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Footnotes · for the preparer’s desk

Partnership Basis, Distributions, and Liquidation

A partner’s basis is the one number nobody in the partnership keeps, and every distribution, loss, and sale depends on it.

The debt counts. Then the debt goes away and the partner has income with no cash.

Here is the order of operations, from building the basis to closing the interest out.

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Three rules do most of the work in Subchapter K, and they fight each other. Basis follows the money and the debt (§705, §752). Distributions are tax-free up to basis, and property comes out with carryover basis (§731, §732). Ordinary income cannot be converted to capital gain by routing it through a distribution or a sale of the interest (§751). Everything on this page is one of those three rules applied to a particular moment: a draw, a refinance, a truck handed to a partner, a partner retiring, an interest sold.

The practical problem is that the partnership tracks capital accounts and the partner is supposed to track basis, and in a small LLC nobody does the second one. The K-1’s item L capital account has been on the tax-basis method since 2020 and is close enough to be dangerous: it leaves out the partner’s share of liabilities, which is the piece that makes the real estate LLC work and the piece that produces phantom gain when the loan is paid off.

On this page

  1. Step 1: Outside Basis, Built in Order §705 and the ordering rule; the K-1 capital account is not it
  2. Step 2: The Liability Share §752: recourse, nonrecourse, guarantees, and the refinance trap
  3. Step 3: Current Distributions Money, liability relief, property, and the 7-year rules
  4. Step 4: Hot Assets §751: receivables, inventory, and depreciation recapture
  5. Step 5: Liquidating Distributions §732(b), the one case a loss is allowed, and §736 for a retiring partner
  6. Step 6: Sale of the Interest §741, §751(a), liabilities in the amount realized, Form 8308
  7. Step 7: Reporting Forms 7217, 8308, 8949, 4797, and the basis worksheet
  8. Three Worked Examples A refinance, a property distribution, a retirement
  9. Questions at the desk
  10. Authority
  11. Checklist

Step 1: Outside Basis, Built in Order

Start with what the partner put in or paid: cash contributed, the adjusted basis (not value) of property contributed, gain recognized on the contribution, or the purchase price of an interest bought from another partner, or date-of-death value for an inherited interest. Add the partner’s share of liabilities (Step 2). Then, each year, apply §705 in this order (Reg. §1.704-1(d)(2), §1.705-1):

  • Increase for the distributive share of taxable income, separately stated income, and tax-exempt income; and for any increase in the liability share.
  • Decrease for distributions of money (including liability relief) and the basis of property distributed.
  • Decrease for nondeductible, noncapital expenditures (the disallowed half of meals, penalties, the partnership’s own nondeductibles) and for depletion.
  • Decrease, last, for the distributive share of losses and deductions, but not below zero; what won’t fit is suspended under §704(d) and carries forward.

The order matters because distributions come out before losses. A partner with $10,000 of basis, a $15,000 loss allocation and a $10,000 draw in the same year has a tax-free draw and a fully suspended loss, not a $5,000 deductible loss and a $10,000 taxable distribution. (For an S corporation the order is the reverse on nondeductibles and losses unless the §1367 election is made; that is one reason the two entities feel different at the desk.)

What basis is not. The K-1 item L capital account, even on the tax-basis method, excludes the liability share and excludes any §743(b) adjustment. Outside basis is, roughly, item L plus the partner’s share of item K liabilities, adjusted for §743(b) and for any difference between the partnership’s books and the partner’s actual history (a purchased interest, an inherited one). When there is no schedule at all, rebuild from the oldest K-1 available forward, and if the start is unknown use the tax-basis capital plus liability share at the earliest year as the opening figure, documented as such.

Guaranteed payments do not change basis. Neither do payments the partnership makes to a partner acting as an outsider (§707(a)). Only distributive share, contributions, distributions and liabilities move it.

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Step 2: The Liability Share

A partner’s share of partnership liabilities is treated as money contributed (§752(a)); a decrease in that share is treated as money distributed (§752(b)). This is the mechanism that gives real estate partners basis they never paid for, and the mechanism that takes it back.

  • Recourse liabilities (Reg. §1.752-2) are shared by economic risk of loss: who would have to pay if every asset were worthless and the debt came due. A general partner bears it. An LLC member bears none of an LLC’s debt unless the member personally guaranteed it, in which case the guaranteeing member takes the whole guaranteed amount. A partner who lends money to the partnership bears the risk on that loan.
  • Nonrecourse liabilities (Reg. §1.752-3) are shared in three tiers: first the partner’s share of minimum gain, then §704(c) minimum gain, then by profit-sharing ratio. For a small LLC with a bank mortgage and no guarantee, the practical answer is profit share.
  • Cash-basis payables are not liabilities for basis (§1.752-1(a)(4)): they would give a deduction when paid and would double count. Accrued payables of an accrual partnership are.
  • At-risk is a different question: nonrecourse debt gives basis but not at-risk amount, except qualified nonrecourse financing on real property from a qualified lender (§465(b)(6)).

