Partnership Disguised Sales (§ 707)

IRC § 707 addresses transactions between a partner and a partnership that Congress determined should be treated as arm's-length transactions — not the tax-favored partner-partnership interactions that benefit from nonrecognition. The most important provision is § 707(a)(2)(B), the disguised sale rule: when a partner contributes property to a partnership and within two years receives a distribution, the IRS will treat the entire transaction as a taxable sale if the distribution would not have been made "but for" the contribution. Without this rule, a partner owning appreciated real estate could contribute it to a partnership (deferring gain under § 721), then receive a "distribution" of the property's full value in cash — effectively cashing out tax-free while the gain remained locked in the partnership's basis. Section 707(b) covers guaranteed payments (fixed payments to partners regardless of partnership income — ordinary income to recipients, deductible to the partnership), and § 707(a)(1) covers services and property transactions that are not "in the capacity of a partner" — treated as arm's-length transactions. The two-year presumption means any contribution-distribution pair within 24 months is presumed a disguised sale unless the taxpayer proves otherwise, making careful documentation and timing essential for any real estate contribution to a partnership where the contributing partner also receives distributions.

Current Law (2026)

Key Mechanics

Section 707(a)(2)(B) targets contribution-distribution pairs that are economically equivalent to a sale of property to the partnership. The core test is "but for" causation: if the partnership would not have distributed cash or property to the partner absent the contribution, the transfers are treated as a disguised sale — the partner recognizes gain or loss on the contributed property as if sold at FMV, and § 721 nonrecognition does not apply. A 2-year presumption applies: contributions and distributions occurring within 2 years of each other are presumed to be a disguised sale; beyond 2 years the presumption reverses. Exceptions exist for operating cash flow distributions, reimbursements of pre-formation capital expenditures, certain liability assumptions, and debt-financed distributions (governed by the complex § 1.707-5 regulations). § 707(a)(2)(A) applies the same logic to service arrangements: if a partner's allocation and distribution is in substance compensation for services rather than a partnership income share, it is taxed as ordinary income paid to a non-partner. § 707(b) disallows loss deductions on sales and exchanges between a partnership and a person owning more than 50% of capital or profits, and on sales between commonly controlled partnerships. Guaranteed payments under § 707(c) — fixed payments to partners for services or capital use determined without regard to partnership income — are ordinary income to the recipient and generally deductible by the partnership.

Legal Authority

• 26 U.S.C. § 707(a)(1) — If a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner
• 26 U.S.C. § 707(a)(2)(A) — Certain allocations and distributions treated as disguised payments for services: if a partner performs services for a partnership and receives an allocation and distribution — and the transaction is determined to be a payment for services in substance — it is treated as a payment to a non-partner (ordinary income; no capital account impact)
• 26 U.S.C. § 707(a)(2)(B) — Certain transfers of money or property treated as sales or exchanges: if a partner transfers property to a partnership and there is a related direct or indirect transfer of money or other consideration from the partnership to the partner, and "the transfers, when viewed together, are properly characterized as a sale or exchange of property," the transfers are treated as a sale — the gain or loss on the contributed property is recognized as if sold at FMV to the partnership
• 26 U.S.C. § 707(b) — Guaranteed payments: to the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital are treated as paid to a person who is not a member of the partnership (ordinary income to recipient, generally deductible by partnership)
• 26 U.S.C. § 707 (DB) — Transactions between partner and partnership: no loss deduction is allowed for sales or exchanges of property between a partnership and a person who owns more than 50% of the partnership's capital or profits, or between two partnerships controlled by the same people; ownership is determined using § 267(c) constructive ownership rules except paragraph (3); the rule also applies when the buyer ends up with property that is not a capital asset

How It Works

The disguised sale problem: The § 721 nonrecognition rule for partnership contributions (no gain on contributing property to a partnership) could be weaponized: contribute appreciated property, get § 721 deferral, then immediately receive a cash "distribution" equal to the property's value — effectively selling the property without recognizing gain. Section 707(a)(2)(B) closes this by treating contribution-distribution pairs as disguised sales when the distribution is economically tied to the contribution.

The "but for" test: The IRS determines whether a disguised sale occurred by asking whether the distribution would have been made "but for" the contribution. If the answer is no — the partnership would not have distributed cash to this partner if they hadn't contributed the property — the transaction is a disguised sale. The partnership took the property; the partner received cash; that's economically a sale, and it's taxed as one.

