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Footnotes · for the preparer’s desk

Disguised Sales

A partner contributes a building and the partnership distributes cash to him. Section 721 says the contribution is tax-free; section 731 says the cash is tax-free to the extent of basis.

Put the two together within two years and the regulations say it was a sale all along.

This is the pattern Colorado real estate LLCs actually use. The two-year presumption and the Form 8275 disclosure are the desk procedure.

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Section 707(a)(2)(B) and Reg. §1.707-3 recharacterize a contribution plus a related distribution as a sale of the property, in whole or in part, to the partnership. The partner recognizes gain as a seller; the partnership takes a cost basis in the purchased portion. The 2025 act made §707(a)(2) self-executing for transactions after July 4, 2025, so the rule no longer depends on the regulations being “prescribed” — the public partnerships page notes this; here is what the regulations actually say.

On this page

  1. Step 1: The Two-Part Test But-for, and not dependent on entrepreneurial risk
  2. Step 2: The Ten Facts Reg. §1.707-3(b)(2)
  3. Step 3: The Two-Year Presumptions Inside two years: a sale unless clearly not; outside: not a sale unless clearly so
  4. Step 4: The Exceptions Preferred returns, guaranteed payments for capital, operating cash flow, reimbursed preformation expenditures
  5. Step 5: Debt-Financed Distributions The refinance-and-distribute pattern
  6. Step 6: The Arithmetic of a Partial Sale Reg. §1.707-3(f), Example 1
  7. Step 7: Disclosure Form 8275 and Schedule B
  8. Questions at the desk
  9. Quick notes
  10. Authority
  11. Checklist

Step 1: The Two-Part Test

Reg. §1.707-3(b)(1). A transfer of property by a partner to a partnership and a transfer of money or other consideration by the partnership to the partner are a sale if, on all the facts and circumstances:

  1. the transfer of money would not have been made but for the transfer of property; and
  2. for non-simultaneous transfers, the later transfer is not dependent on the entrepreneurial risks of partnership operations.

Facts are tested as of the earliest of the transfers. The order does not matter: cash first and property later is as much a sale as the reverse. “Property” excludes money; a contribution of cash followed by a distribution of cash is not a disguised sale of anything (though it may be a disguised sale of a partnership interest under §707(a)(2)(B)’s other branch, or a §731 distribution).

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Step 2: The Ten Facts

Reg. §1.707-3(b)(2). Each points toward a sale; none is conclusive.

  1. The timing and amount of the later transfer are determinable with reasonable certainty when the earlier transfer is made.
  2. The transferor has a legally enforceable right to the later transfer.
  3. The partner’s right to the later transfer is secured.
  4. Another person is obligated to contribute money to the partnership so it can make the transfer.
  5. Another person has agreed to lend the partnership the money to make it.
  6. The partnership has incurred, or is obligated to incur, debt to fund the transfer, taking guarantees and other arrangements into account.
  7. The partnership holds liquid assets beyond its reasonable business needs that are expected to be available to fund the transfer.
  8. Distributions, allocations or control of operations are designed to effect an exchange of the benefits and burdens of ownership of the property.
  9. The transfer is disproportionately large in relation to the partner’s continuing interest in profits.
  10. The partner has no obligation to return or repay the money, or only a distant one.
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Step 3: The Two-Year Presumptions

  • Within two years (Reg. §1.707-3(c)): transfers between a partner and a partnership within a two-year period, in either order, are presumed to be a sale unless the facts and circumstances clearly establish otherwise.
  • Outside two years (Reg. §1.707-3(d)): presumed not to be a sale unless the facts clearly establish that they are.

The standard is “clearly establish,” not “more likely than not.” A distribution within two years of a contribution that the client wants to treat as a plain §731 distribution needs a documented reason the later transfer depended on how the business did — and the disclosure in Step 7.

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Step 4: The Exceptions

Reg. §1.707-4. Transfers that are not treated as part of a sale, and need no disclosure:

  • Reasonable guaranteed payments for capital (§707(c)): a payment for the use of capital, at a reasonable rate (presumed reasonable at not more than 150% of the highest applicable federal rate), not dependent on income.
  • Reasonable preferred returns: a preferential distribution of partnership cash flow at a reasonable rate, to the extent of net cash flow from operations, paid out of profits.
  • Operating cash flow distributions: distributions of the partnership’s net cash flow from operations, presumed to be such to the extent they do not exceed the partner’s share of net cash flow for the year (with a safe-harbor computation in the regulation).
  • Reimbursements of preformation expenditures (Reg. §1.707-4(d)): capital expenditures the partner incurred in the two years before the contribution, reimbursed by the partnership, up to 20% of the property’s value (the 20% cap does not apply if the value is no more than 120% of the partner’s basis).
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Step 5: Debt-Financed Distributions

Reg. §1.707-5. The common Colorado pattern: contribute the building, the partnership borrows against it, the cash goes to the contributor.

A distribution traceable to a liability the partnership incurred within 90 days of the distribution is treated as sale consideration only to the extent it exceeds the contributing partner’s allocable share of that liability. If the partner is allocated 100% of a recourse loan (he guaranteed it), the distribution of its proceeds is not a sale; if the loan is nonrecourse and he is allocated 30% of it under the §752 rules, 70% of the distribution is sale proceeds. Liabilities the partnership assumes with the property are handled the same way: qualified liabilities (incurred more than two years before, or in the ordinary course, or to acquire or improve the property) are not sale consideration; other liabilities are, to the extent they exceed the partner’s share after the transfer. This is where the liability allocation arithmetic earns its keep.

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Step 6: The Arithmetic of a Partial Sale

Reg. §1.707-3(f), Example 1.

A contributes land with a fair market value of $4,000,000 and a basis of $1,200,000 to a partnership that immediately distributes $3,000,000 to A. The transfer is a sale of three-quarters of the land: amount realized $3,000,000; basis allocated to the sold portion $1,200,000 × ($3,000,000 / $4,000,000) = $900,000; gain $2,100,000. The remaining quarter (value $1,000,000, basis $300,000) is a §721 contribution with a $300,000 carryover basis and a §704(c) built-in gain of $700,000. The partnership’s basis in the land is $3,000,000 + $300,000 = $3,300,000.

Example 3 — the construction case. A contributes land; the agreement provides that the partnership will distribute $900,000 to A when the building it is constructing is completed. If the distribution is made within two years it is presumed a sale; the presumption is rebutted only if the facts clearly show the distribution did not depend on the land transfer, or did depend on the entrepreneurial risk of the project (for instance, payable only from project cash flow, and only if the project succeeded).

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Step 7: Disclosure

Reg. §1.707-8.

Where a partner and a partnership make transfers within two years of each other that are not treated as a sale, and the Reg. §1.707-4 exceptions do not cover them, the partner must disclose on Form 8275 (or a statement) attached to the return for the year of the transfer: a caption identifying it as a §707 disclosure, the item and amount, and the facts affecting the tax treatment. The partnership’s Schedule B asks whether any such disclosure was required. The same disclosure applies in reverse where transfers more than two years apart are treated as a sale. Failure to disclose does not itself create a sale, but it removes any accuracy-penalty protection and invites the question on audit.

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Questions at the desk

The members contributed a rental, refinanced it eight months later, and split the proceeds in proportion to their interests.

Each member received a debt-financed distribution. To the extent each member’s allocable share of the new loan equals the cash he got, there is no sale; if the loan is nonrecourse and shares were allocated by profits, that usually works for pro rata distributions. Document the §752 allocation and consider the Form 8275 disclosure anyway, since the transfers are within two years.

One member contributed land; the other contributed cash; the land contributor took the cash out at closing as a “return of capital.”

That is the Example 1 pattern — a partial sale on the day of contribution. Compute the sold fraction, report the gain on the contributor’s return, and give the partnership a cost basis in that fraction.

A member gets a 7% preferred return on contributed capital, paid quarterly out of rents.

A reasonable preferred return paid from operating cash flow is excepted; no sale, no disclosure. Keep the rate within the 150%-of-AFR presumption and the payments within net cash flow.

The distribution came 25 months after the contribution.

Presumed not a sale. But if it was promised at the outset, secured, or funded with a loan arranged at contribution, the facts can still clearly establish a sale; the presumption only shifts the burden.

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Quick notes

One line each, from the course study questions and the final exam; the bracketed tag is the question and the answer I derived.

  • A transfer of property to a partnership followed by a transfer of cash to the partner within two years is presumed a sale unless the facts clearly establish otherwise; outside two years the presumption reverses. [course Ch. 3E]
  • The disguised-sale test is two parts: the cash would not have been paid but for the property, and the payment did not depend on the entrepreneurial risk of the business. [course Ch. 3E]
  • A reasonable preferred return, a reasonable guaranteed payment for capital, and an operating-cash-flow distribution are not sale consideration and need no disclosure. [course Ch. 3E; Reg. §1.707-4]
  • Land worth $4,000,000 with a $1,200,000 basis, contributed with $3,000,000 cash back at once, is a sale of three-quarters: amount realized $3,000,000, basis $900,000, gain $2,100,000; the other quarter is a contribution. [Reg. §1.707-3(f) Ex. 1]
  • A debt-financed distribution is sale consideration only to the extent it exceeds the contributing partner’s share of the new liability. [Reg. §1.707-5]
  • Transfers within two years that are treated as not a sale must be disclosed on Form 8275 unless an exception covers them; Schedule B asks. [Reg. §1.707-8]
  • Since July 4, 2025, §707(a)(2) applies on its own terms and no longer waits for regulations to be prescribed. [P.L. 119-21]

Authority

  • §707(a)(2)(B); Reg. §1.707-3 (disguised sales of property; the ten facts; presumptions; examples)
  • Reg. §1.707-4 (guaranteed payments, preferred returns, operating cash flow distributions, preformation expenditures)
  • Reg. §1.707-5 (liabilities; qualified liabilities; debt-financed distributions; the 90-day rule)
  • Reg. §1.707-8 (disclosure); Form 8275; Form 1065 Schedule B
  • §752; Reg. §§1.752-2, -3 (partner’s share of liabilities)
  • P.L. 119-21 §70602 (§707(a)(2) self-executing for transactions after July 4, 2025)

Checklist: contribution with cash back

Print this page; the header and footer drop out

  • Dates of every contribution and every distribution to the contributing partner listed; two-year window checked in both directions
  • Ten facts reviewed and the conclusion documented
  • Exceptions tested: preferred return rate and source; guaranteed payment for capital; operating cash flow safe harbor; preformation expenditures within 20%
  • Debt-financed distributions: loan date within 90 days; partner’s §752 share computed; excess treated as sale proceeds
  • Assumed liabilities classified as qualified or not
  • Partial-sale fraction computed; gain reported by the partner; partnership basis split between cost and carryover portions; §704(c) layer set up for the contributed portion
  • Form 8275 disclosure attached where transfers within two years are treated as not a sale; Schedule B answered
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Written for the Tax Shop desk from my continuing-education course notes; figures are for the 2026 tax year unless stated. Items marked (verify) are to be confirmed against primary sources before they are relied on. Private reference, not client advice.