Key Takeaways:
- Inside basis: Partnership’s basis in its assets
- Outside basis: Partner’s basis in their partnership interest
- Outside basis determines deductible losses and tax-free distributions
- Basis can never go negative. Excess losses are suspended until basis increases.
- Partner’s share of liabilities increases outside basis
- Important: Track basis annually. Errors compound over time.
A partner calls their CPA in March. “I got my K-1. It shows a $75,000 loss. Can I deduct that?”
The answer depends on one number: their outside basis.
If basis is $100,000, they can deduct the full $75,000. If basis is $40,000, they deduct $40,000 now and carry forward $35,000. If basis is zero, the entire loss is suspended.
Partnership basis isn’t complicated in theory. But in practice, most partners don’t track it. They rely on K-1s that show capital accounts, not basis. When something goes wrong, they’re surprised.
This guide explains inside versus outside basis, how to calculate and track your basis annually, and why those calculations matter every time you receive distributions or allocate losses.
Table of Contents
Why Partner Basis Matters
Your outside basis controls several critical tax outcomes:
Loss deductions You can only deduct your share of partnership losses up to your outside basis. Section 704(d) prevents deducting losses that exceed basis. Excess losses suspend until basis increases.
Tax-free distributions Cash distributions are generally tax-free up to your basis. Once distributions exceed basis, you recognize capital gain.
Sale or exchange When you sell your partnership interest, gain or loss equals the difference between sales price and your outside basis. Wrong basis means wrong gain/loss calculation.
QBI deduction calculations Your qualified business income deduction depends partly on partnership items that interact with basis.
Partners who don’t track basis often discover problems at the worst times. An IRS audit. A partnership sale. A major distribution. By then, reconstructing years of basis adjustments is expensive.
Inside Basis vs. Outside Basis Explained
These terms confuse most business owners. They sound similar but measure different things.
Inside Basis
Inside basis is the partnership’s basis in its assets.
When the partnership owns equipment, real estate, inventory, or other property, the partnership has a tax basis in each asset. This determines gain or loss when the partnership sells that asset.
Example: The partnership buys equipment for $50,000. The partnership’s inside basis in that equipment is $50,000. If the partnership later sells the equipment for $70,000, it recognizes $20,000 gain.
Inside basis comes from two sources:
- Partner contributions (carryover basis from contributed property)
- Partnership purchases (cost basis)
Outside Basis
Outside basis is each partner’s basis in their partnership interest.
This represents the partner’s after-tax investment in the partnership. It’s a partner-level concept, not a partnership-level concept. Each partner has their own outside basis.
Outside basis starts with what you contributed. It then adjusts for income, losses, contributions, and distributions over time.
Key distinction: The partnership tracks inside basis. Each partner tracks their own outside basis.
How They Start Equal
At partnership formation, total outside basis equals total inside basis.
Example: Partner A contributes $100,000 cash. Partner B contributes equipment worth $100,000 with a tax basis of $60,000.
- Total inside basis: $100,000 (cash) + $60,000 (equipment basis) = $160,000
- Partner A’s outside basis: $100,000
- Partner B’s outside basis: $60,000
- Total outside basis: $160,000
The numbers match because everything in the partnership came from partner contributions.
Over time, inside and outside basis diverge. The partnership might buy new assets (increasing inside basis without affecting outside basis). Partners might receive allocations (changing outside basis without changing asset basis). Section 754 elections exist specifically to realign these numbers in certain situations.
Comparison Table
| Feature | Inside Basis | Outside Basis |
|---|---|---|
| What it measures | Partnership’s basis in assets | Partner’s basis in partnership interest |
| Who tracks it | Partnership | Each individual partner |
| Primary use | Calculate gain/loss on asset sales | Limit losses, determine distribution taxation |
| Reported on | Form 1065 (various schedules) | Not directly reported; partner must calculate |
| Affected by | Asset purchases, depreciation, sales | Income, losses, contributions, distributions, liabilities |
Determining Initial Basis
Your outside basis starts with your initial contribution to the partnership.