The two-year presumption: Transfers within two years are presumed disguised sales. The regulations list facts and circumstances that rebut the presumption: the existence of entrepreneurial risk (the distribution amount depends on partnership performance, not fixed), the timing of distributions to all partners (not just the contributing partner), the absence of any plan for the distribution before the contribution, and the general creditworthiness of the partnership independent of the contributed property. Distributions more than two years after the contribution are presumed NOT to be a disguised sale — though facts can still establish a disguised sale if the two-year presumption is rebutted.

Exceptions to disguised sale treatment: Not every contribution-followed-by-distribution is a disguised sale. The regulations carve out:

Operating cash flow distributions: Distributions of a partner's proportionate share of partnership operating cash flows (not attributable to the contributed property) are not disguised sale proceeds — they are legitimate distributions of ongoing business income.

Reimbursement of preformation expenditures: If the partnership distributes cash to reimburse a contributing partner for capital expenditures they made on the contributed property before contribution (within 2 years), those reimbursements are not disguised sales — they're legitimate reimbursements.

Debt-financed distributions: The most complex exception. When a partnership takes on debt and distributes the proceeds, those distributions may not be disguised sales if the debt is allocable to the contributing partner under the § 752 liability allocation rules. If the debt (and therefore the deemed distribution) is properly allocable to the contributing partner as their share of nonrecourse liability, it's not a disguised sale — it's a liability assumption. The regulations under § 1.707-5 provide detailed rules for when debt-financed distributions are "qualified liabilities" excluded from disguised sale analysis.

UPREIT contribution implications: The § 707 disguised sale rules are critically important in 721 UPREIT exchange transactions. When a real estate owner contributes appreciated property to a REIT's operating partnership, § 721 defers gain — but if the REIT's operating partnership makes a distribution to the contributor within two years, the IRS may recharacterize the transaction as a disguised sale of the real estate, triggering full gain recognition. Practitioners structure UPREIT contributions to minimize distribution activity within the two-year window and carefully document that any distributions are operating cash flows, not tied to the contribution.

Guaranteed payments — § 707(b): When a partnership agrees to pay a partner a fixed amount regardless of partnership income — a salary-equivalent, a guaranteed minimum return, or a fixed interest payment on a partner's capital loan — those payments are "guaranteed payments." They are ordinary income to the receiving partner and generally deductible by the partnership (like wages or interest). Guaranteed payments are not subject to the § 704(b) allocation rules — they are treated as if paid to a non-partner. Real estate partnerships frequently use guaranteed payments for property management fees paid to a partner who manages the properties, for development fees, or for acquisition fees.

§ 707(a)(1) — non-partner capacity transactions: When a partner provides services to a partnership in their individual capacity (not as a partner sharing in profits/losses), the transaction is treated as between unrelated parties. The service provider receives ordinary income (or a deductible payment from the partnership, depending on whether the service is a currently deductible expense or a capitalized cost). This provision governs construction management agreements, property management contracts, and other service relationships between partners and the partnership where the partner is acting as a vendor, not as a profit-sharing owner.

How It Affects You

If you are contributing appreciated real estate to a partnership and expect to receive distributions: The disguised sale rules are the primary tax risk in any leveraged real estate contribution to a partnership. Before contributing property, work with partnership tax counsel to: (1) document that any expected distributions within two years are from operating cash flows and not tied to your contribution; (2) analyze whether any mortgage assumed by the partnership and the resulting § 752 liability allocations create deemed distributions that trigger disguised sale analysis; and (3) review the two-year presumption carefully — plan to wait more than two years after contribution before receiving any substantial distributions, unless you can clearly demonstrate they fall within an exception.

If you contributed property to a partnership and received distributions shortly afterward: If within two years of a property contribution you received distributions that weren't clearly (a) operating cash flows allocated to all partners proportionately, (b) reimbursements of preformation expenditures, or (c) qualified liability distributions under § 1.707-5, you may have an unreported disguised sale. The IRS has been active in challenging these arrangements — a disguised sale results in recognition of gain on the contributed property at the time of contribution (possibly requiring an amended return and substantial penalties for prior years). Review your situation with a tax professional who specializes in partnership tax.

If you are a real estate developer contributing a newly developed property to a partnership: Developers who contribute built-to-suit properties to real estate partnerships shortly after completion face heightened disguised sale scrutiny because (a) the contribution and distribution timing is typically tight, and (b) the distribution of construction loan proceeds or refinancing proceeds may look like the developer is simply monetizing the property through a partnership intermediary. The IRS closely scrutinizes developer contributions where the contributed property serves as collateral for partnership borrowing that is immediately distributed.

