Partnership Distributions (§ 731)
IRC § 731 establishes the foundational rule that partners generally do not recognize gain or loss when they receive distributions from a partnership — with two important exceptions that limit this deferral and shape the entire economics of leveraged real estate partnerships. The general rule is elegant: distributions are a return of the partner's existing investment, not a taxable event, and the partner simply reduces their outside basis by the amount distributed. But the first exception — gain is recognized when cash distributed exceeds the partner's outside basis — is the engine behind one of the most powerful (and risky) real estate tax structures in the tax code: the "refinance and distribute" cycle, where a partnership borrows against appreciated property, distributes the loan proceeds to partners tax-free (up to basis), and the partners enjoy the cash while the property continues to generate depreciation deductions. The second exception — losses are recognized in a liquidating distribution only when the partnership distributes only cash, unrealized receivables, and inventory — limits the ability to recognize losses by simply walking away from a failing partnership. Layered on top of § 731 are the § 732 basis rules for distributed property and the § 751 hot asset rules that override § 731 whenever the distribution involves disproportionate ordinary income property — together, these provisions define the complete tax treatment of money and property moving from partnerships to partners.
Current Law (2026)
| Parameter | Value |
|---|---|
| General rule | No gain or loss on receipt of partnership distribution |
| Gain exception | Gain recognized to extent cash distributed exceeds partner's adjusted basis in the partnership interest |
| Gain character | Capital gain (long-term if interest held >1 year) |
| Loss recognition | No loss recognized in current (non-liquidating) distributions |
| Loss in liquidating distributions | Loss recognized only if the partnership distributes solely cash, unrealized receivables, and inventory (and the distribution is less than the partner's outside basis) |
| Property basis (§ 732) | Distributed property takes the lesser of: (a) the partnership's adjusted basis in the property, or (b) the partner's remaining outside basis after reducing for cash received |
| Basis reduction order (§ 733) | Cash first, then property (in the order distributed) |
| § 751 override | Hot asset distributions override § 731 — disproportionate distributions of receivables/inventory trigger ordinary income treatment |
| Deemed distribution | Reduction in a partner's share of partnership debt under § 752 is a deemed cash distribution for § 731 purposes |
Key Mechanics
Section 731 establishes the general rule that partners recognize no gain or loss on receipt of a partnership distribution — deferral is the default. Two exceptions: (1) a partner recognizes capital gain to the extent cash distributed exceeds their outside basis in the partnership interest; (2) a partner in a liquidating distribution recognizes loss only if the partnership distributes solely cash, unrealized receivables, and inventory, and the distribution is less than outside basis. The partnership itself never recognizes gain or loss on distributions. Basis rules under §§ 732–733: distributed property takes a substituted basis (the partnership's basis in the property) capped at the partner's remaining outside basis after reducing for cash received; outside basis is then reduced by cash received first, then by the basis of distributed property. In liquidating distributions, property takes a basis equal to the partner's outside basis minus cash received (residual basis rule), which may be higher or lower than the partnership's book basis. A deemed distribution under § 752 occurs whenever a partner's share of partnership liabilities decreases (a debt reduction is treated as a cash distribution for § 731 purposes). Marketable securities are treated as money (not property) when distributed, closing the potential arbitrage of distributing appreciated securities to trigger the non-recognition rule. The § 751 hot asset override applies regardless: disproportionate distributions of receivables or inventory trigger ordinary income treatment.
Legal Authority
- 26 U.S.C. § 731(a) — Recognition of gain or loss on distribution: in the case of a distribution by a partnership to a partner — (1) gain shall not be recognized except to the extent that any money distributed exceeds the adjusted basis of such partner's interest in the partnership immediately before the distribution; (2) loss shall not be recognized except that a distributee partner shall recognize loss in the case of a distribution in liquidation of such partner's interest if no property other than money, unrealized receivables, and inventory items is distributed
- 26 U.S.C. § 731(b) — Partnership's gain or loss: no gain or loss shall be recognized to a partnership on a distribution to a partner of property (including money)
- 26 U.S.C. § 732(a) — Basis of distributed property: the basis of property (other than money) distributed by a partnership to a partner other than in liquidation shall be its adjusted basis to the partnership (substituted basis) — but this basis cannot exceed the partner's adjusted basis of their partnership interest (the ceiling rule)
- 26 U.S.C. § 732(b) — Basis of distributed property in liquidating distributions: basis of property received in a liquidating distribution equals the partner's adjusted basis in the partnership interest less any cash received in the same distribution
- 26 U.S.C. § 733 — Basis of distributee partner's interest: on a current distribution, the partner's basis is reduced (but not below zero) by: (1) the amount of money received, and (2) the basis of distributed property (determined under § 732)
- 26 U.S.C. § 731 (DB) — Extent of recognition of gain or loss on distribution: the partnership itself never recognizes gain or loss when making a distribution; marketable securities are treated as money at fair market value when distributed; special investment partnership rules apply to distributions of marketable securities to eligible partners
- 26 U.S.C. § 732 (DB) — Basis of distributed property other than money: if the allowed basis is smaller than the amounts involved, the reduction goes first to items with unrealized losses, then by adjusted bases; if basis must be increased, extra amounts go first to items with unrealized gains; a partner who recently bought an interest without a § 754 election may elect within 2 years to use an adjusted-basis rule as if the election had been made
- 26 U.S.C. § 733 (DB) — Basis of distributee partner's interest: when a partnership gives a partner property and the partner is not leaving, the partner's tax basis in the partnership must be reduced (but not below zero) by the cash received and by the partner's basis in any distributed property as measured under § 732
How It Works
The general nonrecognition rule: A distribution from a partnership to a partner is treated as a return of the partner's investment in the partnership — not as income. The partner reduces their outside basis by the amount of cash received or the § 732 basis of property received, but no gain or loss is recognized. This reflects the "aggregate" theory of partnerships: a distribution is the partner simply withdrawing part of their proportionate interest in the partnership's assets.
