Example 2.   If, in Example 1, the contributed property had a $12,000 mortgage, the basis of John's partnership interest would be zero. The $1,600 difference between the mortgage assumed by the other partners, $9,600 (80% × $12,000), and his basis of $8,000 would be treated as capital gain from the sale or exchange of a partnership interest. However, this gain would not increase the basis of his partnership interest.

Book value of partner's interest.   The adjusted basis of a partner's interest is determined without considering any amount shown in the partnership books as a capital, equity, or similar account.

Example.   Sam contributes to his partnership property that has an adjusted basis of $400 and a fair market value of $1,000. His partner contributes $1,000 cash. While each partner has increased his capital account by $1,000, which will be reflected in the partnership books, the adjusted basis of Sam's interest is only $400 and the adjusted basis of his partner's interest is $1,000.

When determined.   The adjusted basis of a partner's partnership interest is ordinarily determined at the end of the partnership's tax year. However, if there has been a sale or exchange of all or part of the partner's interest or a liquidation of his or her entire interest in a partnership, the adjusted basis is determined on the date of sale, exchange, or liquidation.

Alternative rule for figuring adjusted basis.   In certain cases, the adjusted basis of a partnership interest can be figured by using the partner's share of the adjusted basis of partnership property that would be distributed if the partnership terminated.

This alternative rule can be used in either of the following situations.

• The circumstances are such that the partner cannot practicably apply the general basis rules.
• It is, in the opinion of the IRS, reasonable to conclude that the result produced will not vary substantially from the result under the general basis rules.

Adjustments may be necessary in figuring the adjusted basis of a partnership interest under the alternative rule. For example, adjustments would be required to include in the partner's share of the adjusted basis of partnership property any significant discrepancies that resulted from contributed property, transfers of partnership interests, or distributions of property to the partners.

Effect of Partnership Liabilities

A partner's basis in a partnership interest includes the partner's share of a partnership liability only if, and to the extent that, the liability:

1. Creates or increases the partnership's basis in any of its assets,
2. Gives rise to a current deduction to the partnership, or
3. Is a nondeductible, noncapital expense of the partnership.

The term assets in (1) includes capitalized items allocable to future periods, such as organization expenses.

A partner's share of accrued but unpaid expenses or accounts payable of a cash basis partnership are not included in the adjusted basis of the partner's interest in the partnership.

Partner's basis increased.   If a partner's share of partnership liabilities increases, or a partner's individual liabilities increase because he or she assumes partnership liabilities, this increase is treated as a contribution of money by the partner to the partnership.

Partner's basis decreased.   If a partner's share of partnership liabilities decreases, or a partner's individual liabilities decrease because the partnership assumes his or her individual liabilities, this decrease is treated as a distribution of money to the partner by the partnership.

Assumption of liability.   A partner or related person is considered to assume a partnership liability only to the extent that:

1. He or she is personally liable for it,
2. The creditor knows that the liability was assumed by the partner or related person,
3. The creditor can demand payment from the partner or related person, and
4. No other partner or person related to another partner will bear the economic risk of loss on that liability immediately after the assumption.

Related person.   Related persons, for these purposes, includes all the following.

• An individual and his or her spouse, ancestors, and lineal descendants.
• An individual and a corporation if the individual directly or indirectly owns 80% or more in value of the outstanding stock of the corporation.
• Two corporations that are members of the same controlled group.
• A grantor and a fiduciary of any trust.
• Fiduciaries of two separate trusts if the same person is a grantor of both trusts.
• A fiduciary and a beneficiary of the same trust.
• A fiduciary and a beneficiary of two separate trusts if the same person is a grantor of both trusts.
• A fiduciary of a trust and a corporation if the trust or the grantor of the trust directly or indirectly owns 80% or more in value of the outstanding stock of the corporation.
• A person and a tax-exempt educational or charitable organization controlled directly or indirectly by the person or by members of the person's family.
• A corporation and a partnership if the same persons own 80% or more in value of the outstanding stock of the corporation and 80% or more of the capital or profits interest in the partnership.
• Two S corporations or an S corporation and a C corporation if the same persons own 80% or more in value of the outstanding stock of each corporation.
• An executor and a beneficiary of an estate.
• A partnership and a person owning, directly or indirectly, 80% or more of the capital or profits interest in the partnership.
• Two partnerships if the same persons directly or indirectly own 80% or more of the capital or profits interests.

Property subject to a liability.   If property contributed to a partnership by a partner or distributed by the partnership to a partner is subject to a liability, the transferee is treated as having assumed the liability to the extent it does not exceed the fair market value of the property.

