Section 754 Election When a Fund Investor Sells or Redeems

Should the fund make a section 754 election after an investor sale?

The election gives a buyer a section 743(b) step-up when its outside basis exceeds its share of fund asset basis, and a step-down when it is lower. It also commits the fund to adjustments on later qualifying transfers and distributions. Section 743; section 754.

Outside basis is the investor’s tax basis in the partnership interest. Inside basis is the fund’s tax basis in its assets. The buyer’s share of inside basis is its share of liabilities plus “previously taxed capital.” Start with cash it would receive if the fund sold all assets at market value and liquidated. Add allocated tax losses and subtract allocated tax gains for the acquired interest. This is a tax calculation, not the administrator’s capital balance. Allocate the adjustment to specific assets under section 755. Regulation 1.743-1(b)–(d).

Evaluate asset values, tax basis, expected sales and tracking costs. A securities step-up generally reduces gain on sale. A step-up in depreciable property generally earns deductions only for the buyer, as if newly bought on the transfer date, subject to special contributed-property rules. Qualified property may also receive bonus depreciation. Regulation 1.743-1(j).

How does the fund make the section 754 election?

The fund attaches a written election statement to its timely Form 1065 for the tax year of the transfer or distribution, including extensions. A partner or LLC member signs the return. The statement gives the partnership’s name and address and declares that the partnership elects under section 754 to apply both sections 734(b) and 743(b). Regulation 1.754-1(b).

A fund cannot elect only for a favorable buyer or only for transfers. The election covers all qualifying transfers and distributions in the election year and later years until revoked. An existing valid election does not need annual renewal. Regulation 1.754-1(a)–(b).

Must the fund adjust basis without a section 754 election?

A partnership fund generally must make a section 743(b) adjustment after a sale or exchange if either substantial built-in loss test is met immediately after the transfer. Testing only the fund’s net portfolio loss can miss a buyer-specific loss. Section 743(a), (d).

Both thresholds use “more than.” Test asset-level values and allocations at the transfer date. The adjustment remains buyer-specific. Qualifying securitization partnerships have a separate exception to the mandatory rule under section 743(f). Section 743(b), (d), (f).

Does the electing investment partnership exception apply?

An open-ended fund without a limited term cannot use this exception. A qualifying electing investment partnership, or EIP, uses buyer loss deferral instead of mandatory section 743 loss adjustments. Every statutory condition must be met. Section 743(e).

The fund must:

• Make the separate section 743(e) election.
• Be an investment company under section 3(a)(1)(A) of the Investment Company Act but for an exemption under section 3(c)(1) or 3(c)(7).
• Have never engaged in a trade or business and hold substantially all assets for investment.
• Receive at least 95% of contributed assets as money, with no contributed assets having tax basis above fair market value at contribution.
• Issue all partnership interests in private offerings before the date 24 months after the first capital contribution.
• Have substantive restrictions on each partner’s ability to cause a redemption.
• Have an agreement providing for a term no longer than 15 years.

Review redemption rights against the substantive-restriction requirement and check transition treatment for older funds. Section 743(e)(5) and statutory notes.

To elect, attach a statement to an original or amended partnership return with the fund’s name, address and tax identification number, a representation of eligibility, and a declaration electing EIP treatment. File no later than 6 months after the return’s unextended due date. A fund with a section 754 election in effect cannot elect EIP treatment. Notice 2005-32, section 4.

The EIP election continues in later years. It terminates if the fund ceases to qualify or elects section 754; other revocations require IRS consent. Loss limits for interests transferred while the EIP election was in effect survive termination. Notice 2005-32, section 4.

EIPs must separately state gross gains and losses and attach the annual EIP notice to partner statements. The seller supplies loss history to the buyer and fund within 30 days after receiving the transfer-year K-1. The buyer may have to defer losses tied to current or prior sellers’ losses; missing information can require disallowing all allocated losses. EIP status does not excuse mandatory section 734 distribution adjustments. Notice 2005-32, sections 2 and 5.

What must the buyer tell the fund, and who tracks section 743(b)?

The buyer must give the fund written notice within 30 days of a sale or exchange when section 754 is in effect. Notice 2005-32 extends the notice rules to mandatory section 743 adjustments without an election. The fund computes and reports the adjustment. Regulation 1.743-1(k); Notice 2005-32, section 3.

