A partner contributes land worth $400,000 (basis $60,000) with a $300,000 mortgage for a 25% interest. He believes he has $60,000 of basis. The IRS sees something different. Outside basis is the most-tested concept in subchapter K because it drives deductible losses, taxability of distributions, character of gain on sale, and whether a §754 election is needed.
Every partnership has two parallel basis systems running at all times. Confusing them is the single biggest source of errors on REG.
Outside basis is the partner's basis in the interest itself. It controls deductible losses, distributions, and gain/loss on sale.
Inside basis is the partnership's basis in its assets. It controls depreciation, gain on the partnership's sale, and basis carried into property distributions.
At formation, inside and outside basis usually match: the partnership's inside basis in a contributed asset equals the contributor's adjusted basis (carryover, never FMV). Over time the two can drift apart through purchases, distributions, or §704(c) allocations.
KEY: Outside = partner's basis in the interest. Inside = partnership's basis in its assets. Both start from the contributor's adjusted basis under §721/§723 carryover.
Common mistakes
- Confusing inside and outside basis. Outside controls deductibility, distributions, and sale. Inside controls depreciation and partnership-level gain. They start equal under carryover but drift apart through purchases, distributions, and §704(c). Mixing them corrupts every downstream answer.
- Computing §752 gross instead of net. A contributed liability appears as both an increase (the contributor's new share) and a decrease (relief given by other partners). Net them. A 25% partner contributing a 100% mortgage has a net decrease of 75% × mortgage, not 100%.
- Allocating recourse to limited partners or unguaranteed LLC members. Recourse follows economic risk of loss. LPs are capped at their contribution; LLC members bear no recourse risk unless they guarantee. Allocating recourse to a passive LP overstates basis.
Bottom line
- Initial outside basis = cash + adjusted basis of property contributed - liabilities relieved + share of liabilities assumed + gain recognized. Inside basis = carryover under §723.
- §752 splits liabilities: recourse goes to the partner bearing economic risk of loss; nonrecourse uses the three-tier allocation (minimum gain, §704(c) gain, then profit ratios).
- §721 contributions are tax-free except for services (ordinary income), net liability relief exceeding basis (gain), and §707 disguised sales within two years.
- §731 nonliquidating: cash above basis = capital gain; property never triggers gain (basis capped at lesser of inside or remaining outside basis); loss is never recognized.
Exam shortcut
For initial basis, write the formula: property basis + cash + share of new liabilities - liabilities relieved + gain recognized. Always net the liability shift. For nonrecourse, run the three tiers: built-in gain on contributed property usually pulls the mortgage entirely to the contributor under tier 2. For distributions, ask first: liquidating or nonliquidating? Then: cash or property? Cash always reduces basis dollar-for-dollar, with gain on excess.
The full lesson (about 3,483 words, 23 min read) adds 2 worked examples, all 9 common mistakes, a self-check, free in the app.
Learning objectives
- V.D2
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