IRC 732: Basis of Distributed Partnership Property

Under IRC Section 732, the basis of distributed property depends on whether the partnership distribution is current or liquidating. In a current (non-liquidating) distribution, you take the partnership’s basis in the property, but not more than your outside basis in the partnership. In a liquidating distribution, your basis in the property equals whatever outside basis you had left after subtracting any cash received in the same transaction. Get this number right and your future gain or loss on sale falls out cleanly; get it wrong and every downstream calculation is off.

Current Distributions: Carryover Basis With a Ceiling

A current distribution is any distribution that leaves you still holding a partnership interest afterward. The default rule under Section 732(a)(1) is that you take the same basis the partnership had in the property immediately before it distributed it to you.¹ That is often called a carryover basis, because the partnership’s inside basis carries over to you unchanged.

If your outside basis is $150,000 and the partnership distributes equipment it carried at $40,000, your basis in the equipment is $40,000. Your outside basis drops by that same $40,000, to $110,000.

The carryover rule has one hard ceiling. Under Section 732(a)(2), your basis in the distributed property cannot exceed your outside basis (reduced by any cash distributed in the same transaction).¹ When the partnership’s inside basis in the property is higher than your remaining outside basis, the property’s basis is capped and your outside basis falls to zero.

Suppose your outside basis is $75,000 and you receive land the partnership carried at $100,000. Your basis in the land is capped at $75,000, and your outside basis goes to zero. The $25,000 gap does not disappear; it is preserved as built-in gain you will recognize when you sell the land.

Liquidating Distributions: Substituted Basis

A liquidating distribution completely terminates your interest in the partnership, and the basis rule flips. Under Section 732(b), your basis in the distributed property equals your outside basis in the partnership, reduced by any cash distributed in the same transaction.¹ The partnership’s inside basis in the property does not control the answer.

Your entire remaining outside basis moves to the distributed assets. In a current distribution, that outside basis is only a ceiling; in a liquidation, it is the exact amount assigned. Compared to what the partnership was carrying, the result can be either a step-up or a step-down.

Say your outside basis is $200,000 and you receive two assets in a liquidating distribution. Asset A has an inside basis of $50,000 and Asset B has an inside basis of $175,000. The combined inside basis is $225,000, but only $200,000 of basis is available, so $25,000 of basis has to be squeezed out through the allocation rules below. If your outside basis had been $250,000 instead, the two assets would have received a combined $25,000 step-up.

How Cash in the Same Distribution Changes the Math

Cash comes first. Both Section 732(a)(2) and Section 732(b) require you to reduce outside basis by any money distributed in the same transaction before you calculate the basis of property.¹ That ordering matters because it shrinks the pool of basis available for property.

If the partnership distributes $30,000 cash and equipment with an inside basis of $60,000 to a partner with a $75,000 outside basis, the cash reduces outside basis to $45,000 first. The equipment then takes a basis of $45,000 (the carryover figure would have been $60,000, but the outside-basis cap kicks in), and outside basis drops to zero.

Cash can also trigger immediate gain. Under Section 731(a)(1), if the money distributed exceeds your outside basis, you recognize gain equal to the excess.² That gain is treated as gain from the sale of your partnership interest, which is generally capital gain.³ The rule applies to both current and liquidating distributions. For this purpose, marketable securities count as money and are valued at fair market value on the distribution date.⁴

When You Can Recognize a Loss

You can never recognize a loss on a current distribution. Loss recognition is available only in a liquidating distribution, and only when you receive nothing other than cash, unrealized receivables, or inventory.⁴ If even one other asset comes through in the same liquidation (equipment, real estate, stock, anything else), the loss is blocked entirely.

When a loss does qualify, the amount equals the excess of your outside basis over the sum of cash distributed plus the basis of any unrealized receivables and inventory received (as determined under Section 732).⁴ Like gain, this loss is treated as arising from the sale of your partnership interest.