If you are negotiating UPREIT contribution terms: Require that the REIT's operating partnership agreement clearly distinguish between operating distributions (quarterly distributions equivalent to REIT dividends, made to all OP unit holders proportionately) and any contribution-related payments. Operating distributions made to all OP unit holders on an equal-per-unit basis — regardless of when each holder contributed their property — are strong evidence they are not "but for" the particular contribution and thus not disguised sales. Document everything: the board resolution approving the distribution, the distribution record date (showing it applies to all unitholders), and the long-standing distribution policy of the OP.

State Variations

States generally follow federal § 707 rules for disguised sales and guaranteed payments, with the primary variation being in sourcing:

• CA: California conforms to the federal disguised sale rules. Gain on a disguised sale of California real property is California-source income — taxable to the contributing partner (including non-residents) at California ordinary income or capital gain rates depending on the property's character.
• NY: New York follows federal § 707 treatment. A disguised sale of New York real property triggers New York source income, taxable to non-resident partners at New York rates.
• State guaranteed payment rules: Most states follow federal treatment for guaranteed payments (ordinary income to recipient, deductible to partnership). California, New Jersey, and Pennsylvania have state-specific rules on the deductibility of guaranteed payments that can diverge from federal in certain circumstances.

Implementing Regulations

• 26 CFR § 1.707-1 — Transactions between partner and partnership: general rules for § 707(a)(1) non-partner capacity transactions; guaranteed payment rules under § 707(b); anti-abuse rules preventing partners from characterizing arm's-length transactions as partnership-capacity transactions to avoid recognition
• 26 CFR § 1.707-3 — Contributions of property — disguised sales: the "but for" analysis; the two-year presumption; the facts and circumstances that rebut the presumption; the aggregation and disaggregation of multiple transfers; rules for partial disguised sales when only part of the distribution is "but for" the contribution
• 26 CFR § 1.707-4 — Exceptions to disguised sale: operating cash flow distributions (the "operating cash flow" safe harbor); reimbursements of preformation expenditures (capital expenditures within 2 years pre-contribution, up to 20% of FMV of the contributed property); guaranteed payments for use of capital; preferred returns
• 26 CFR § 1.707-5 — Debt-financed transfers: the complex rules distinguishing which debt assumed by the partnership from a contributing partner is a "qualified liability" (excluded from disguised sale) vs. an "excess liability" (treated as a disguised sale payment); the partnership's assumption of the contributing partner's liabilities; debt refinancing and its treatment

Pending Legislation

• UPREIT clarification: The One Big Beautiful Bill Act included provisions clarifying the treatment of UPREIT contributions that interact with § 707 disguised sale concerns — providing that operating distributions by the OP to all unit holders do not constitute disguised sale proceeds when made under a standing distribution policy.
• Section 707(b) guaranteed payment modernization: Treasury has periodically proposed modernizing the guaranteed payment rules to address complex partnership structures (multi-tiered partnerships, preferred returns that blend guaranteed payment and partnership allocation characteristics) that create uncertainty about the correct character and timing of payments.
• S.J.Res. 95 (119th Congress) — A joint resolution providing for congressional disapproval of the IRS rule relating to "Interim Guidance Simplifying Application of the Corporate Alternative Minimum Tax to Partnerships"; would cancel IRS Notice 2025-28 on CAMT treatment of partnership allocations — relevant to § 707 disguised sale analysis where the character of partnership distributions as "disguised sale proceeds" vs. legitimate operating distributions affects CAMT adjusted financial statement income. Status: in_committee.

Recent Developments

• IRS UPREIT audit guidance: The IRS has focused examination resources on UPREIT contribution transactions where operating partnership distributions within two years of a real estate contribution may constitute disguised sales. Several large REITs have received IRS inquiries about the characterization of OP distributions to recently contributing partners.
• Debt-financed distribution complexity: The § 1.707-5 regulations governing debt-financed distributions from partnerships to contributing partners have been the subject of ongoing taxpayer-IRS controversy, particularly in transactions where the partnership assumes a mortgage from the contributing partner and simultaneously refinances. Treasury has indicated interest in updating these regulations to address modern transaction structures.
• CPAR interaction with disguised sales: The centralized partnership audit regime (CPAR) creates challenges when disguised sales are discovered at audit — the gain from a disguised sale should have been reported in the contribution year, but CPAR audits often examine later years. Coordination between CPAR adjustment year rules and disguised sale recharacterization for earlier years remains an active area of IRS guidance.