The cash-exceeds-basis gain trigger: When cash distributions exceed a partner's outside basis, the excess is capital gain. This exception prevents tax-free distributions from exceeding the partner's investment in the partnership — if you've received back more than you put in (including your share of partnership debt that flows into basis under § 752), the excess is taxable. Character is generally capital (long-term if the interest has been held more than one year).
The leveraged real estate distribution cycle: The most economically significant application of § 731 is the real estate refinancing cycle. A partnership buys an apartment building for $2 million, takes on $1.5 million in mortgage debt (which flows into each partner's basis under § 752), and takes depreciation deductions over the years. The building appreciates to $5 million. The partnership refinances — takes a new $4 million mortgage, pays off the old $1.5 million, and has $2.5 million in net proceeds to distribute. The distributions to partners are tax-free up to their outside basis. Because the higher new mortgage increases their § 752 debt allocation, the distribution doesn't necessarily exceed their basis. The partners receive $2.5 million in cash without recognizing income, and the building continues to depreciate. This is the cash-out refi cycle that real estate limited partnerships have used for decades — it's entirely legal under current law but requires careful basis tracking.
Liquidating distributions and loss recognition: When a partner's interest is completely liquidated, the usual no-loss rule gives way — but only in the narrow circumstance where the partnership distributes solely cash, unrealized receivables, and inventory. If the partner receives only cash that is less than their outside basis, they recognize a capital loss (basis minus cash received). If the liquidating distribution includes any other property (real estate, securities, anything other than the three enumerated categories), no loss is recognized — instead, the distributed property takes a substitute basis equal to the partner's remaining outside basis, preserving the unrecognized loss in the property's basis for later recognition when the property is sold.
The § 732 substituted basis ceiling: When a partnership distributes property (other than cash) in a current distribution, the distributed property's tax basis in the partner's hands is the lesser of: (a) the partnership's adjusted basis in the property (substituted basis — the same basis the partnership had), or (b) the partner's remaining outside basis after subtracting cash received in the same distribution. The ceiling rule prevents a partner from receiving more basis in distributed property than their entire outside basis in the partnership interest. When the ceiling applies (partner's basis is less than the partnership's basis in the property), the partner takes a reduced basis, and if the partnership has a § 754 election, a § 734(b) downward basis adjustment may occur inside the partnership.
Deemed distributions from debt relief: Under § 752(b), a decrease in a partner's share of partnership debt is treated as a cash distribution. These deemed distributions flow through § 731 exactly like actual cash distributions — they reduce outside basis and can trigger gain if they exceed basis. Mortgage paydowns, refinancings that reduce a partner's debt allocation, and property sales that eliminate secured debt all create deemed distributions. A partner who has taken large depreciation deductions (reducing basis to near zero) is particularly vulnerable to gain recognition from deemed distributions that arise from debt events, even when no actual cash changes hands.
How It Affects You
If you are a partner receiving a cash distribution: The distribution is tax-free to the extent of your outside basis in the partnership interest. Track your basis annually using the Schedule K-1's beginning-of-year capital account and debt allocation — but note that capital accounts are often maintained on a "book" basis, not tax basis. Your tax basis is different from your book capital account; it includes your share of partnership liabilities under § 752. If you are unsure of your tax basis, request a tax basis capital account calculation from the partnership before assuming a distribution is fully tax-free. If you've been in the partnership for many years with large depreciation deductions reducing your basis, a substantial distribution may trigger unexpected gain.
If you are a partner in a real estate partnership that refinanced: A cash-out refinancing of a real estate partnership's mortgage may or may not be a taxable event depending on how the new debt is allocated. If the new mortgage is larger than the old one and allocated to you proportionally, your § 752 basis increases (offsetting the deemed distribution from the old debt relief). If the allocation changes — perhaps because new partners joined, or the debt terms changed to reduce your allocated share — you may have a net deemed distribution that exceeds your basis and triggers gain. Ask the partnership's tax advisor to prepare a "§ 752 and § 731 analysis" after any mortgage refinancing showing how each partner's basis and debt allocation changed.