The notice must be signed under penalties of perjury and include:

• Buyer and seller names, addresses and tax identification numbers, with seller information if ascertainable.
• Any relationship between buyer and seller, and the transfer date.
• Liabilities assumed or taken subject to.
• Money paid, fair market value of other consideration delivered or to be delivered, and other information needed to compute the buyer’s basis.

The transfer-year Form 1065 statement identifies the buyer and tax identification number, shows the adjustment calculation, and identifies the assets receiving the adjustment. It is distinct from annual K-1 reporting. Regulation 1.743-1(k)(1).

Maintain a schedule for each buyer, asset allocation, recovery amount and remaining adjustment. Annual K-1 disclosures show the adjustment’s income effects and remaining basis. Section 743(b) does not enter item L tax-basis capital. Assign tracking responsibility before filing. Form 1065 instructions: section 743(b), item L and box 20 code U.

On a later sale of the interest, compute the new buyer’s adjustment without including the seller’s section 743(b) adjustment in common asset basis. The seller’s remaining adjustment does not carry over on a sale; retain separate schedules. Regulation 1.743-1(f), (j)(1).

If the fund knows of a sale but lacks buyer notice, attach a statement with the buyer’s name and tax identification number, if ascertainable. Print RETURN FILED PURSUANT TO § 1.743-1(k)(5) prominently on the first page of the return and buyer’s K-1. Adjust reporting when notice arrives and provide information to correct prior buyer returns. Regulation 1.743-1(k).

How does the fund split income and report the 743(b) adjustment on K-1s?

For items governed by regulation 1.706-4, interim closing is the default when investor interests change. Proration is available by agreement of the partners; the allocation convention is a separate choice from the method. Separate rules govern certain cash-basis and lower-tier partnership items. Contributed-property and revaluation allocations also follow separate rules; see Fund tax capital and allocations. Regulation 1.706-4(a)(2)–(3), (c), (f).

By agreement, the fund can also close its books at each month-end, or each mid-month and month-end, whether or not interests change. Use the same convention for all interim-closing changes during the year. A convention cannot move a change outside the partnership’s tax year. Keep the dated written selection with the books by the extended return due date. Special rules cover investors entering and exiting in the same convention period. Regulation 1.706-4(c), (d), (f).

Extraordinary items generally follow ownership when the item occurred. A portfolio sale outside the ordinary course can qualify, subject to a small-item exception. Do not automatically prorate a major exit gain. Regulation 1.706-4(e).

A sale of the investor’s entire interest closes the partnership tax year for that investor; a partial sale does not. A redemption closes it when the interest is completely liquidated. Regulation 1.706-1(c).

For a fund other than a publicly traded partnership, the latest published Form 1065 instructions direct these disclosures:

The income codes describe the effect on taxable income. A basis step-up can reduce taxable gain. Form 1065 instructions: section 743(b) and codes F, V and U.

For a taxable interest sale, check the seller’s item J “Sale” box. When item L is required, transfer the tax capital attributable to the sold interest immediately before the transfer through “Other increase (decrease),” with explanatory statements: remove it from the seller and add it to the buyer. The purchase price is not a contribution to the fund; section 743(b) stays separate. Form 1065 instructions: items J and L.

A sale involving section 751 property can also require Form 8308 and seller disclosures. The seller’s own gain and a small-business buyout belong in Buying out a partner.

What does a 754 election change when the fund redeems an investor?

A redemption paid by the fund is generally a distribution, so evaluate section 731 gain or loss and section 734(b) adjustments to remaining assets. If a new investor’s contribution funds a related redemption, section 707(a)(2)(B) can instead treat the steps as a sale between investors; then evaluate section 743(b). Classification depends on the facts. Section 707(a)(2). Sections 731 and 734.

Cash above outside basis generally produces gain; debt relief and marketable securities can count as money. Liquidation losses have strict property limits. Securities distributed by a section 731(c)(3) investment partnership to an eligible partner escape the money rule. The fund must always have held substantially only qualifying investment assets, such as cash, securities and qualifying derivatives, and never conducted a business for this test; trading those assets does not count. The partner generally must have contributed only qualifying assets; an ineligible predecessor in a nonrecognition transfer can disqualify it. Section 731(c)(3). Publication 541: distributions and retiring partners.

With section 754 in effect, section 734(b) adjusts the fund’s remaining assets: up for recognized distribution gain, down for recognized liquidation loss. In-kind property basis shifts can also change the adjustment. Unlike buyer-specific section 743(b), this changes common asset basis for remaining partners. The property-basis increase under section 734(b)(1)(B) does not apply to a distributed interest in another partnership without its own section 754 election; the recognized-gain increase under section 734(b)(1)(A) remains available. Without the election, unless the section 734(e) securitization-partnership exception applies, a reduction is mandatory when recognized liquidation loss plus the relevant excess basis of distributed property exceeds $250,000. This is a basis-reduction test, not a test of the redemption payment. Section 734(b), (d), (e).

A disproportionate redemption involving section 751 property, including accrued market discount on bonds, can create ordinary income under section 751(b). Report the fund’s resulting item in K-1 box 11, code L. Section 751(b), (c); Form 1065 instructions.

A buyer who purchased without section 754 and receives noncash property within 2 years may elect section 732(d) to use the asset basis a section 743(b) adjustment would have produced. The buyer attaches an election and calculation schedule to its signed tax return: for the distribution year if any property is depreciable, depletable or amortizable; otherwise no later than the first year its basis affects tax. Treatment is mandatory even outside that window if, at purchase, noncash asset value exceeded 110% of basis, hypothetical liquidation would shift basis from assets without cost-recovery deductions to assets eligible for depreciation, depletion or amortization, and the adjustment would change the distributed property’s basis. The fund supplies the basis information. Regulation 1.732-1(d).

The latest published instructions put redemption distributions in K-1 box 19: code A for cash and marketable securities to non-service partners, code D for deemed money distributions from liability reductions, and applicable property or service-partner codes for other payouts. When item L is required, record withdrawals and distributions there; affected partners’ shares of section 734(b) basis changes enter “Other increase (decrease).” Form 1065 instructions: box 19 and item L.

Attach the section 734(b) statement showing the calculation, class of distributed property and remaining assets receiving the adjustment. For a full redemption’s gain or “fill-up” allocation, see Fund tax capital and allocations. Form 1065 instructions: section 734(b).

What does the fund report when a foreign investor sells or redeems?

A fund directly or indirectly conducting a US trade or business generally supplies Schedule K-3 Part XIII when a foreign investor’s transfer is subject to section 864(c)(8). A distribution recognizing gain or loss can count as a transfer. The reporting helps determine how much transfer gain or loss is connected with the US business. K-2 and K-3 instructions, Part XIII.

For a covered interest sale, foreign sellers and domestic partnership sellers with direct foreign partners or known indirect foreign ownership generally must notify the fund in writing within 30 days after the transfer. Include both parties’ names and addresses, the transferor’s US tax identification number, the buyer’s number if known, and the transfer date. This notice is not required for a transfer arising from a fund distribution or a publicly traded PTP interest. The fund completes Part XIII when notified or otherwise aware of a covered transfer; its own distribution counts as actual knowledge. Furnish the information to the notifying transferor by the K-1 due date, including extensions. Publication 541: foreign partner’s transfer; K-3 Part XIII instructions.

Also report the number of foreign partners subject to section 864(c)(8) from transfers or distributions on Form 1065 Schedule B, question 26 in the latest published form. Form 1065 instructions. Report the transfer date and interest transferred, section 751 information, and deemed-sale effectively connected ordinary and capital gain or loss. Prepare separate schedules for separate transfers or classes as required. Tiered funds need deemed-sale information from underlying partnerships; a foreign seller alone does not establish that section 864(c)(8) applies. US real property can require separate section 897(g) reporting. K-3 Part XIII instructions.

If the fund must withhold on a redemption or later distributions after buyer default and fails, the IRS can collect tax and interest from it. Responsible general partners or other persons who willfully fail to collect or pay it can owe a section 6672 penalty equal to unpaid withholding. Collection generally remains possible for 10 years after assessment, with suspensions, extensions and timely court proceedings affecting the limit. See Foreign partners and withholding. Form 8288 instructions; section 6672; section 6502.

What if the fund missed the election or wants to revoke it?

A missed section 754 election can qualify for automatic relief of 12 months if the fund takes corrective action within the relief period. Revocation requires IRS approval; stopping the schedules does not revoke the election. Regulation 301.9100-2; regulation 1.754-1(c).

The automatic period runs from the election due date, including a filing extension actually obtained. It is available even if the original return was late. Separately, a late Form 1065 due in 2027 costs the fund $260 per person who was a partner at any time in the year, per month or part-month, up to 12 months, unless reasonable cause applies. Section 6698; Revenue Procedure 2025-32, section 4.55. Corrective action includes the election statement and required return filing, with FILED PURSUANT TO § 301.9100-2 at the top. All affected taxpayers must report consistently. Determine the permitted correction procedure, including partnership audit-regime restrictions, through Correcting a filed business return. Regulation 301.9100-2(a), (c)–(d).

IRS section 754 FAQs explain nonautomatic relief. For revocation, increased administrative burden can support a request. Avoiding asset basis step-downs cannot be its primary purpose. Form 15254 and instructions; regulation 1.754-1(c).

What changes in a GP-led secondary or continuation fund?

A GP-led secondary has no single tax treatment: identify whether investors sell fund interests, the old fund sells assets, or assets are contributed to a new partnership. Each structure puts basis and reporting duties in different places.

The transaction steps determine which rules apply. Section 1001; Section 743; section 1012; section 721; Publication 541: contributed property.

In a partnership division, a resulting vehicle continues the old fund if its members held more than 50% of the old fund’s capital and profits. It keeps the old elections, including section 754; other resulting vehicles are new partnerships. Regulation 1.708-1(d). Review each transfer, contribution and distribution. A “rollover” may be taxable under section 721’s investment-company exception. Bring transaction steps and asset values for hedge fund tax and accounting.

Does each tier of a fund need its own election?

Each partnership has its own section 754 election status. An upper fund’s election does not automatically give every underlying partnership an election.

Where both tiers have elections, an upper-tier interest sale can create deemed-transfer adjustments at the lower tier. A section 734(b) adjustment allocated to a lower-tier partnership interest can also require lower-tier adjustments when that partnership has an election. Coordinate the calculations at each affected tier. Revenue Rulings 87-115 and 92-15, summarized in the T.D. 9999 preamble.

Check mandatory loss rules at each relevant tier. EIP qualification also needs review where an underlying partnership operates a business; Notice 2005-32, section 7, provides limited guidance. Gather election histories, values and schedules for hedge fund tax and accounting. Section 743; Notice 2005-32, section 7.

What should the fund gather before preparing the return?

Reconcile transaction documents with tax records. An administrator’s capital statement alone does not establish buyer basis or section 743(b) adjustments. Form 1065 instructions: item L.

Gather the transfer or redemption agreement, closing date, price and other consideration, signed buyer notice, liabilities, asset values and tax bases, prior section 743(b) schedules, election history, written allocation-method selections, foreign-investor information and underlying-fund records. Resolve gaps before issuing K-1s.

Example

Illustrative amounts in US dollars. Assume no liabilities, a taxable interest purchase, and investment assets whose basis adjustment is recovered on sale.

A buyer pays $12 million for an LP interest. The buyer’s share of the fund’s existing asset tax basis is $8 million, with $4 million of built-in gain attributable to that interest. With a valid section 754 election, the fund computes a $4 million section 743(b) step-up and allocates it to the assets under section 755.

If the fund later sells those assets at unchanged values, the buyer’s $4 million allocated gain is offset by the $4 million adjustment, assuming the asset allocations match. The other partners do not share that adjustment. The fund reports the buyer’s adjustment separately; it does not add the step-up to K-1 item L tax capital. Regulation 1.743-1(j); Form 1065 instructions.

Without an election, no section 743(b) adjustment is required if neither substantial built-in loss test is met. The buyer then receives $4 million of taxable gain, raising outside basis from $12 million to $16 million. With no other basis changes, a later full cash redemption for $12 million generally produces a $4 million capital loss. The gain and loss may occur in different years. Section 731.

Different for you?

• A foreign investor sold or redeemed: review foreign-partner withholding and bring the transfer documents for hedge fund tax and accounting.
• A Canadian investor sold US partnership units: see US partnership units and withholding for Canadians.
• A full redemption needs a fill-up allocation: see Fund tax capital and allocations.
• A transfer involves carried interest: see The carried interest three-year rule.
• The election or adjustment was missed and K-1s went out: see Correcting a filed business return.
• The transaction is a secondary, continuation fund or tiered structure: prepare the transaction steps, election histories and basis schedules for hedge fund tax and accounting.
• You need transfer and section 743(b) schedules prepared: bring the signed notices, agreements and asset records to fund tax services.