The refinance trap

  • The LLC refinances and distributes the proceeds: the distribution is money, basis goes up by the new debt share first (netting under Reg. §1.752-1(f)), and the partner is usually fine. Then the loan is paid down over the years, each principal payment is a deemed distribution, and in the year basis hits zero the partner has §731 capital gain with no cash.
  • A partner stops guaranteeing a loan, or the lender releases the guarantee: the partner’s whole share of that debt becomes a deemed distribution that year.
  • An interest is sold or gifted: the transferor’s liability share is part of the amount realized (sale) or can produce gain on a gift if the share exceeds basis.
  • A partnership converts to an S corporation: every partner’s liability share is a deemed distribution immediately before the conversion. Partners with negative tax capital recognize gain on the day of the election.
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Step 3: Current Distributions

A current (operating) distribution reduces basis and is otherwise tax-free, with these exceptions, applied in this order:

  • Money over basis is capital gain (§731(a)(1)). Money includes liability relief and, under §731(c), marketable securities at fair market value (with a reduction for the partner’s share of the partnership’s own gain in those securities). No loss is ever recognized on a current distribution.
  • Property takes a carryover basis (§732(a)(1)) — the partnership’s basis in the asset — limited to the partner’s outside basis less any money received in the same distribution (§732(a)(2)). When the limit applies, allocate under §732(c): first to unrealized receivables and inventory up to their partnership basis, then to other property; any required decrease goes first to assets with built-in loss (to the extent of it), then in proportion to remaining basis. The partner’s holding period tacks (§735(b)); distributed receivables stay ordinary forever and inventory stays ordinary for five years (§735(a)).
  • The 7-year rules. If the partnership distributes property that another partner contributed within the previous seven years, the contributing partner recognizes the remaining §704(c) gain (§704(c)(1)(B)). If a partner who contributed appreciated property within seven years receives other property, that partner recognizes the lesser of net precontribution gain or the excess of the property’s value over outside basis (§737). Both are easy to miss because the triggering event looks like an ordinary distribution.
  • Disproportionate distributions of hot assets go to Step 4 before any of the above.
  • Form 7217 is required of the partner for every distribution that includes property other than money, for tax years beginning in 2024 and later, one form per distribution date, attached to the partner’s return.
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Step 4: Hot Assets

§751 exists so that a partner cannot turn ordinary income into capital gain by taking it out as a distribution or selling the interest. Unrealized receivables (§751(c)) are the cash-basis receivables and, importantly, all the depreciation recapture that would be ordinary under §1245 or §1250 if the partnership sold its assets. Inventory (§751(d)) is anything that is not a capital or §1231 asset, which sweeps in more than stock in trade.

  • On a distribution (§751(b)): if the partner receives more or less than his share of hot assets, the disproportionate part is treated as a taxable exchange between the partner and the partnership, and the partner recognizes ordinary income to that extent. For this purpose inventory counts only if substantially appreciated: FMV more than 120% of basis. Reg. §1.751-1(b) and the 2014 proposed regulations describe the hypothetical-sale computation; for a small partnership the practical check is whether a partner is walking away with cash while the others keep the receivables, or the reverse.
  • On a sale of the interest (§751(a)): the seller’s share of the gain attributable to hot assets is ordinary, and here all inventory counts, appreciated or not. The partnership must furnish the information (Form 8308 and a §751 statement).
  • The most common hot asset in a small LLC is not inventory. It is §1245 recapture on equipment and, for a corporate partner, §291. A trucking LLC with fully depreciated tractors has a large §751 asset the balance sheet does not show.
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Step 5: Liquidating Distributions

A distribution that ends the partner’s entire interest, whether the partnership dissolves or one partner is bought out by the partnership, follows the current-distribution rules with three differences:

