When you put cash or property into a partnership, the basis of your contributing partner’s interest starts at the cash contributed plus the adjusted basis of the property, measured on the day of the contribution. Fair market value doesn’t come into it. IRC Section 722 sets that starting number, and Section 705 then moves it up and down every year for income, losses, distributions, and shifts in your share of partnership debt. Getting it right controls how much loss you can deduct, whether distributions are tax-free, and what you’ll owe when you eventually sell.1Office of the Law Revision Counsel. 26 USC 722 Basis of Contributing Partner’s Interest
The Starting Number
Section 722 is short and mechanical. Add the cash you contribute to the adjusted basis of any property you contribute. That sum is your initial outside basis in the partnership interest.
Say you contribute equipment worth $100,000 that you originally bought for $60,000 and depreciated down to $40,000. Your outside basis is $40,000. The $60,000 spread between fair market value and adjusted basis doesn’t vanish; it becomes built-in gain that travels with your partnership interest. When you later sell the interest, or the partnership sells the equipment, that gain gets recognized.
Contribute cash and property together and you just add them. A $25,000 check plus property with a $40,000 adjusted basis gives you $65,000 of starting basis.
Outside Basis vs. Inside Basis
Two numbers get tracked from the day of contribution. Outside basis is your personal stake, kept on your own records. Inside basis is the partnership’s basis in the assets it holds. The partnership takes your contributed property at carryover basis, so in the equipment example above the partnership records $40,000 of inside basis for that asset.2Office of the Law Revision Counsel. 26 U.S. Code 723 – Basis of Property Contributed to Partnership It also inherits your holding period in the property.3eCFR. 26 CFR 1.723-1 – Basis of Property Contributed to Partnership
The two figures often start at the same amount and drift apart over years of depreciation, new asset purchases, and elections. Confusing them is where a lot of partnership tax mistakes begin.
Holding Period in the Interest You Received
If you contributed a capital asset or Section 1231 property, the holding period of that property tacks onto your holding period in the partnership interest. Three years of holding the property before contribution means three years of holding on the interest from day one.4eCFR. 26 CFR 1.1223-3 – Rules Relating to the Holding Periods of Partnership Interests Contribute cash or ordinary-income property like inventory, and the clock starts on the contribution date. Mix them, and the interest ends up with a divided holding period, split by the fair market value of the piece of the interest attributable to each contributed asset.
Liabilities Change the Number
Partnership debt drives basis under Section 752. Your share of partnership liabilities is treated as if you’d contributed that much cash, so it adds to outside basis. A drop in your allocated share is treated as a cash distribution, which reduces basis.5Office of the Law Revision Counsel. 26 U.S. Code 752 – Treatment of Certain Liabilities
This matters most when you contribute encumbered property. Suppose you contribute property carrying a $200,000 mortgage in exchange for a 25% interest. The partnership takes the full $200,000 debt, but only $50,000 gets allocated back to you. You’ve effectively been relieved of $150,000, treated as a deemed cash distribution. If that number exceeds your outside basis, the excess is taxable gain right there at contribution.
How the debt is classified affects who gets what share. Recourse liabilities, where at least one partner bears the economic risk of loss, are allocated to the partner who would ultimately be on the hook if the partnership couldn’t pay. Nonrecourse liabilities, which no partner is personally liable for, are allocated under a separate three-step process that draws on partnership minimum gain, Section 704(c) built-in gain, and profit-sharing ratios.6eCFR. 26 CFR 1.752-3 – Partner’s Share of Nonrecourse Liabilities For real estate partnerships, the nonrecourse share can be the main driver of a partner’s ability to absorb depreciation.
How Basis Changes Every Year
Section 722 gives you the opening number. From there, Section 705 controls the annual movement.7Office of the Law Revision Counsel. 26 USC 705 Determination of Basis of Partner’s Interest
Basis goes up for:
- Your share of partnership taxable income, whether or not any cash was distributed
- Your share of tax-exempt income, such as municipal bond interest
- Any additional cash or property you contribute
- Any net increase in your share of partnership liabilities
Basis goes down for:
- Cash distributed to you and the partnership’s basis in property distributed to you
- Your share of partnership losses and deductions
- Your share of nondeductible, noncapital expenses, such as the disallowed half of business meals or partnership penalties
- Any net decrease in your share of partnership liabilities
Basis cannot go below zero. When losses and distributions in the same year would push you past zero, increases apply before decreases, which sometimes lets a loss deduct that would otherwise be suspended. Losses that still can’t fit get carried forward until basis is rebuilt. Distributions that exceed remaining basis produce immediate gain.
