IRC 707(b): Related Party Losses, Gains, and Ownership Rules

IRC Section 707(b) is the related-party rule for partnerships: when a partner controls more than 50% of a partnership, or the same people control two partnerships, losses on sales of property between them are disallowed, and certain gains are converted from capital gain into ordinary income.¹ The rule reaches further than most people expect, because ownership is measured after applying family and entity attribution, not just what appears on the partnership agreement.

When Section 707(b) Applies

Two situations trigger the rule. The first is a sale or exchange between a partnership and a person who owns more than 50% of its capital interest or profits interest. The second is a sale or exchange between two partnerships in which the same persons own more than 50% of both.¹

The threshold is “more than 50%,” not “50% or more.” A partner sitting at exactly 50% is outside the rule. The test is also disjunctive between capital and profits: you fail it if you exceed 50% in either one. A capital interest is your share of net assets if the partnership liquidated today; a profits interest is your share of future earnings and growth. Only one has to cross the line.

How Ownership Is Actually Measured

Direct ownership rarely tells the whole story. Section 707(b)(3) borrows the constructive ownership rules of Section 267(c), with one carve-out: the partner-to-partner attribution rule in Section 267(c)(3) does not apply, so you are not treated as owning a co-partner’s separate interests just because you’re in another venture together.¹ Everything else in Section 267(c) does apply.

Family Attribution

You are treated as owning any partnership interest held by your spouse, siblings (including half-siblings), ancestors (parents and grandparents), and lineal descendants (children and grandchildren).² Aunts, uncles, cousins, in-laws, and stepchildren are not on that list. A partner who directly holds 30% while a spouse holds 25% is treated as owning 55%, and Section 707(b) applies to any sale between that partner and the partnership even if the spouse has nothing to do with it.

Entity Attribution

Interests held by a corporation, partnership, estate, or trust are attributed proportionally to shareholders, partners, or beneficiaries.² A 50% beneficiary of a trust that holds a 40% partnership interest is treated as owning 20%. This closes the workaround of parking ownership in an intermediary.

Option Attribution

Holding an option to acquire an interest is treated as holding the interest itself. A call option cannot be used to stay below the 50% line while retaining the right to cross it later.

The No Double Family Attribution Rule

Family attribution does not chain. If your father owns 30% and that interest is attributed to you, it stops there — it is not then re-attributed from you to your spouse under a second application of the family rule. Entity attribution does chain: an interest treated as owned through an entity is treated as actually owned, so it can be attributed further through the family or entity rules.²

Losses Are Disallowed Entirely

When a sale or exchange of property crosses the related-party line described above, any loss the seller realizes is disallowed in full. It cannot offset other gains, and the seller cannot carry it forward. The loss is simply gone from the seller’s return.¹

Fair market value doesn’t save the transaction. A perfectly arm’s-length price with a legitimate business reason still produces a disallowed loss if the ownership threshold is met. The statute contains no good-faith or reasonable-price exception.

Two boundaries matter. The rule reaches only “sales or exchanges,” so losses from casualties, condemnations, or other involuntary events are outside its scope. And the disallowance does not apply to the sale of a partnership interest itself. Selling your interest to a related party at a loss is not governed by Section 707(b)(1), though Section 267’s separate loss disallowance rules can still bite, so it is not a free pass.¹

How the Buyer Can Use the Disallowed Loss

The buyer gets a partial remedy. When the buyer later sells the property to an unrelated party at a gain, that gain is reduced dollar for dollar by the amount of loss disallowed to the original seller. Section 707(b)(1) accomplishes this by directing that Section 267(d) apply to the later sale as though the loss had been disallowed under Section 267(a)(1).³

Say Partner A holds 60% and sells an asset with a $100,000 basis to the partnership for $70,000. The $30,000 loss is disallowed. The partnership takes a $70,000 cost basis.

