A cost segregation study on a partnership-held building produces the same reclassification it would on any other property. What happens next is different. The partnership does not use the deduction; it allocates it. Whether that allocation reaches the partners who can actually use it depends on the operating agreement, on whether a section 754 election is in place, and on each partner’s own tax position. Those questions sit outside the study and determine most of its value.
Why Partnership Structure Affects Who Benefits From the Study
A partnership is a conduit for depreciation, not a consumer of it. An engineering-based cost segregation study reclassifies the building in the usual way, and the resulting deductions pass through on Schedule K-1 to land on individual returns where the partners’ circumstances vary enormously. One partner may qualify as a real estate professional and materially participate in the rental activity, which can allow the resulting loss to be treated as nonpassive. Another may remain passive, with the deduction suspended until there is passive income or a disposition.
That variation means the same study produces different economics for different partners in the same deal. A sponsor evaluating whether to commission a study on behalf of a fund is asking a question about the partner group, not only about the building. Our overview of cost segregation for real estate investment firms covers the portfolio-level view.
Partner-level basis also caps the benefit. A partner cannot deduct losses beyond their adjusted basis in the partnership interest under section 704(d), with excess amounts suspended and carried forward. The at-risk rules under section 465 and the passive activity rules under section 469 then apply as separate further limitations. A large first-year deduction allocated to a partner with thin basis produces a suspended loss rather than a current one.
Special Allocations of Depreciation Among Partners
Partnership agreements frequently allocate depreciation disproportionately. That is permitted, within limits, and the limits are about economics rather than tax efficiency.
Special allocations are respected only if they satisfy section 704(b), generally because they have substantial economic effect or otherwise accord with the partners’ interests in the partnership. Under the standard economic effect test, the agreement maintains section 704(b) capital accounts, liquidating distributions follow positive capital accounts, and deficit balances are subject to a qualifying restoration obligation. The regulations provide an alternate framework, including a qualified income offset, for arrangements without a full deficit restoration obligation. Where an allocation fails, it is reallocated according to the partners’ interests, which usually means the intended result does not hold.
Contributed property runs on a separate track. Where a partner contributes appreciated property, section 704(c) requires that the built-in gain or loss be allocated to the contributing partner. Partnerships choose among the traditional, curative and remedial methods to do this. One point matters for accelerated depreciation: remedial allocations under section 704(c) do not qualify for bonus depreciation, because the partnership’s basis is determined by reference to the contributing partner’s basis.
The Section 754 Election and Inside Basis Adjustments
Without a section 754 election, a partner who buys into a partnership at a price reflecting appreciated property takes an outside basis that reflects what they paid, while the partnership’s inside basis in its assets stays where it was. The new partner effectively funds appreciation they get no depreciation for.
The election closes that gap. It produces two different adjustments, which are routinely merged and behave differently.
| Adjustment | Trigger | Bonus depreciation |
| Section 743(b) | Transfer of a partnership interest, including a sale or exchange | Generally eligible, subject to the acquisition requirements |
| Section 734(b) | Certain distributions of partnership property | Not eligible |
The 743(b) adjustment is personal to the transferee partner. It does not change the partnership’s common basis or affect the other partners. It is allocated among partnership assets under section 755, and where the underlying property has been segregated into 5, 7 and 15-year classes, the adjustment can be allocated across those classes rather than dropped entirely into a 39-year bucket. The positive adjustment is then depreciated as though it were newly placed in service.
On bonus eligibility, the final regulations are favorable. A 743(b) increase generally qualifies for the special depreciation allowance where the acquiring partner has not previously used the portion of partnership property to which the adjustment relates, notwithstanding that the partnership itself has used the property. For partnerships that are not publicly traded and meet the relevant exception, the entire 743(b) basis increase is eligible. Bonus can also be elected out separately for each partner’s adjustment by class of property, so partners are not locked into a single choice.
One case needs its own advice. Where the transfer arises on the death of a partner rather than a sale, the transferee’s basis is determined under section 1014, and the bonus depreciation analysis raises the same obstacle that applies to inherited real property directly.
A section 754 election, once made, applies to the year it is made and to all later years unless it is revoked with IRS consent. A basis adjustment is also mandatory, election or not, where the partnership has a substantial built-in loss.
When a Partner Buys In After the Study
A study completed before an interest changes hands does not become stale. It becomes the allocation schedule for the incoming partner’s adjustment.
The sequence usually runs: the partnership commissions the study and reclassifies the building; the reclassified schedule drives depreciation for the existing partners; an interest is later sold; the 754 election produces a 743(b) adjustment for the buyer; and section 755 allocates that adjustment across the asset classes the study already identified. A partnership without a study allocates the same adjustment across a much blunter asset schedule.
Coordinating With the Partnership Return and K-1 Reporting
The partnership computes depreciation on its common basis and reports each partner’s distributive share. Section 743(b) adjustments are tracked and reported separately for the transferee partner, since they do not belong to the partnership as a whole.
Three coordination points cause most of the friction. Basis adjustments have to be communicated between the transferee and the partnership, since the partnership cannot compute what it has not been told. Passive characterization is determined at partner level, so the partnership cannot tell a partner whether their allocation is currently deductible. And where a study is completed after the return has been filed, whether the correction runs through a superseding return or a method change depends on where you are in the filing calendar.
If your partnership holds commercial property and has not tested whether a study is worth commissioning, or a partner is buying in and the 754 position is unsettled, that is worth resolving before the next return. You can request a free analysis, or run initial figures through our cost segregation calculator.
Frequently Asked Questions
Does a cost segregation study require a section 754 election?
No. The study reclassifies the building regardless of the partnership’s elections. A 754 election generally matters when an interest changes hands, because it can produce a section 743(b) adjustment for the transferee reflecting what they paid rather than the partnership’s historic inside basis. Certain mandatory adjustment rules apply even without the election.
Can depreciation be allocated to specific partners?
Yes, within limits. Special allocations must satisfy section 704(b), generally through substantial economic effect: capital account maintenance, liquidation in accordance with positive capital accounts, and a qualifying deficit restoration obligation. An alternate framework including a qualified income offset covers arrangements without a full restoration obligation. Allocations that fail are reallocated according to the partners’ interests.
Is a section 743(b) adjustment eligible for bonus depreciation?
Generally yes, where the adjustment arises from a sale or exchange of a partnership interest and the acquiring partner has not previously used the relevant portion of the property. Section 734(b) adjustments arising on distributions are not eligible, and neither are remedial allocations under section 704(c).
What if a partner cannot use the depreciation allocated to them?
The deduction may be suspended rather than lost, but the release rule depends on which limitation applies. Losses disallowed under section 704(d) for insufficient basis remain suspended until sufficient basis becomes available. Passive losses are governed separately under section 469, and the at-risk rules can impose a further limitation with its own release rule.
Should the study be done before or after a partner buys in?
Either works, but doing it first is usually cleaner. The reclassified asset schedule is then already available to allocate the incoming partner’s section 743(b) adjustment across asset classes under section 755, rather than allocating it against a single undifferentiated building figure.
This article provides general information about federal tax rules and is not tax advice. Speak with your tax adviser about your specific circumstances.