When the Contribution Itself Isn’t Tax-Free
Section 721 treats most contributions as nonrecognition events, but there’s a real exception for investment companies. If the partnership would be treated as an investment company under the Section 351 rules, gain on the contributed property is recognized immediately.8Office of the Law Revision Counsel. 26 U.S. Code 721 – Nonrecognition of Gain or Loss on Contribution
The test looks at whether more than 80% of the partnership’s assets (setting aside cash and nonconvertible debt) are readily marketable stocks, securities, or interests in regulated investment companies, and whether the contribution results in diversification for the transferors. Two people each contributing a concentrated stock position to the same partnership can trip this because pooling gives each partner exposure neither had before.9eCFR. 26 CFR 1.351-1 – Transfer to Corporation Controlled by Transferor
When gain gets recognized under this exception, it’s added to your initial outside basis so you’re not taxed twice on the same appreciation.1Office of the Law Revision Counsel. 26 USC 722 Basis of Contributing Partner’s Interest
When Section 722 Doesn’t Apply
Section 722 covers contributions of cash and property. It doesn’t answer for two common paths into a partnership.
A partner who receives an interest in exchange for services falls outside 722 because nothing has been contributed. A capital interest received for services is generally taxable as compensation at its fair market value, and the recipient’s basis equals the amount recognized as income. A profits interest, which entitles the holder only to future profits and appreciation and not to existing assets, is generally not a taxable event on receipt under Rev. Proc. 93-27, subject to conditions in later guidance.10Internal Revenue Service. Rev. Proc. 2001-43 Its value at receipt is treated as zero, so the service partner starts with zero basis and can’t absorb losses until income allocations or contributions build basis up.
A partner who buys an interest from an existing partner is under Section 742, not 722. Basis equals cost, plus your share of any partnership liabilities assumed. Pay $500,000 for a 20% interest and your outside basis starts at $500,000 plus liabilities. Annual adjustments under 705 then apply the same way.11Office of the Law Revision Counsel. 26 U.S. Code 742 – Basis of Transferee Partner’s Interest
Why the Number Matters Later
Basis is the ceiling on loss deductions. Under Section 704(d), your share of partnership losses is deductible only up to your adjusted outside basis at year end, and the rest is suspended until basis is available.12Office of the Law Revision Counsel. 26 U.S. Code 704 – Partner’s Distributive Share – Section: (d) Limitation on Allowance of Losses Even if you clear this hurdle, the at-risk rules of Section 465 and the passive activity rules of Section 469 apply next, and losses have to survive all three to reach your return.
Basis also controls distributions. Cash distributions are tax-free up to your outside basis; anything over triggers gain treated as if you’d sold part of your interest.13Office of the Law Revision Counsel. 26 U.S. Code 731 – Extent of Recognition of Gain or Loss on Distribution Property distributions generally reduce your outside basis by the partnership’s basis in the property under Section 733.14Office of the Law Revision Counsel. 26 U.S. Code 733 – Basis of Distributee Partner’s Interest
And when you sell, the math is simple: amount realized minus adjusted outside basis. Years of tax-free distributions leave a lower basis and a larger gain on the way out. That’s the deferred bill.
Keep the Records
Tracking outside basis is on you, not the partnership. Schedule K-1 reports your capital account on the tax-basis method, which captures contributions, income, and distributions, but capital account isn’t the same as outside basis because outside basis also includes your share of liabilities.15Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) (2025)
Because a contribution is a nontaxable exchange, the IRS expects you to keep records on both the originally contributed property and the partnership interest itself until the limitations period runs for the year you dispose of the interest.16Internal Revenue Service. How Long Should I Keep Records? For an interest held for decades, that means decades of records. Losing the paper trail on your original contribution, your allocated share of liabilities, or the annual income and loss numbers can leave you unable to prove any basis at all, which turns the full sale price into taxable gain.