  • Property takes a substituted basis (§732(b)): the partner’s outside basis less money received, whatever the partnership’s basis was. The partner’s remaining basis is absorbed into the property, up or down. Allocate under §732(c): receivables and inventory first, limited to the partnership’s basis in them; then other property; a required increase goes first to assets with unrealized appreciation (to the extent of it), then by relative FMV; a decrease as in Step 3.
  • A loss may be recognized, but only if the distribution consists solely of money, unrealized receivables and inventory, and only to the extent outside basis exceeds the money plus the partnership’s basis in those items (§731(a)(2)). Distribute one truck along with the cash and the loss disappears into the truck’s basis.
  • Payments to a retiring or deceased partner are split under §736. §736(b) payments are for the partner’s interest in partnership property: distribution treatment, capital gain over basis. §736(a) payments are everything else: treated as a distributive share if measured by income, or as a guaranteed payment if not, ordinary and subject to SE tax, deductible to the partnership in substance. For a general partner in a partnership where capital is not a material income-producing factor (a service partnership), payments for unrealized receivables and for goodwill (unless the agreement provides for goodwill) are forced into §736(a). For an LLC holding real estate, nearly everything is §736(b).

A partner being paid out over several years remains a partner until the last payment (Reg. §1.736-1(a)(1)(ii)), keeps receiving a K-1, and the partnership does not terminate. A sale of the interest to the partnership is a liquidating distribution, not a §741 sale, so §736 and §751(b) apply rather than §751(a). A sale to the other partners individually is a §741 sale. The documents decide which one happened; draft them on purpose.

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Step 6: Sale of the Interest

  • Amount realized = cash + FMV of property received + the seller’s share of partnership liabilities (§752(d)). A partner who “walks away for nothing” from an LLC with a mortgage has an amount realized equal to the debt share.
  • Basis is outside basis adjusted through the date of sale for the current year’s distributive share (§706(c)(2), (d)): close the books or prorate, by agreement.
  • Character: capital under §741, except the §751(a) portion, which is ordinary and can exceed the total gain (ordinary gain plus a capital loss on the rest). Within the capital gain, look through for unrecaptured §1250 gain at 25% and collectibles at 28% (Reg. §1.1(h)-1).
  • Installment sales are allowed for the §741 portion; the §751 portion attributable to recapture is recognized in the year of sale (§453(i)); the partner’s share of liabilities is treated as a payment in the year of sale to the extent it exceeds basis.
  • §754: if an election is in effect, or is made for the year, the buyer gets a §743(b) adjustment; see the §754 page. A transfer with a substantial built-in loss (over $250,000) forces the step-down with or without the election.
  • Form 8308: the partnership files it for any sale or exchange involving §751 property, with Form 1065, and furnishes a copy to both parties. Beginning with 2023 transfers the form was expanded to include Part IV (the §751 figures) and the statement to the transferor is due by January 31 of the following year; the IRS has granted penalty relief for Part IV timing for 2023, 2024 and 2025 transfers while the form is phased in (verify current notice before relying on relief for 2026 transfers).
  • Termination: since 2018 a sale of 50% or more of the interests no longer terminates the partnership (§708(b)(1)(B) repealed). The partnership terminates only when it stops doing business or has one owner left; a two-member LLC that buys out one member becomes a disregarded entity on that day (Rev. Rul. 99-6).
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Step 7: Reporting

  • K-1 to the partner: distributions on line 19 (A money, B property other than securities, C securities); liability share on item K (recourse, qualified nonrecourse, nonrecourse); tax-basis capital on item L; §751 and §737 information in box 20; the partner’s share of §704(c) built-in gain or loss on item N.
  • Partner’s basis worksheet: the Schedule K-1 instructions include one; keep it in the partner’s file every year, with the liability share documented. Form 7203 is the S corporation form; there is no required partnership equivalent, which is why the worksheet gets skipped.
  • Form 7217 by the partner for each property distribution date (2024 forward). Form 8308 by the partnership for §751 sales. Form 8949 / Schedule D for §731 gain and §741 gain; Form 4797 Part II for the §751(a) ordinary portion; Form 6198, 8582, 461 for the loss limits in order.
  • Retiring partner: §736(a) guaranteed payments on K-1 line 4 and subject to SE tax (Schedule SE); §736(b) amounts as distributions on line 19.
  • Colorado follows the federal character; the partner’s gain on sale of an interest in a partnership doing business in Colorado is Colorado-source to a nonresident to the extent of the partnership’s Colorado property and payroll (DR 0104PN, Reg. 39-22-109).

