Partnership Taxation Basis Notes: Inside vs Outside Basis [Worked Examples]

Partnership taxation basis is the tax figure that decides how much loss a partner can deduct and how much gain a partner recognizes on a distribution. Every partner carries two basis numbers at once. Inside basis is the partnership’s basis in its own assets. Outside basis is the partner’s basis in the partnership interest. REG tests whether a candidate can track both. For the full set of REG study notes, visit the CPA notes hub.

What Partnership Taxation Basis Means

Partnership taxation basis has two parts: inside basis, the partnership’s basis in its assets, and outside basis, a partner’s basis in the partnership interest. Inside basis sets gain or loss on a partnership sale. Outside basis sets deductible loss and distribution gain.

Under section 701, a partnership pays no income tax. Partners pay tax on their distributive shares. Also, section 702(a) requires each partner to take into account separately the partner’s share of income, gains, losses, deductions, and credits, including separately stated items.

Partnership taxation falls in REG Area V, Federal Taxation of Entities, weighted 23 to 33 percent, under the AICPA Uniform CPA Examination Blueprints (approved 18 August 2025, effective January 2026). REG lasts 4 hours, with 72 multiple choice questions and 8 task-based simulations. Finally, the passing score is 75 on the 0 to 99 scale.

Outside Basis: How Partnership Taxation Basis Starts at Contribution

First, under section 721(a), a contribution of property in exchange for a partnership interest triggers no gain or loss. However, it does not apply to services: a partner who receives an interest for services recognizes ordinary income equal to its fair market value.

Section 722 sets the basis of a partnership interest acquired by contribution at the money contributed plus the adjusted basis of the contributed property, plus any gain the contributing partner recognizes. In short, adjusted basis is the key point, not fair market value. Property worth $50,000 with an adjusted basis of $30,000 gives $30,000 of basis.

Under section 752(a), an increase in a partner’s share of partnership liabilities counts as a contribution of money and increases outside basis. In contrast, section 752(b) treats a decrease as a distribution of money that decreases outside basis. An assumed liability then reduces the contributor’s outside basis by the other partners’ share.

Inside Basis and the 704(c) Built-In Gain Rule

Under section 723, the partnership takes the contributor’s adjusted basis in contributed property immediately before contribution (carryover basis). So, there is no step-up to fair market value. Therefore, built-in gain or loss carries over.

Under section 704(c)(1)(A), partners must share items with respect to contributed property to reflect the variation between the partnership’s basis and fair market value at contribution; therefore, the built-in gain or loss goes back to the contributing partner.

Under section 704(c)(1)(B), if contributed property passes to another partner within 7 years of contribution, the contributor then recognizes gain or loss as if the property had been sold at fair market value. Similarly, section 737 adds a guard for other property.

Annual Adjustments: How Partnership Taxation Basis Moves Each Year

Section 705(a) lists the annual adjustments. Increases: contributions, higher liability shares, taxable income, tax-exempt income, excess depletion. Decreases (never below zero): distributions (section 733), losses, nondeductible expenditures, oil and gas depletion, foreign taxes (post-2017).

Section 704(d) sets the first loss limitation hurdle: a partner deducts a loss only to the extent of outside basis at year end, and any excess carries over to a later year with sufficient basis. After the basis limitation, at-risk rules (section 465) and passive activity rules (section 469) apply.

Distributions and the Zero Floor

Under section 731(a)(1), a partner recognizes gain only to the extent money distributed exceeds outside basis before the distribution, as capital gain. Section 731(b) gives the partnership no gain or loss on a distribution of property. A partner recognizes loss only under section 731(a)(2): the entire interest must be liquidated, the distribution must be solely money, unrealized receivables, or inventory items, and basis must exceed it.

For a nonliquidating distribution, section 732(a) gives the property the partnership’s basis, capped at outside basis less money received. In a complete liquidation, section 732(b) gives the property outside basis less money received. Section 733: a money distribution reduces outside basis, never below zero.

Worked Example 1: Formation with Debt

A partner contributes $20,000 cash plus property (fair market value $50,000, adjusted basis $30,000) subject to a $10,000 mortgage assumed by the partnership, and receives a 50 percent interest. The example assumes the 50 percent interest, as the fact pattern gives no ownership percentage. The contribution triggers no gain under section 721.

First, Step 1: $20,000 cash plus $30,000 adjusted basis equals $50,000 outside basis before debt relief (section 722). Next, Step 2: the partner retains 50 percent of the $10,000 mortgage, which is $5,000 (section 752(a)). Step 3: $10,000 assumed minus $5,000 retained equals $5,000 net relief, a deemed money distribution (section 752(b)). Step 4: $50,000 minus $5,000 equals $45,000.

