A partial redemption of a partnership interest is taxed as a current, non-liquidating distribution under IRC Section 731: the partner who is bought back reduces outside basis by the cash received, recognizes gain only if that cash (including any deemed cash from a shift in partnership debt) exceeds remaining basis, cannot recognize a loss, and may see part of the result converted to ordinary income if the partnership holds hot assets. Because the partner keeps a residual interest, Section 736 (which governs complete liquidations) does not apply, and that single fact drives every downstream consequence for both the partner and the partnership.
Why It’s a Section 731 Distribution, Not a Sale or Liquidation
Three different transactions get confused in practice, and each one runs on a different code section.
A sale of the interest to another partner or an outside buyer is a Section 741 transaction. The selling partner recognizes capital gain or loss equal to amount realized minus outside basis, and the partnership itself is largely a bystander. A Section 743(b) inside-basis adjustment applies to the buyer’s share if a Section 754 election is in place.
A complete liquidation of a partner’s entire interest by the partnership runs through Section 736, which splits payments between amounts for the partner’s share of partnership property and amounts characterized as guaranteed payments or a distributive share. The regulations state that Section 736 applies “only to payments made to a retiring partner or to a deceased partner’s successor in interest in liquidation of such partner’s entire interest.”1eCFR. 26 CFR 1.736-1 – Payments to a Retiring Partner or a Deceased Partner’s Successor in Interest A partial redemption leaves the partner in place with a smaller interest, so Section 736 is out.
What remains is Section 731. The partnership distributes cash (or property) to the partner in exchange for a portion of the interest, no gain is recognized unless total cash exceeds adjusted outside basis, and loss cannot be recognized on a current distribution.2Office of the Law Revision Counsel. 26 U.S. Code 731 – Extent of Recognition of Gain or Loss on Distribution Section 751(b) may recharacterize part of the distribution as ordinary income where hot assets are involved.
Gain, Basis, and the No-Loss Rule for the Redeeming Partner
The mechanics for the partner are straightforward on paper. Cash received reduces outside basis dollar for dollar. Only when total cash exceeds the partner’s entire adjusted outside basis does gain appear, and the excess is treated as gain from the sale of a partnership interest, generally capital gain. No loss is allowed on a current distribution, no matter how small the payment.2Office of the Law Revision Counsel. 26 U.S. Code 731 – Extent of Recognition of Gain or Loss on Distribution
Installment payments do not change this. The partnership isn’t doing a Section 453 installment sale; each payment is its own distribution under Section 731, each reduces basis in turn, and gain surfaces only in the year cumulative distributions push past remaining basis.
Gain is long-term capital gain if the redeemed portion of the interest was held more than a year. A partner who built up the interest in tranches at different times may have a split holding period, with each portion’s period determined separately based on its fair market value relative to the whole.3eCFR. 26 CFR 1.1223-3 – Rules Relating to the Holding Periods of Partnership Interests
Deemed Cash From Debt Relief
The trap that catches partners most often is the automatic shift in partnership liabilities. When ownership percentage drops, the partner’s allocable share of partnership debt drops with it, and under Section 752 any decrease in a partner’s share of liabilities is treated as a distribution of cash to that partner.4Office of the Law Revision Counsel. 26 U.S. Code 752 – Treatment of Certain Liabilities That deemed cash stacks on top of the actual cash paid in the redemption.
If actual cash plus deemed cash from debt relief exceeds adjusted outside basis, the excess is taxable gain that the partner never receives in hand. For a partnership carrying significant debt, this phantom gain can dwarf the check itself. The liability shift needs to be modeled before the redemption price is finalized, not after.
Hot Assets and Ordinary Income
The clean capital-gain result gets complicated when the partnership holds hot assets. Section 751 defines these as unrealized receivables and inventory items.5Office of the Law Revision Counsel. 26 U.S. Code 751 – Unrealized Receivables and Inventory Items Unrealized receivables are rights to payment for goods or services not yet included in income under the partnership’s accounting method. Inventory items are “substantially appreciated” when their aggregate fair market value exceeds 120 percent of the partnership’s adjusted basis in them.6eCFR. 26 CFR 1.751-1 – Unrealized Receivables and Inventory Items
When a distribution changes a partner’s proportionate share of hot assets versus other property, Section 751(b) treats the shifting portion as a deemed sale or exchange between the partner and the partnership, and the piece attributable to the partner’s share of hot assets is taxed as ordinary income rather than capital gain. The mechanics compare the partner’s share of hot and cold assets before and after the distribution and treat any shift as an exchange of one type for the other. The IRS has itself called the regulations “extraordinarily complex and burdensome,” but they remain in force.7Internal Revenue Service. Notice 2006-14 – Certain Distributions Treated As Sales or Exchanges
Net Investment Income Tax
An additional 3.8 percent Net Investment Income Tax can apply to gain from a partial redemption. It hits the lesser of net investment income or the amount by which modified adjusted gross income exceeds the filing-status threshold. The thresholds are not indexed for inflation:
- Married filing jointly: $250,000
- Single or head of household: $200,000
- Married filing separately: $125,000
Net investment income includes capital gains and income from passive activities.8Internal Revenue Service. Questions and Answers on the Net Investment Income Tax Whether the gain is subject to NIIT turns largely on material participation. A passive investor owes the tax on any resulting gain; a partner who actively ran the business generally does not, except on capital gain attributable to assets not used in the active trade or business.
Partnership-Level Consequences
The partnership must adjust its books immediately. Under the capital account maintenance rules, the redeeming partner’s capital account is decreased by the fair market value of property (including cash) distributed.9eCFR. 26 CFR 1.704-1 – Partner’s Distributive Share The reduced profit-and-loss percentage is then reallocated among the continuing partners under the amended agreement.
The Section 754 Election and Inside Basis
Without a Section 754 election, the partnership’s inside basis in its assets does not change when the redeeming partner recognizes gain. The continuing partners effectively inherit built-in gain that has already been taxed once at the departing partner’s level. A Section 754 election closes the mismatch by requiring a Section 734(b) adjustment.10Office of the Law Revision Counsel. 26 U.S. Code 754 – Manner of Electing Optional Adjustment to Basis of Partnership Property
With the election in effect and the redeeming partner recognizing gain under Section 731(a)(1), the partnership increases the adjusted basis of its remaining assets by the amount of that gain.11Office 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 The increase is allocated across assets under Section 755 based on the difference between each asset’s fair market value and existing tax basis. Continuing partners then aren’t taxed a second time on appreciation that already triggered a bill for the departing partner.
The election is durable. Once made, it applies to every distribution and every transfer of a partnership interest for that year and all future years, and it can only be revoked with the IRS Commissioner’s permission. Revocation requires filing Form 15254 no later than 30 days after the close of the partnership year for which the revocation is intended.12Internal Revenue Service. FAQs for Internal Revenue Code (IRC) Sec. 754 Election and Revocation
To make the election, the partnership attaches a written statement to a timely filed Form 1065 (including extensions) for the year of the distribution. The statement includes the partnership’s name and address and a declaration that it elects under Section 754 to apply Sections 734(b) and 743(b).12Internal Revenue Service. FAQs for Internal Revenue Code (IRC) Sec. 754 Election and Revocation If the deadline is missed, an automatic 12-month extension is available under Treasury Regulation 301.9100-2. Beyond 12 months, relief becomes discretionary under Section 301.9100-3.
Mandatory Adjustment Without an Election
Even without a Section 754 election, a basis adjustment becomes mandatory when there is a “substantial basis reduction,” meaning the downward adjustment that would have been required under Section 734(b) exceeds $250,000.11Office 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 For large-dollar partial redemptions, the numbers need to be run even if no election is on file.
Disguised Sale Risk
If a partial redemption sits close in time to a contribution of property by the same partner, the IRS may collapse the two under the disguised sale rules of IRC Section 707 and Treasury Regulation 1.707-3. Property in from the partner, cash out from the partnership in a related transaction, and the arrangement can be recharacterized as an outright sale of the property rather than a contribution followed by a distribution.13eCFR. 26 CFR 1.707-3 – Disguised Sales of Property to Partnership; General Rules When that happens, the partner recognizes gain or loss on the property as if sold outright, and the nonrecognition rules of Sections 721 and 731 fall away.
A disguised sale is treated as a sale “for all purposes of the Internal Revenue Code,” pulling in the installment sale, imputed interest, and original issue discount rules.13eCFR. 26 CFR 1.707-3 – Disguised Sales of Property to Partnership; General Rules Where a partial redemption follows a property contribution, documenting the independent business purpose of each transaction matters.
Reporting the Redemption
The partnership reports the transaction on its annual Form 1065. The redeeming partner’s Schedule K-1 for the year must reflect the reduced capital account balance and revised profit-and-loss percentage. If payment is spread across years, each year’s K-1 reflects the distributions made in that year.
Calendar-year partnerships file Form 1065 by March 15 of the following year, with an automatic six-month extension available through Form 7004. Late filing costs $255 per partner for each month or part of a month the return is late, up to 12 months.14Internal Revenue Service. 2025 Instructions for Form 1065 A 10-partner entity filing three months late accrues $7,650 in penalties before the underlying tax is even calculated.
If the partnership makes (or already has) a Section 754 election, the required statement is attached to the return for the year the distribution occurs. Missing the attachment does not kill the election if relief is sought in time, but delay pushes the partnership into the harder discretionary relief process.