Where it goes wrong

  • No basis schedule exists; the preparer uses the K-1 capital account and deducts losses the partner has no basis for, or misses the §731 gain on a refinance distribution.
  • The LLC member’s share of a bank loan is counted as recourse because “the LLC owes it,” giving basis and at-risk amount that aren’t there; or the guaranteeing member’s share is split pro rata instead of allocated entirely to the guarantor.
  • A partner takes a vehicle or a lot out of the LLC and nobody files Form 7217, and the property is set up at fair market value instead of carryover basis.
  • A buyout is papered as a “sale” to the LLC, then reported as a §741 sale by the seller and as a distribution by the LLC, with the §751(b) exchange ignored by both.
  • Depreciation recapture inside the partnership is forgotten when an interest is sold, and the whole gain is reported as capital.
  • A retiring partner in a service partnership is paid for goodwill with no provision in the agreement, and the payments are treated as capital gain instead of §736(a) ordinary income.
  • The S election is made for an LLC with negative tax capital, and the deemed distribution on conversion is never reported.
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Three Worked Examples

1. The refinance: Pine Street LLC, three equal members, one building

Each member contributed $100,000 in 2016. The LLC bought a building for $1,200,000 with a $900,000 nonrecourse mortgage; nobody guaranteed it. Opening outside basis for each: $100,000 + $300,000 liability share = $400,000. Through 2025, each member’s cumulative net income allocations are $90,000 and cumulative draws are $150,000; the mortgage has been paid down to $600,000. Basis at the end of 2025: $100,000 + $90,000 − $150,000 + $200,000 (share of $600,000) = $240,000. Tax-basis capital on the K-1 shows $40,000, because it leaves the debt out.

In 2026 the LLC refinances to $1,500,000 and distributes $300,000 to each member. Each member’s liability share rises by $300,000 (to $500,000) and the $300,000 cash is a distribution; netted under Reg. §1.752-1(f) the basis effect is zero, and no gain is recognized. Basis stays $240,000 for the year before income. The trap is later: every principal payment on the $1,500,000 is a deemed distribution, and when the cumulative paydown exceeds $240,000 plus later income, the members recognize capital gain with no cash. Put the schedule in the file now and tell the members.

2. The property distribution: Dana takes the truck

Dana, a 40% member of a landscaping LLC, has outside basis of $9,000. The LLC distributes to her a truck with a partnership basis of $14,000 (cost $40,000, §1245 recapture potential $26,000) and FMV $22,000, in a current distribution. Under §732(a)(2) her basis in the truck is limited to $9,000, not $14,000; her outside basis goes to zero. No gain on the distribution itself. She files Form 7217 with her 1040 showing the partnership basis, the limitation, and the $9,000 basis in her hands. If she sells the truck for $22,000 next year, the gain is $13,000 and all of it is ordinary: the §1245 recapture follows the truck (§1245(a) and §735). If the LLC had other hot assets and the other members were not receiving their share, §751(b) would also have to be run, with ordinary income to Dana on the disproportionate part.

3. The retirement: Walt leaves the engineering firm

Walt is a one-third general partner in a cash-basis engineering partnership; capital is not a material income-producing factor. His outside basis is $60,000. The partnership agrees to pay him $300,000 over three years: $60,000 for his share of fixed assets, $90,000 for his share of receivables, and $150,000 for goodwill, with no goodwill provision in the agreement. Under §736: the $60,000 for property is §736(b), a distribution, tax-free against his $60,000 basis. The $90,000 for unrealized receivables and the $150,000 for goodwill are §736(a) payments because he is a general partner in a service partnership and the agreement is silent on goodwill: ordinary income, subject to self-employment tax, deductible by the partnership as guaranteed payments, and reported on his K-1 line 4 in each of the three years. Had the agreement provided for goodwill, the $150,000 would have been §736(b) capital gain to Walt and nondeductible to the firm; the firm would prefer the agreement silent and Walt would prefer it written. That is a negotiation, and it should happen before the first payment, not at the desk in March.

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Questions at the desk

The K-1 capital account is negative. Is that the same as a negative basis?

No. Basis cannot be negative; a negative tax-basis capital account means the partner has taken out or deducted more than contributed and earned, and the difference is supported by the liability share. Basis is roughly the negative capital plus the share of debt. If that is still negative, something has already been under-reported: a §731 gain or a disallowed loss in a prior year.

Our two-member LLC bought out one member. What did the LLC become?

A disregarded entity, as of the buyout date (Rev. Rul. 99-6). The 1065 for that year is a final short-period return through the buyout; the remaining member reports the rest of the year on Schedule C or E. The departing member has a liquidating distribution or a sale depending on who paid; the remaining member is treated as buying the departing member’s share of the assets, with a cost basis in that half and carryover basis in the other.

A partner wants to take a lot out of the LLC and build a house on it. Taxable?

Generally not to the partner on the way out, beyond basis limits, but check three things: whether another partner contributed that lot within seven years (§704(c)(1)(B) gain to the contributor); whether this partner contributed other appreciated property within seven years (§737); and whether the lot is inventory to the LLC, in which case it stays ordinary in the partner’s hands for five years. Then Form 7217.