Cash Contributions
Cash contributions equal basis. Contribute $50,000, your initial outside basis is $50,000. Simple.
Property Contributions
When you contribute property, your basis in the partnership equals your adjusted basis in the contributed property, not its fair market value.
Example: You contribute real estate to the partnership.
- Fair market value: $200,000
- Your adjusted basis (cost minus depreciation): $120,000
- Your initial outside basis: $120,000
The $80,000 difference is “built-in gain” that the partnership tracks under Section 704(c). If the partnership later sells that property, the built-in gain allocates specifically to you.
This rule prevents partners from contributing appreciated property and having the gain spread among all partners.
Services for Partnership Interest
Receiving a partnership interest for services is different. Generally, you have:
- Ordinary income equal to the fair market value of the interest received
- Basis equal to that fair market value
Exception: A profits-only interest (no capital interest) received for services may not be taxable on receipt under certain conditions.
Example: Multiple Contribution Types
Partner A contributes $80,000 cash. Partner B contributes inventory with $100,000 FMV and $40,000 basis. Partner C contributes services valued at $30,000 for a 20% profits interest.
- Partner A’s initial outside basis: $80,000
- Partner B’s initial outside basis: $40,000 (basis of contributed inventory)
- Partner C’s initial outside basis: $30,000 (FMV of interest received, taxable as compensation)
Partnership’s inside basis in inventory: $40,000 (Partner B’s carryover basis)
Note that Partner B owns a larger economic share than their tax basis reflects. The $60,000 built-in gain will be allocated to Partner B when the inventory sells.
Adjustments to Outside Basis
After initial contribution, basis changes annually based on partnership activity.
Increases to Basis
Your outside basis increases for:
Additional capital contributions Put more money or property into the partnership, basis goes up by the cash or your basis in the contributed property.
Share of partnership income Your allocated share of all income items (ordinary, capital gains, tax-exempt) increases basis. You pay tax on this income, so your after-tax investment increases.
Share of tax-exempt income Even though not taxable, tax-exempt income increases basis. This ensures you don’t pay tax when you receive those dollars as distributions.
Increase in share of liabilities Your share of partnership liabilities adds to your basis. This is where things get complicated but also powerful. Debt creates basis that allows loss deductions and tax-free distributions.
Decreases to Basis
Your outside basis decreases for:
Distributions Cash distributions reduce basis dollar-for-dollar. Property distributions reduce basis by the partnership’s inside basis in the property (generally).
Share of partnership losses Losses you’re allocated reduce basis. If losses exceed basis, the excess is suspended under Section 704(d).
Share of nondeductible expenses Expenses that aren’t tax-deductible (like 50% of meals, penalties, certain fines) still reduce basis. You lose the deduction and the basis.
Decrease in share of liabilities If the partnership pays down debt or your share of liabilities decreases, your basis decreases. This can trigger unexpected gain if it pushes distributions over basis.
The Annual Adjustment Formula
Every year, calculate your ending basis:
Beginning Basis
- Capital contributions
- Share of income (including tax-exempt)
- Increase in share of liabilities − Distributions − Share of losses (limited to available basis) − Share of nondeductible expenses − Decrease in share of liabilities = Ending Basis
Order matters. Apply adjustments in this sequence:
- First: Increases for contributions
- Second: Increases for income items
- Third: Decreases for distributions
- Fourth: Decreases for nondeductible, non-capitalizable expenses
- Fifth: Decreases for losses and deductions
This ordering prevents artificial loss recognition. You apply income increases before loss decreases, ensuring maximum loss deductibility.
Partner’s Share of Liabilities
Partnership liabilities increase partner basis. This is one of the most powerful features of partnership taxation.
Types of Liabilities
Recourse liabilities Liabilities where partners bear personal economic risk if the partnership can’t pay. In general partnerships, these are common. The partner who would bear the loss includes the liability in basis.
Nonrecourse liabilities Liabilities where no partner is personally liable. Typically, the lender can only look to partnership assets. These allocate among partners based on profits interest (with special rules).
