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Partnership Basis &
Capital Accounts

Master the rules for computing a partner's outside basis, understanding inside basis, and tracking capital accounts for the CPA REG exam.

CPA Regulation (REG)

What Is a Partnership for Tax Purposes?

A partnership is a pass-through entity: it files an informational return (Form 1065) but pays no federal income tax itself. Instead, each partner reports their distributive share of income, deductions, and credits on their own return.

Pass-Through
Income and losses flow through to each partner's individual tax return.
Form 1065
The partnership files an informational return; Schedule K-1 is issued to each partner.
Flexibility
Partners can specially allocate income, losses, and deductions if they have substantial economic effect.

Two Key Concepts: Basis & Capital Accounts

The CPA exam tests two distinct but related tracking systems. Both start with the partner's contribution but diverge as different events occur.

Partner's Outside Basis
A tax concept that tracks the partner's investment for purposes of gain/loss recognition, loss limitations, and distribution rules.
Capital Account
A book/economic concept that reflects the partner's equity in the partnership, used to determine economic rights on liquidation.

How Basis & Capital Accounts Relate

Partner Contributes Assets Outside Basis (Tax) Capital Account (Book) Income, losses, contributions, distributions Affect BOTH + Share of partnership liabilities Book revaluations (704(b)) Liabilities: Basis YES, Capital Account NO

Computing Outside Basis

A partner's outside basis is tracked annually and determines the tax consequences of distributions, loss deductions, and dispositions of the partnership interest.

1
Initial basis: Cash contributed + adjusted basis of property contributed (not FMV).
2
Increase by: Distributive share of partnership income (including tax-exempt income) + additional contributions + increase in share of liabilities.
3
Decrease by: Distributions received + distributive share of losses + nondeductible expenses + decrease in share of liabilities.
4
Floor: Outside basis can never go below zero. Excess losses are suspended.

Contribution Rules: IRC §721 & §722

Under §721, no gain or loss is recognized when property is contributed to a partnership in exchange for a partnership interest. Under §722, the partner's initial outside basis equals the adjusted basis of the contributed property, plus any cash contributed.

Liabilities & Basis: The Critical Link

Partnership liabilities are shared among partners. A partner's share of recourse and nonrecourse liabilities directly affects their outside basis.

Recourse Liabilities
Allocated to the partner(s) who bear the economic risk of loss (typically general partners).
Nonrecourse Liabilities
Shared among all partners based on profit-sharing ratios (with adjustments for §704(c) minimum gain).

Tracking the Capital Account

1
Initial capital: FMV of property contributed (not adjusted basis) + cash contributed.
2
Increase by: Share of partnership book income + additional contributions at FMV.
3
Decrease by: Share of partnership book losses + distributions (at FMV of property distributed).
4
Can go negative: Unlike outside basis, capital accounts can be negative (deficit restoration obligations may apply).

Outside Basis vs. Capital Account

Outside Basis Capital Account
Initial property value Adjusted tax basis FMV
Liabilities Yes: increases basis No effect
Tax-exempt income Increases basis Increases (book income)
Nondeductible expenses Decreases basis Decreases (book expense)
Floor Cannot go below \( 0 \) Can be negative
Purpose Loss limits, gain on sale Economic equity tracking

Don't Forget: Inside Basis

The inside basis is the partnership's own adjusted basis in its assets. It is distinct from any individual partner's outside basis.

Inside Basis
The partnership's tax basis in the assets it holds. Determined under §723 for contributed property (carryover from the contributing partner).
Outside Basis
Each individual partner's basis in their partnership interest. Varies partner by partner.

Step-by-Step: Computing Basis

1
Start with contribution: Cash + adjusted basis of property contributed.
2
Add liabilities assumed: Partner's share of all partnership liabilities (recourse + nonrecourse).
3
Subtract liabilities relieved: If the partner contributes property with a mortgage, the portion assumed by other partners reduces the contributing partner's basis.
4
Annual adjustments: Add income (including tax-exempt), subtract losses, distributions, and nondeductible expenses.
5
Check the floor: Outside basis cannot go below \( 0 \). Suspend excess losses.