Can the partnership deduct what it pays a retiring partner?

Only the §736(a) portion, and only in substance, by treating it as a guaranteed payment or a distributive share that reduces the remaining partners’ income. The §736(b) portion is a purchase of the partner’s share of the assets: no deduction, but with a §754 election the partnership gets a §734(b) basis step-up in the assets instead.

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Authority

  • §705 (basis adjustments); Reg. §1.705-1; Reg. §1.704-1(d) (ordering of losses and distributions); §704(d) (basis limitation)
  • §722, §723, §742 (basis of interest and of contributed property; purchased or inherited interests); §1014
  • §752(a)–(d); Reg. §1.752-1 (definition; netting, (f)), §1.752-2 (recourse; economic risk of loss; guarantees), §1.752-3 (nonrecourse; three tiers); §465(b)(6) (qualified nonrecourse financing)
  • §731(a)–(c) (gain and loss on distributions; marketable securities); §732(a)–(c) (basis of distributed property; substituted basis in liquidation; allocation); §733; §735 (character and holding period of distributed property)
  • §704(c)(1)(B) and §737 (seven-year rules); Reg. §1.704-4, §1.737-1 through -3
  • §751(a)–(d); Reg. §1.751-1; Prop. Reg. §1.751-1 (2014); §1245, §1250, §291 (recapture as unrealized receivables)
  • §736(a)–(b); Reg. §1.736-1 (retiring and deceased partners; capital as a material income-producing factor; goodwill)
  • §741; §706(c)–(d) (closing the year for a departing partner; varying interests); §752(d); §453(i); Reg. §1.1(h)-1 (look-through); §743(b), §754, §743(d)
  • §708(b) as amended by TCJA (technical termination repealed); Rev. Rul. 99-6 (two-member LLC to one member); Rev. Rul. 84-52 (conversions)
  • §6050K and Form 8308; Notice 2024-19, Notice 2025-2 (Part IV penalty relief) (verify for 2026); Form 7217 and instructions (tax years beginning after 2023); Schedule K-1 (Form 1065) instructions, item K, item L (tax-basis method, 2020 forward), item N, box 19, box 20; Partner’s Basis Worksheet in the K-1 instructions
  • §1402(a) (SE tax on §736(a) payments); §707(c)
  • Colorado: C.R.S. §39-22-109; Reg. 39-22-109; DR 0106, DR 0104PN

Checklist: any partnership distribution, buyout, or sale of an interest

Print this page; the header and footer drop out

  • Partner’s basis schedule located, or rebuilt from the earliest K-1 forward, with the liability share shown separately and the method documented
  • Liabilities classified: recourse (who bears the economic risk; guarantees), nonrecourse (profit share), qualified nonrecourse; cash-basis payables excluded
  • Current-year §705 adjustments applied in order: income up; distributions; nondeductibles; losses last, not below zero
  • Distribution identified as current or liquidating; money (including liability relief and marketable securities) separated from property
  • §731 gain on money over basis computed; no loss claimed on a current distribution
  • Property basis: carryover limited to outside basis (current) or substituted (liquidating); §732(c) allocation run; holding period tacked; §735 character noted
  • Seven-year test run both directions: §704(c)(1)(B) for property another partner contributed; §737 for a partner who contributed appreciated property
  • Hot assets inventoried: cash-basis receivables, inventory (120% test for distributions), and §1245 / §1250 recapture potential; §751(b) disproportion checked
  • Retiring partner: payments split between §736(a) and (b); capital-as-material-income-producing-factor determined; agreement checked for a goodwill provision; SE tax on (a) payments
  • Sale of interest: amount realized includes liability share; basis closed through the sale date; §751(a) ordinary portion computed from the partnership’s §751 statement; look-through rates applied
  • §754 status confirmed; §743(b) or §734(b) computed if in effect; §743(d) / §734(d) mandatory tests run
  • Forms: 7217 (partner, each property distribution date); 8308 (partnership, §751 sale, Part IV statement by January 31); 8949 / Schedule D; 4797 Part II; 6198, 8582, 461 in order
  • Two-member LLC reduced to one: final short-period 1065, Rev. Rul. 99-6 basis split, Schedule C/E from the buyout date
  • Entity converting to S corporation: liability shares treated as distributions on the conversion date; negative-capital partners’ gain computed and reported
  • Client told, in writing, what the basis schedule says and what the next loan paydown or distribution will do to it
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Written for the Tax Shop desk; figures are for the 2026 tax year as currently published. Items marked (verify) are to be confirmed against primary sources before the figures freeze in December. Last updated October 19, 2026.