Partner's share of recourse liabilities.   A partnership liability is a recourse liability to the extent that any partner or a related person, defined earlier, has an economic risk of loss for that liability. A partner's share of a recourse liability equals his or her economic risk of loss for that liability. A partner has an economic risk of loss if that partner or a related person would be obligated (whether by agreement or law) to make a net payment to the creditor or a contribution to the partnership with respect to the liability if the partnership were constructively liquidated. A partner who is the creditor for a liability that would otherwise be a nonrecourse liability of the partnership has an economic risk of loss in that liability.

Constructive liquidation.   Generally, in a constructive liquidation, the following events are treated as occurring at the same time.

• All partnership liabilities become payable in full.
• All of the partnership's assets have a value of zero, except for property contributed to secure a liability.
• All property is disposed of by the partnership in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor's right to reimbursement is limited solely to one or more assets of the partnership).
• All items of income, gain, loss, or deduction are allocated to the partners.
• The partnership liquidates.

Example.   Ted and Jane form a cash basis general partnership with cash contributions of $20,000 each. Under the partnership agreement, they share all partnership profits and losses equally. They borrow $60,000 and purchase depreciable business equipment. This debt is included in the partners' basis in the partnership because incurring it creates an additional $60,000 of basis in the partnership's depreciable property.

If Jane is required to pay the creditor if the partnership defaults, she has an economic risk of loss in the liability. Her basis in the partnership would be $80,000 ($20,000 + $60,000), while Ted's basis would be $20,000.

Limited partner.   A limited partner generally has no obligation to contribute additional capital to the partnership and therefore does not have an economic risk of loss in partnership recourse liabilities. Thus, absent some other factor, such as the guarantee of a partnership liability by the limited partner or the limited partner making the loan to the partnership, a limited partner generally does not have a share of partnership recourse liabilities.

Partner's share of nonrecourse liabilities.   A partnership liability is a nonrecourse liability if no partner or related person has an economic risk of loss for that liability. A partner's share of nonrecourse liabilities is generally proportionate to his or her share of partnership profits. However, this rule may not apply if the partnership has taken deductions attributable to nonrecourse liabilities or the partnership holds property that was contributed by a partner.

More information.   For more information on the effect of partnership liabilities, including rules for limited partners and examples, see sections 1.752-1 through 1.752-5 of the regulations.

Disposition of
Partner's Interest

The following discussions explain the treatment of gain or loss from the disposition of an interest in a partnership.

Abandoned or worthless partnership interest.   A loss incurred from the abandonment or worthlessness of a partnership interest is an ordinary loss only if both of the following tests are met.

• The transaction is not a sale or exchange.
• The partner has not received an actual or deemed distribution from the partnership.

If the partner receives even a de minimis actual or deemed distribution, the entire loss generally is a capital loss. However, see Payments for Unrealized Receivables and Inventory Items, later.

Partnership election to adjust basis of partnership property.   Generally, a partnership's basis in its assets is not affected by a transfer of an interest in the partnership, whether by sale or exchange or because of the death of a partner. However, the partnership can elect to make an optional adjustment to basis in the year of transfer. See Adjusting the Basis of Partnership Property, later, for information on making the election.

Sale, Exchange,
or Other Transfer

The sale or exchange of a partner's interest in a partnership usually results in capital gain or loss. However, see Payments for Unrealized Receivables and Inventory Items, later, for certain exceptions. Gain or loss is the difference between the amount realized and the adjusted basis of the partner's interest in the partnership. If the selling partner is relieved of any partnership liabilities, that partner must include the liability relief as part of the amount realized for his or her interest.

Example 1.   Fred became a limited partner in the ABC Partnership by contributing $10,000 in cash on the formation of the partnership. The adjusted basis of his partnership interest at the end of the current year is $20,000, which includes his $15,000 share of partnership liabilities. The partnership has no unrealized receivables or inventory items. Fred sells his interest in the partnership for $10,000 in cash. He had been paid his share of the partnership income for the tax year.

Fred realizes $25,000 from the sale of his partnership interest ($10,000 cash payment + $15,000 liability relief). He reports $5,000 ($25,000 realized - $20,000 basis) as a capital gain.

Example 2.   The facts are the same as in Example 1, except that Fred withdraws from the partnership when the adjusted basis of his interest in the partnership is zero. He is considered to have received a distribution of $15,000, his relief of liability. He reports a capital gain of $15,000.