If your outside basis is $120,000 and you receive $50,000 cash and inventory with a basis of $30,000 in a complete liquidation, your recognized loss is $40,000. Add a piece of equipment to that same liquidation and the loss disappears, whatever the other numbers look like.

Allocating Basis Across Multiple Assets

When more than one property comes out in the same distribution and either the current-distribution cap applies or a liquidation forces basis substitution, the available basis has to be split among the assets. Section 732(c) sets a specific order, and it is designed to keep ordinary income from being converted into capital gain.¹

Hot Assets First

Basis is assigned first to unrealized receivables and inventory items (the “hot assets”). Each hot asset takes a basis equal to the partnership’s inside basis in that asset, capped at that inside basis no matter how much outside basis you still have.¹ If the outside basis available is not even enough to cover the hot assets’ inside basis, the shortfall reduces the hot assets’ basis proportionally.

Then the Other Properties

Whatever basis remains after the hot-asset step is allocated to the other distributed properties (capital assets and Section 1231 property). If that remainder equals the combined inside basis of those properties, each simply keeps its carryover basis. When the numbers don’t match, a decrease or an increase has to be spread.

Allocating a Decrease

A decrease is required when the remaining outside basis is less than the combined inside basis of the non-hot assets. The statute walks you through two steps:¹

Allocate the decrease first to properties with unrealized depreciation (inside basis above fair market value), in proportion to each property’s depreciation, up to the amount of that depreciation.
Then allocate any remaining decrease among those properties in proportion to their adjusted bases (after the first-step reduction).

A worked example. Partner P has an outside basis of $150,000 and receives three assets in a liquidating distribution:

Asset A (inventory): inside basis $50,000
Asset B (capital): inside basis $100,000, FMV $80,000 ($20,000 unrealized depreciation)
Asset C (capital): inside basis $70,000, FMV $60,000 ($10,000 unrealized depreciation)

Total inside basis is $220,000; only $150,000 is available. Asset A takes its full $50,000, leaving $100,000 for Assets B and C. Their combined inside basis is $170,000, so a $70,000 decrease is required.

Step one allocates by unrealized depreciation. Total depreciation between B and C is $30,000. Asset B absorbs $20,000 and Asset C absorbs $10,000, dropping their bases to $80,000 and $60,000. That accounts for $30,000 of the $70,000; $40,000 remains.

Step two allocates by adjusted basis. Combined adjusted basis is $140,000. Asset B absorbs 80,000/140,000 × $40,000 = $22,857, and Asset C absorbs 60,000/140,000 × $40,000 = $17,143. Final bases: B is $57,143, C is $42,857. Add Asset A’s $50,000 and the total ties back to Partner P’s $150,000 outside basis.

Allocating an Increase

An increase applies only in a liquidating distribution, when remaining outside basis exceeds the combined inside basis of the non-hot assets. Again, two steps:¹

Allocate the increase first to properties with unrealized appreciation (FMV above inside basis), in proportion to each property’s appreciation, up to that appreciation amount.
Then allocate any remaining increase in proportion to the properties’ fair market values.

Partner Q has an outside basis of $200,000 and receives three assets in a liquidating distribution:

Asset D (inventory): inside basis $50,000
Asset E (capital): inside basis $70,000, FMV $100,000 ($30,000 unrealized appreciation)
Asset F (capital): inside basis $40,000, FMV $80,000 ($40,000 unrealized appreciation)

Total inside basis is $160,000, $40,000 less than the $200,000 outside basis. Asset D takes $50,000, leaving $150,000 for E and F. Their combined inside basis is $110,000, so a $40,000 increase is needed. Total unrealized appreciation is $70,000, more than the increase, so step one absorbs the whole thing. Asset E gets 30,000/70,000 × $40,000 = $17,143 (new basis $87,143). Asset F gets 40,000/70,000 × $40,000 = $22,857 (new basis $62,857). The three assets combined equal Partner Q’s $200,000.

Holding Period and Character After You Receive the Property

Your holding period generally includes the time the partnership held the property. Section 735(b) tacks the partnership’s holding period onto yours for long-term versus short-term capital gain purposes.⁵ Three years in the partnership means you’re treated as having held the asset three years the moment you receive it.