Qualified nonrecourse financing Nonrecourse debt secured by real property used in the partnership’s activity. This allocates to the partners receiving allocations from that activity.
How Liabilities Affect Basis
Example: Partnership borrows $500,000 nonrecourse. Partners split profits 50/50.
Each partner’s share of the liability: $250,000
Each partner’s outside basis increases by $250,000.
Without this rule, a partner contributing $100,000 cash would have only $100,000 basis. With a 50% share of $500,000 debt, their basis is $350,000. They can deduct up to $350,000 in losses.
Changes in Liability Allocations
When liability allocations change, basis changes.
Scenario: New partner joins, changing your share of nonrecourse debt from 50% to 33%. On $600,000 partnership debt:
- Old share: $300,000
- New share: $200,000
- Decrease: $100,000
Your basis drops by $100,000. If this pushes total decreases above total increases, you may recognize gain.
Section 704(d) Loss Limitations
Section 704(d) prevents partners from deducting losses exceeding their outside basis.
How It Works
- Calculate your total loss allocation for the year
- Determine your outside basis before applying the loss
- Deductible loss is limited to basis
- Excess loss suspends and carries forward
Example
Partner’s outside basis before loss: $25,000 Allocated loss: $60,000
- Deductible loss this year: $25,000 (limited to basis)
- Suspended loss carryforward: $35,000
- Ending basis: $0
The $35,000 suspended loss carries forward indefinitely. When basis increases in future years (through income allocations, contributions, or increased liability share), the suspended loss becomes deductible.
Interaction with At-Risk and Passive Activity Rules
Section 704(d) is the first limitation. But it’s not the only one.
Application order:
- Basis limitation (Section 704(d))
- At-risk limitation (Section 465)
- Passive activity limitation (Section 469)
A loss passing the basis test may still be limited by at-risk rules (particularly for nonrecourse debt not qualifying as “at-risk”). Losses surviving at-risk limitations may then face passive activity restrictions.
Each layer potentially further limits current deduction. Track all three.
Basis Can Never Go Negative
Your outside basis cannot go below zero.
If distributions would reduce basis below zero, you recognize gain on the excess.
If losses would reduce basis below zero, the excess suspends under Section 704(d).
If decreases in liability share would reduce basis below zero, combined with other adjustments, you recognize gain.
Example: Beginning basis: $10,000. You receive $25,000 cash distribution.
- Distribution reduces basis to zero
- Excess $15,000 triggers capital gain recognition
This surprises partners who think distributions are always tax-free. They are, up to basis. Beyond that, gain recognition.
Documentation Requirements
The IRS doesn’t require you to file your basis calculation. But they can request it during an audit. Partners who can’t substantiate basis face adjustments.
What to Maintain
Annual basis calculations Create a spreadsheet tracking each year’s beginning basis, adjustments, and ending basis. Roll it forward annually.
Contribution records Document cash contributions, property contributed (with FMV and basis), and any debt assumed.
Distribution records Track every distribution received: date, amount, character (cash vs. property).
K-1 copies Keep every Schedule K-1 you’ve received. These show income, loss, and liability allocations.
Capital account reconciliations Compare your basis calculation to K-1 capital account reporting. Differences are normal (liabilities are excluded from capital accounts) but should be explainable.
Best Practice
Start a spreadsheet when you join the partnership. Update it every year when you receive your K-1. Don’t try to reconstruct ten years of basis at once. Errors in year one compound through year ten.
Practical Examples with Calculations
Example 1: Basic Annual Calculation
Facts:
- Beginning basis: $100,000
- Share of partnership ordinary income: $50,000
- Share of tax-exempt interest: $5,000
- Cash distribution received: $40,000
- Increase in share of liabilities: $20,000
Calculation: Beginning basis: $100,000
- Share of ordinary income: $50,000
- Share of tax-exempt income: $5,000
- Increase in liabilities: $20,000
- Cash distribution: ($40,000) = Ending basis: $135,000
Example 2: Loss Limitation
Facts:
- Beginning basis: $60,000
- Share of partnership loss: ($90,000)
- No other adjustments
Calculation: Beginning basis: $60,000 Limited loss deduction: ($60,000) Suspended loss carryforward: $30,000 = Ending basis: $0
The partner deducts $60,000 this year. The remaining $30,000 loss carries forward until basis increases.
Example 3: Distribution Exceeding Basis
Facts:
- Beginning basis: $50,000
- Share of partnership income: $20,000
- Cash distribution: $80,000
Calculation (applying ordering rules): Beginning basis: $50,000
- Share of income: $20,000 = Interim basis: $70,000
- Cash distribution: ($80,000) = Basis would be: ($10,000)
Since basis can’t go negative:
- Basis reduces to $0
- Excess distribution of $10,000 = capital gain recognized
Ending basis: $0 Capital gain recognized: $10,000
Example 4: Property Contribution with Built-In Gain
Facts:
- Partner contributes land to partnership
- Land FMV: $300,000
- Partner’s adjusted basis in land: $150,000
Partner’s initial outside basis: $150,000
The $150,000 built-in gain is tracked under Section 704(c). If the partnership sells the land for $350,000:
- Total gain: $200,000
- Built-in gain allocated to contributing partner: $150,000
- Remaining gain: $50,000 (allocated per partnership agreement)
When Section 754 Elections Matter
Sometimes inside and outside basis diverge significantly. Section 754 elections allow adjustments that realign them.
Transfer of Partnership Interest
New partner buys an interest for $300,000. Their share of inside basis is $200,000. Without Section 754, they’d eventually pay tax on $100,000 of “phantom” appreciation that was already reflected in their purchase price.
With Section 754 election, the partnership adjusts inside basis under Section 743(b) to give the new partner a $100,000 step-up. They avoid double taxation.
Distributions
When distributions cause basis disparities, Section 734(b) adjustments under a 754 election can correct remaining partner allocations.
Why It Matters for Basis
A 754 election affects inside basis (partnership assets), not your outside basis. But it affects the income allocations you receive, which indirectly affects your outside basis over time.
Frequently Asked Questions
What is the difference between inside and outside basis?
Inside basis is the partnership’s basis in its assets. Outside basis is each partner’s basis in their partnership interest. Inside basis determines gain/loss when the partnership sells assets. Outside basis limits partners’ deductible losses and determines distribution taxation.
How do partnership liabilities affect my basis?
Your share of partnership liabilities increases your outside basis. This allows you to deduct a larger share of losses and receive larger tax-free distributions. Different allocation rules apply to recourse vs. nonrecourse debt.
Can my partnership basis go negative?
No. Basis cannot go below zero. If losses would reduce basis below zero, the excess suspends under Section 704(d). If distributions exceed basis, you recognize capital gain on the excess.
What happens to suspended losses when I sell my partnership interest?
Suspended losses under Section 704(d) increase your basis in the partnership interest at sale. This reduces gain or increases loss on the sale. You don’t get a separate deduction for suspended losses upon sale.
How often should I calculate my partnership basis?
Calculate basis annually when you receive your Schedule K-1. Track it cumulatively in a spreadsheet. Errors compound over time, making annual tracking essential.
Is the capital account on my K-1 the same as my tax basis?
No. Your tax basis includes your share of partnership liabilities, which is not reflected in capital accounts. Box L shows your capital account. Box I shows your share of liabilities. Together, they approximate your outside basis.
Track Basis Before Problems Arise
Partnership basis isn’t optional knowledge. It controls your tax outcomes on losses, distributions, and sales.
The K-1 gives you capital account information. It doesn’t give you basis. You need to calculate basis yourself, adjusting for liabilities and tracking changes annually.
Partners who ignore basis until an audit or sale discover expensive surprises. Reconstructing ten years of adjustments is time-consuming and often imprecise.
Start tracking now. Update annually. Document everything.
If you’re uncertain about your current basis or need help establishing a tracking system, SDO CPA works with partnership owners on exactly these issues. Partnership complexity is what we do. Contact us to discuss your situation.