Partnership Tax Basis: Inside vs. Outside Basis, §704(b) & §754 Elections (2026)

Partnership taxation has two separate basis concepts that operate independently and frequently diverge: outside basis (a partner's basis in the partnership interest itself) and inside basis (the partnership's basis in its assets, allocated among partners through capital accounts). A partner's outside basis determines gain or loss on sale of the interest and the deductibility of losses. The inside basis in partnership assets determines depreciation deductions and gain on asset sales. When a partnership interest is sold or a partner dies, these two bases can be wildly different - and without a §754 election, the buyer inherits the seller's inside basis position rather than stepping up to what they paid.

The Core Distinction

Outside basis: Each partner's individual tax basis in their partnership interest. Starts at contribution, adjusted annually for: +allocated income, +additional contributions, -distributions, -allocated losses. Determines: whether you can deduct your share of partnership losses (cannot deduct below zero outside basis); gain or loss on sale of the interest; taxability of distributions.

Inside basis: The partnership's own tax basis in each of its assets. Allocated among partners through the capital account system. Determines: depreciation deductions flowing to partners; gain or loss when the partnership sells assets; basis of assets distributed to partners.

Outside Basis: The Partner's Running Total

Under IRC §705, a partner's outside basis begins with the amount contributed (cash plus adjusted basis of property) and is adjusted each year. Increases: partner's distributive share of partnership income (including tax-exempt income), and any additional contributions. Decreases: partner's distributive share of losses and deductions, distributions received, and the partner's share of partnership liabilities decreased. A partner cannot deduct losses that would reduce outside basis below zero - those losses are suspended and carried forward until basis is restored.

Partnership liabilities are included in outside basis - a critical difference from S-corps. A partner's share of recourse and non-recourse partnership debt increases outside basis under IRC §752. This means a limited partner can have basis - and therefore can absorb loss allocations - exceeding their actual cash investment by their share of partnership debt. S-corp shareholders do not get basis from entity-level debt (only from direct loans to the S-corp), which is one reason high-leverage real estate is often held in partnerships rather than S-corps.

The §754 Election: Closing the Gap

When a partnership interest is sold or transferred, the buyer takes a fair-market-value outside basis but inherits the seller's share of inside basis in partnership assets. If the assets have appreciated, the buyer is paying for value they will not get to depreciate or deduct. The §754 election allows the partnership to adjust the inside basis of its assets to match what the new partner paid - a §743(b) adjustment. This step-up flows only to the transferee partner and increases their share of depreciation and reduces their share of gain when assets are sold.

§734(b): The Distribution Basis Adjustment

A separate §754-related adjustment applies when the partnership makes a distribution of appreciated or depreciated property. IRC §734(b) allows (and under certain circumstances requires) the partnership to adjust the inside basis of remaining assets to reflect the distribution. Without this adjustment, basis can be lost or duplicated when property is distributed in liquidation of a partner's interest.

Authority: IRC §705 (determination of basis of partner's interest - starts with contribution, adjusted for distributive share of income/loss, contributions, distributions, and liability changes); IRC §722 (basis of contributing partner's interest - cash contributed plus adjusted basis of property contributed); IRC §752 (treatment of certain liabilities - partner's share of partnership debt increases outside basis; decrease in share decreases basis and may trigger gain); IRC §704(b) (partner's distributive share - capital account maintenance; substantial economic effect requirement); IRC §704(c) (allocation of built-in gain or loss on contributed property - precontribution gain must be allocated back to contributing partner); IRC §754 (election to adjust basis of partnership property - one-time election applies to all future transfers and distributions; must be made on timely filed return); IRC §743(b) (special basis adjustment on transfer of partnership interest - steps up inside basis for transferee partner only; triggered by §754 election); IRC §734(b) (adjustment to basis of undistributed partnership property - triggered by §754 election on distributions; prevents basis duplication or loss); Treas. Reg. §1.704-1(b)(2) (capital account maintenance rules; book vs. tax basis distinction); Treas. Reg. §1.743-1 (optional basis adjustments on transfer; computation methodology).