Example 1: Cash Contribution

Alice contributes \( $50{,}000 \) cash to the AB Partnership for a 50% interest. The partnership has \( $20{,}000 \) in recourse liabilities.

Alice $50,000 cash AB Partnership $20K recourse debt Outside Basis Calculation: Cash contributed $50,000 + 50% share of liabilities ($20K) +$10,000 Outside Basis = $60,000

Example 2: Property Contribution

Bob contributes land with an adjusted basis of \( $30{,}000 \) and FMV of \( $80{,}000 \), subject to a \( $20{,}000 \) mortgage, for a 50% interest in the BC Partnership.

Outside Basis: Adjusted basis of land $30,000 - Mortgage assumed by partnership ($20,000) + Bob's 50% share of mortgage +$10,000 Outside Basis = $20,000 Capital Account: FMV of land contributed $80,000 - Mortgage assumed by partnership ($20,000) Capital Account = $60,000

Example 3: Annual Adjustments

Carol has an outside basis of \( $40{,}000 \) at the start of Year 2. During the year, the partnership reports: ordinary income \( $20{,}000 \), tax-exempt interest \( $2{,}000 \), §1231 loss \( $5{,}000 \), nondeductible expenses \( $1{,}000 \), and makes a cash distribution of \( $8{,}000 \). Carol has a 50% interest.

Year 2 Basis Calculation (50% share): Beginning basis $40,000 + 50% ordinary income ($20K) +$10,000 + 50% tax-exempt interest ($2K) +$1,000 - 50% §1231 loss ($5K) ($2,500) - 50% nondeductible expenses ($1K) ($500) - Cash distribution ($8,000) Ending Outside Basis = $40,000

The Loss Limitation Rules

Partners cannot deduct losses in excess of their outside basis. But basis is only the first hurdle. Three limitations apply in order:

1
Basis limitation (§704(d)): Losses limited to outside basis. Excess is suspended indefinitely and carried forward.
2
At-risk limitation (§465): Losses limited to the amount the partner is at risk (generally similar to basis for general partners, but excludes nonrecourse debt for limited partners).
3
Passive activity rules (§469): If the partner is not a material participant, losses may be further limited as passive losses.

Common Mistakes to Avoid

✕ Using FMV for Basis
Outside basis uses adjusted tax basis of contributed property, not FMV. FMV is for the capital account.
✕ Ignoring Liabilities
Forgetting to add the partner's share of partnership liabilities to outside basis, or double-counting when a partner contributes encumbered property.
✕ Forgetting Tax-Exempt Income
Tax-exempt income (like municipal bond interest) increases outside basis even though it is not taxable. Nondeductible expenses decrease it.

Summary: Basis & Capital at a Glance

Event Outside Basis Capital Account
Cash contribution + Cash + Cash
Property contribution + Adjusted basis + FMV
Ordinary income (share) + Increase + Increase
Losses (share) - Decrease - Decrease
Tax-exempt income + Increase + Increase
Nondeductible expenses - Decrease - Decrease
Liability increase + Increase No effect
Cash distribution - Decrease - Decrease
Floor \( \geq 0 \) Can be negative

Question 1 of 5

Dana contributes \( $25{,}000 \) cash and equipment with an adjusted basis of \( $15{,}000 \) and FMV of \( $40{,}000 \) for a 50% partnership interest. The partnership has no liabilities. What is Dana's initial outside basis?

Question 2 of 5

Which of the following increases a partner's outside basis but has no effect on the partner's capital account?

Question 3 of 5

Eric contributes land (adjusted basis \( $20{,}000 \), FMV \( $70{,}000 \)) subject to a \( $30{,}000 \) mortgage for a 50% interest. What is Eric's initial outside basis?

Question 4 of 5

A partner has a beginning outside basis of \( $10{,}000 \). During the year, their distributive share of partnership loss is \( $15{,}000 \). How much loss can the partner deduct under the basis limitation?

Question 5 of 5

For determining a partner's initial capital account, contributed property is valued at: