election would allow the new partner’s tax basis to reflect the $1.5 million value, ensuring the transfer aligns with the current economic realities.
Example of a Section 754 election clause
Here’s how a Section 754 election clause might appear in a partnership agreement:
“The Partnership hereby elects to apply the provisions of Section 754 of the Internal Revenue Code, and agrees to adjust the basis of its property in accordance with the rules provided in such section upon the transfer of a partnership interest or the distribution of property.”
Conclusion
A Section 754 election is a valuable tax tool for partnerships, allowing them to adjust the basis of their assets when ownership changes. This election helps ensure that the tax treatment of transactions reflects the actual economic value of the partnership’s assets and can provide tax advantages for both the partnership and its partners. By making this election, partners can avoid unwanted tax consequences and improve the overall tax efficiency of their partnership transactions.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.