When you purchase an interest in an existing partnership — a real-estate LP, a family limited partnership, a private fund — you almost always pay more than your share of the partnership’s inside basis in its assets. Absent an election, your outside basis (what you paid) and your share of inside basis (what the partnership carries the assets at) diverge, and every dollar of depreciation, gain, or loss the partnership recognizes thereafter flows through to you on the inside-basis schedule rather than on what you actually paid. You end up taxed on phantom gains the partnership never delivered to you economically.
The Section 754 election, made by the partnership itself, allows a basis adjustment under IRC §743, “Optional adjustment to basis of partnership property” on a sale of an interest, and under IRC §734, “Optional adjustment to basis of partnership property in case of distribution” on a partnership distribution. The effect is to step the inside basis up to match what the new partner paid, so subsequent depreciation and gain allocations track economic reality. The election is irrevocable without IRS consent, applies to all future transactions, and creates administrative burden (separate basis-tracking per partner) — which is why partnerships frequently refuse to make it unless the incoming partner negotiates for it in the purchase agreement.
If you enter a private partnership at a premium to book, getting Section 754 on the record is one of the few terms worth holding the line on. The same election operating in reverse — where the partnership has a loss in built-in value and the election forces a basis step-down on a partner exit — is what makes existing partners resist; absent the election, an exiting partner’s share of inside basis stays with the partnership and quietly subsidizes the remaining partners.