If your partnership is making a liquidating distribution to a departing partner: Structure the distribution carefully to achieve the desired tax result. If the departing partner has losses suspended due to insufficient basis, a cash distribution up to (but not exceeding) their outside basis is tax-free; the remaining basis is preserved in any distributed property. If the partnership wants the departing partner to recognize a loss (e.g., to reflect the economic reality of a failed investment), the distribution must be solely cash — including any distributed receivables or inventory will prevent loss recognition, with the distributed property instead taking a substituted basis that preserves the loss for future recognition.
If you received a K-1 showing distributions larger than your capital account: This often means the distribution exceeded your "book" capital but not necessarily your tax basis — or it could signal that a taxable event occurred. Do not assume a distribution is tax-free just because the partnership treated it as a return of capital on the K-1. Your personal tax basis (tracked outside the K-1's book capital figures) is the determinative number. If you've received distributions in prior years that drew down your basis, a current-year distribution could trigger gain even if the K-1's capital account still shows a positive balance.
State Variations
States generally conform to federal § 731 nonrecognition rules for partnership distributions, but sourcing rules and state-specific basis tracking create variations:
- CA: California follows federal § 731 treatment. However, California-source gain (from gain recognized on cash distributions exceeding basis attributable to California real estate partnerships) is taxable to all partners, including non-residents. California requires separate California tax basis tracking when the California basis differs from federal basis (a common occurrence due to California non-conformity with federal depreciation rules).
- NY: New York follows federal § 731 treatment for most purposes. New York-source gain from partnership distributions is taxable to non-resident partners to the extent the gain is sourced to New York.
- States with different depreciation rules: Several states (notably California, New Jersey, Pennsylvania, and others) do not conform to federal bonus depreciation or have different § 179 limits. This creates state-specific basis differences — a partner's California tax basis in their partnership interest may be materially higher than their federal basis because California didn't allow the same depreciation deductions. Distributions that would be partially taxable for federal purposes may be fully tax-free for California purposes (if California basis is higher), or vice versa.
Implementing Regulations
- 26 CFR § 1.731-1 — Extent of recognition of gain or loss on distribution: the no-gain/no-loss general rule; the cash-exceeds-basis gain exception; the liquidating distribution loss rule and its limitation to cash/receivables/inventory distributions only
- 26 CFR § 1.731-2 — Partnership distributions of marketable securities: special rule treating distributions of marketable securities (publicly traded stocks, bonds) as cash distributions for § 731 gain recognition purposes — preventing tax-free distribution of appreciated securities that could then be sold at capital gain rates
- 26 CFR § 1.732-1 — Basis of distributed property: the substituted basis rule; the ceiling; the ordering rules for multiple property distributions; special basis rules for § 751 hot asset distributions
- 26 CFR § 1.732-2 — Adjustment to basis of distributed property: when the § 754 election is in effect, the § 734(b) adjustment mechanics for distributions that trigger gain/loss or create a basis discrepancy
Pending Legislation
- Marketable securities expansion: The § 731(c) rule treating marketable securities as cash for gain recognition was extended to cover certain partnership interests in 2017; proposals to expand the definition of "marketable securities" further have been discussed in the context of private equity fund secondary transactions.
- Real estate partnership tax reform: Periodic proposals to limit the refinancing-distribution cycle (the cornerstone real estate tax deferral strategy) by treating net proceeds of mortgage refinancings exceeding original investment as taxable income have not passed but continue to appear in progressive tax reform proposals.
Pending Legislation
- 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 application to partnerships — relevant because § 731 cash distributions trigger outside basis reductions that affect how adjusted book income and adjusted basis diverge for CAMT purposes. Status: in_committee.
Recent Developments
- IRS Notice on tiered partnership distributions: The IRS has issued guidance on distributions from tiered partnership structures (fund-of-funds, feeder-master structures) addressing how § 731 applies when a lower-tier partnership distributes property to an upper-tier partnership that then distributes to individual partners. The rules prevent "stacking" of nonrecognition across tiers in ways that would exceed what § 731 intends.
- Qualified opportunity zone fund distributions: QOZF partnerships face special rules on when distributions constitute "inclusion events" that trigger recognition of deferred gain — these rules interact with § 731 in complex ways and have been addressed in IRS regulations under § 1400Z-2.
- Capital account reform (2020 IRS regulations): The IRS finalized regulations in 2020 requiring partnerships to maintain capital accounts on a tax basis (not book basis) for Schedule K-1 reporting purposes beginning 2020. This change has improved the ability of partners to track their § 731 basis for distribution purposes, as K-1 capital accounts now more closely approximate the tax basis calculation needed for § 731 gain analysis.