Then, Step 5: no gain, since the $5,000 deemed distribution is less than the $50,000 pre-relief basis (section 731(a)). Step 6: inside basis equals the $30,000 carryover basis (section 723) plus $20,000 cash, for $50,000 total. Finally, Step 7: built-in gain is $50,000 minus $30,000, or $20,000, and section 704(c) allocates it to the contributor.

Worked Example 2: Operating Year and Liquidation

A partner starts the year with outside basis of $40,000. The partner’s distributive share of income is $15,000 and of loss is $10,000, the figure given for this example. Next, the partner receives a $25,000 cash distribution. Then the partnership liquidates the entire interest with property (fair market value $30,000, partnership basis $18,000) and no money.

Step 1: $40,000 plus $15,000 income equals $55,000 (section 705(a)). Step 2: $55,000 minus $10,000 loss equals $45,000. The full loss is deductible; therefore, section 704(d) suspends nothing. Then, Step 3: $45,000 minus $25,000 cash distribution equals $20,000 remaining outside basis (section 733). No gain arises, because the $25,000 cash stays below the $45,000 basis before the distribution (section 731(a)(1)).

Step 4: the partner’s basis in the distributed property becomes the remaining $20,000 outside basis (section 732(b)), not the partnership’s $18,000 basis. Then, Step 5: no gain or loss on liquidation: the partnership distributed no money in excess of basis, and loss requires a distribution of only money, unrealized receivables, or inventory items (section 731(a)(2)). Step 6: ending outside basis is $0. Finally, Step 7: deferred appreciation equals $30,000 minus $20,000, or $10,000.

The Section 754 Election and the $250,000 Tests

Section 754 lets a partnership elect to apply sections 734(b) (distributions) and 743(b) (transfers). The election is a written statement attached to the partnership return (Form 1065). It applies until revoked; however, revocation requires IRS approval.

Under section 743(a), property basis stays unadjusted on a transfer by sale, exchange, or death unless a section 754 election is in effect or a substantial built-in loss exists. Next, section 743(b) sets the adjustment at the difference between the transferee’s basis in the interest and the transferee’s proportionate share of partnership property basis. It applies to the transferee only.

A substantial built-in loss under section 743(d) exists if partnership basis exceeds fair market value by more than $250,000, or a sale at fair market value right after the transfer would allocate the transferee a loss of more than $250,000. Then the adjustment becomes mandatory even with no election. Under section 734(d), the same $250,000 test makes a negative section 734(b) adjustment mandatory even with no election.

Exam Traps in Partnership Taxation Basis

• Fair market value is not basis. Sections 722 and 723 use adjusted basis.
• Debt relief is a deemed cash distribution (section 752(b)). An assumed mortgage reduces outside basis by the share assumed by the other partners.
• Basis cannot go below zero. Decreases under section 705 stop at zero; excess losses are suspended under section 704(d).
• Pre-contribution gain follows the contributor (section 704(c)). Distributing contributed property to another partner within 7 years triggers gain or loss.
• A disguised sale is a rebuttable presumption (Reg. section 1.707-3). A contribution followed by a related distribution within two years is presumed a sale.
• Marketable securities are money. Under section 731(c), marketable securities distributed are treated as money at fair market value.
• Hot assets convert capital gain to ordinary income. Under section 751, gain from unrealized receivables and inventory is ordinary income.
• Loss on liquidation is narrow (section 731(a)(2)). A loss is recognized only on a complete liquidation, and only if the distribution is solely money, unrealized receivables, or inventory items.

One-Page Revision Box

Rule	Section	Key test
No gain on contribution	721(a)	Services excepted
Outside basis	722	Cash plus adjusted basis
Inside basis	723	Carryover basis, no step-up
Built-in gain	704(c)	To contributor; 7-year rule
Loss limited	704(d)	Excess carried forward
Annual adjustments	705(a)	Increases and decreases; never below zero
Gain or loss on distribution	731(a)	Money over basis; liquidation for loss
Distributed property	732(a), 732(b)	Nonliquidating: capped; liquidating: outside less money
Hot assets	751	Receivables, inventory: ordinary income
Section 754 and $250,000 tests	754, 743(d), 734(d)	Form 1065 election; over $250,000
REG Area V	Blueprints	23-33%; 4 hours; 72 MCQs; 8 TBSs; pass 75

Example 1: outside basis $45,000, inside basis $50,000, built-in gain $20,000. Example 2: $40,000 start, $15,000 income, $10,000 loss, $25,000 distribution, property basis $20,000, ending $0, deferred appreciation $10,000.

Finally, work both examples again, then compare partnerships with the S corporation and C corporation rules: the S corporation taxation REG note and the C corporation taxation note. For the full set of REG study notes, return to the CPA notes hub.