If the partnership later sells for $110,000, its own gain is $40,000. The $30,000 disallowed loss offsets it, leaving $10,000 of taxable gain.
If the partnership sells for $90,000, its own gain is $20,000. The offset wipes it out entirely, and the remaining $10,000 of the disallowed loss vanishes. The offset can only reduce gain; it never creates a deductible loss for the buyer.
If the partnership sells for $65,000, it recognizes its own $5,000 loss on its $70,000 basis. There is no gain to offset, so Partner A’s $30,000 disallowed loss is permanently lost.

Partner A never recovers any of it. The offset lives only in the buyer’s later gain calculation.³

Gains Can Be Recharacterized as Ordinary Income

Section 707(b)(2) attacks a different problem: using related-party sales to turn ordinary income into capital gain. If you sell property to a related partnership (or the reverse) and the property is not a capital asset in the buyer’s hands, any gain you recognize is treated as ordinary income, even if the property was a capital asset to you.¹

The character test looks at the buyer, not the seller. Under Section 1221, “capital asset” excludes inventory, property held for sale to customers, depreciable business property, real property used in a business, and receivables from ordinary business operations.⁴ If the property falls into any of those categories once the buyer has it, the seller’s gain becomes ordinary.

Two common patterns get caught. A partner holds undeveloped land as a personal investment (a capital asset) and sells it to the partnership, which plans to subdivide and sell lots — inventory in the partnership’s hands. The partner’s gain is ordinary income. Same result when a partner sells equipment held as a capital asset to a partnership that will use it in operations, turning it into depreciable trade or business property.

Installment Sales of Depreciable Property Get Accelerated

A separate rule under Section 453(g) blocks the installment method when depreciable property is sold to a related person. All payments to be received are treated as received in the year of sale, so the full gain is taxed up front even though the cash arrives over several years.⁵

There is one escape: if the seller can demonstrate to the IRS that avoiding federal income tax was not a principal purpose of the transaction, installment reporting stays available. The burden sits with the seller, and it is a hard showing when the buyer is a partnership the seller controls. Section 453(g) reaches commonly controlled partnerships by folding in the relationship described in Section 707(b)(1)(B).⁵

Deductions to Related Partners Are Deferred Until Paid

Section 707(b)(1) also pulls in a timing rule from Section 267(a)(2). An accrual-basis partnership cannot deduct amounts owed to a related cash-basis person — management fees, interest, and similar accrued expenses — until the person actually receives payment.¹ So a partnership that accrues a management fee to a controlling partner in December but pays it the following February takes the deduction in the payment year, not the accrual year.

Reporting and Penalties

Property transactions between related parties flow through the partnership return onto each partner’s Schedule K-1. Gain recharacterized under Section 707(b)(2) has to be reported as ordinary rather than capital, and disallowed losses simply cannot appear on the seller’s return. Form 1065 instructions define “related” by cross-reference to both Section 267(b) and Section 707(b).⁶

Getting it wrong exposes the return to the 20% accuracy-related penalty under Section 6662, which applies to underpayments attributable to negligence, substantial understatement, or substantial valuation misstatement.⁷ Deducting a disallowed loss or reporting recharacterized gain as capital can trigger any of those grounds. On a $50,000 loss improperly deducted by a taxpayer in the 37% bracket, the penalty alone runs roughly $3,700 on top of the back tax. Complex partnership returns involving related-party transactions typically run $750 to $5,000 or more in professional preparation fees, which is worth weighing against the cost of a botched attribution analysis.

1
Office of the Law Revision Counsel. 26 USC 707 – Transactions Between Partner and Partnership
2
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest with Respect to Transactions Between Related Persons
3
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest with Respect to Transactions Between Related Persons
4
Office of the Law Revision Counsel. 26 USC 1221 – Capital Asset Defined
5
Office of the Law Revision Counsel. 26 USC 453 – Installment Method
6
Internal Revenue Service. 2025 Instructions for Form 1065
7
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments