A partner contributes appreciated land carrying a mortgage larger than her basis. No cash changes hands, yet she recognizes gain. Subchapter K's basis machinery explains why.
A partnership pays no entity-level tax. Instead, its income, deductions and credits flow through to the partners, and each partner's share is reported on Schedule K-1 (Form 1065). Basis is the account that keeps that flow in check, so the same partnership income isn't taxed twice and the same loss isn't deducted twice.
Three separate basis figures appear in every exam scenario:
- Outside basis: the partner's adjusted basis in the partnership interest itself, tracked by the partner.
- Inside basis: the partnership's adjusted basis in each asset it holds.
- Capital account: a book figure showing the partner's equity on the partnership's books. It usually differs from outside basis because it leaves out the partner's share of partnership liabilities.
When a partner puts property into a partnership in exchange for a partnership interest, the partner has traded one investment for another without cashing out.
Common mistakes
- Netting the liability the wrong way. Candidates subtract only the partner's retained share instead of the full liability. Using $70,000 × 0.30 as the reduction gives $19,000 of basis instead of zero. The formula subtracts the full liability and adds back only the partner's share.
- Letting outside basis go negative. A −$9,000 computed basis is not an answer choice. Stop at zero and recognize the $9,000 as gain.
- Treating a guaranteed payment as a distribution. A guaranteed payment is ordinary income to the partner and a deduction for the partnership. It is not a $50,000 direct basis reduction.
Bottom line
- Section 721 gives nonrecognition on contributed property; §722 sets the partner's basis and §723 gives the partnership a carryover basis.
- Services for a capital interest are taxable compensation at fair market value; a profits interest generally is not.
- Contribution formula: property basis minus the full liability, plus the partner's allocated share; gain equals any negative amount, and basis floors at zero.
- Liability increases are deemed cash contributions; decreases are deemed cash distributions.
Exam shortcut
Read the stem for the word "subject to" on contributed property. That phrase means run the three-part formula, and the answer is usually either zero basis with gain or a small positive number, never the property's full basis. When a stem gives both a cash price and a liability, the amount realized is always the sum. The distractor is the cash figure alone.
The full lesson (about 3,235 words, 22 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2
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