Character carries a wrinkle for inventory. If you sell distributed inventory within five years of the distribution date, any gain or loss is ordinary, even if the asset would otherwise be a capital asset in your hands.⁵ After five years, character depends on how you actually use it. Unrealized receivables always produce ordinary income, no matter how long you hold them.

The Section 732(d) Election for Recent Purchasers

Section 732(d) targets a specific problem: you bought your partnership interest at a price that differs from the partnership’s inside basis attributable to your share, and the partnership does not have a Section 754 election in effect. Without a 754 election, nothing adjusts the inside basis to match what you paid. Section 732(d) lets you fix the mismatch when property is later distributed to you.

The election is available if you acquired your interest by transfer (typically a purchase) and the partnership distributes property to you within two years of that transfer.⁶ It lets you treat the partnership as if a Section 754 election had been in effect when you acquired your interest, but only for purposes of computing the basis of the distributed property. The regular 732(a) or 732(b) rules then run on that adjusted figure.

If you paid $100,000 for an interest when the partnership’s basis attributable to your share was only $70,000, a 754 election would have produced a $30,000 positive adjustment. The 732(d) election applies that $30,000 to the basis of the distributed property before the normal calculations run.

When 732(d) Is Mandatory

The Treasury Regulations require you to apply the 732(d) adjustment (regardless of whether two years have passed) when three conditions were all met at the time you acquired your interest:²

The fair market value of all partnership property (other than money) exceeded 110% of the partnership’s adjusted basis in that property.
An allocation under Section 732(c) upon an immediate hypothetical liquidation would have shifted basis from non-depreciable property to depreciable property.
A Section 743(b) adjustment would have changed the basis of the property actually distributed to you.

All three have to be present. The rule prevents a partner from exploiting the absence of a 754 election to shift basis from land onto depreciable equipment and generate larger depreciation deductions. To make the election, attach a statement to your tax return for the year of the distribution identifying the election under Section 732(d).

What Section 732 Does Not Handle Alone

Section 732 sets your basis in what you receive, but two other provisions can override or precede that calculation, and the answer changes if either is in play.

Section 751(b) treats certain disproportionate distributions of hot assets as a deemed sale between you and the partnership, producing ordinary gain outside the Section 732 framework. If you receive more than your share of hot assets in exchange for giving up your share of other partnership property (or the reverse), the exchange portion is recharacterized before you get to Section 732. Property you originally contributed and Section 736(a) payments to a retiring partner or a deceased partner’s successor are excepted.⁷

Section 734(b) is the partnership’s problem, not yours, but it explains what happens on the other side of the ledger. When a distribution creates a mismatch between the partnership’s inside basis and the remaining partners’ outside bases, the partnership adjusts the basis of retained assets, either optionally (if a Section 754 election is in effect) or mandatorily (if the distribution triggers a “substantial basis reduction,” meaning a required downward adjustment above $250,000).⁸ Your basis in the distributed property is fixed by Section 732 either way.

1
Office of the Law Revision Counsel. 26 U.S. Code 732 – Basis of Distributed Property Other Than Money
2
eCFR. 26 CFR 1.732-1 – Basis of Distributed Property Other Than Money
3
eCFR. 26 CFR 1.731-1 – Extent of Recognition of Gain or Loss on Distribution
4
Office of the Law Revision Counsel. 26 U.S. Code 731 – Extent of Recognition of Gain or Loss on Distribution
5
Office of the Law Revision Counsel. 26 U.S. Code 735 – Character of Gain or Loss on Disposition of Distributed Property
6
Justia. 26 U.S.C. 732 – Basis of Distributed Property Other Than Money
7
Office of the Law Revision Counsel. 26 U.S. Code 751 – Unrealized Receivables and Inventory Items
8
Office of the Law Revision Counsel. 26 U.S. Code 734 – Adjustment to Basis of Undistributed Partnership Property Where Section 754 Election or Substantial Basis Reduction