Exchange of partnership interests.   An exchange of partnership interests generally does not qualify as a nontaxable exchange of like-kind property. This applies regardless of whether they are general or limited partnership interests or interests in the same or different partnerships. However, under certain circumstances, such an exchange may be treated as a tax-free contribution of property to a partnership. See Contribution of Property under Transactions Between Partnership and Partners, earlier.

An interest in a partnership that has a valid election in effect under section 761(a) of the Internal Revenue Code to be excluded from the partnership rules of the Code is treated as an interest in each of the partnership assets and not as a partnership interest. See Exclusion From Partnership Rules, earlier.

Installment reporting for sale of partnership interest.   A partner who sells a partnership interest at a gain may be able to report the sale on the installment method. For requirements and other information on installment sales, see Publication 537.

Part of the gain from the installment sale may be allocable to unrealized receivables or inventory items. See Payments for Unrealized Receivables and Inventory Items, later. The gain allocable to unrealized receivables and inventory items must be reported in the year of sale. The gain allocable to the other assets can be reported under the installment method.

Liquidation at Partner's Retirement or Death

Payments made by the partnership to a retiring partner or successor in interest of a deceased partner in return for the partner's entire interest in the partnership may have to be allocated between payments in liquidation of the partner's interest in partnership property and other payments. The partnership's payments include an assumption of the partner's share of partnership liabilities treated as a distribution of money.

For income tax purposes, a retiring partner or successor in interest of a deceased partner is treated as a partner until his or her interest in the partnership has been completely liquidated.

Liquidating payments.   Payments made in liquidation of the interest of a retiring or deceased partner in exchange for his or her interest in partnership property are considered a distribution, not a distributive share or guaranteed payment that could give rise to a deduction (or its equivalent) for the partnership.

Unrealized receivables and goodwill.   Payments made for the retiring or deceased partner's share of the partnership's unrealized receivables or goodwill are not treated as made in exchange for partnership property if both of the following tests are met.

• Capital is not a material income-producing factor for the partnership. (Whether capital is a material income-producing factor is explained in the discussion under Family Partnership near the beginning of this publication.)
• The retiring or deceased partner was a general partner in the partnership.

However, this rule does not apply to payments for goodwill to the extent that the partnership agreement provides for a reasonable payment to a retiring partner for goodwill.

Payments for unrealized receivables or goodwill are not treated as made in exchange for partnership property under any circumstance if the partner retired or died before January 5, 1993 (or retired on or after that date if a written contract to buy the partner's interest in the partnership was binding on January 4, 1993, and at all times thereafter).

Unrealized receivables are defined later under Payments for Unrealized Receivables and Inventory Items. However, for this purpose, they do not include the items listed in that discussion under Other items treated as unrealized receivables.

Partners' valuation.   Generally, the partners' valuation of a partner's interest in partnership property in an arm's-length agreement will be treated as correct. If the valuation reflects only the partner's net interest in the property (total assets less liabilities), it must be adjusted so that both the value of and the basis for the partner's interest include the partner's share of partnership liabilities.

Gain or loss on distribution.   Upon the receipt of the distribution, the retiring partner or successor in interest of a deceased partner will recognize gain only to the extent that any money (and marketable securities treated as money) distributed is more than the partner's adjusted basis in the partnership. The partner will recognize a loss only if the distribution is in money, unrealized receivables, and inventory items. No loss is recognized if any other property is received. See Partner's Gain or Loss under Partnership Distributions, earlier.

Other payments.   Payments made by the partnership to a retiring partner or successor in interest of a deceased partner that are not made in exchange for an interest in partnership property are treated as distributive shares of partnership income or guaranteed payments. This rule applies regardless of the time over which the payments are to be made. It applies to payments made for the partner's share of unrealized receivables and goodwill not treated as a distribution.

If the amount is based on partnership income, the payment is taxable as a distributive share of partnership income. The payment retains the same character when reported by the recipient that it would have had if reported by the partnership. For more information, see Partner's Income or Loss, earlier.

If the amount is not based on partnership income, it is treated as a guaranteed payment. The recipient reports guaranteed payments as ordinary income. For additional information on guaranteed payments, see Transactions Between Partnership and Partners, earlier.

These payments are included in income by the recipient for his or her tax year that includes the end of the partnership tax year for which the payments are a distributive share or in which the partnership is entitled to deduct them as guaranteed payments.

Former partners who continue to make guaranteed periodic payments to satisfy the partnership's liability to a retired partner after the partnership is terminated can deduct the payments as a business expense in the year paid.

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