Taxterity research

Outside basis and inside basis: reconciling a partner's two basis figures

Reviewed 2026-09-15 · AI-assisted draft and editing; sources and limitations remain visible for independent review.

Answer: A partner file carries three numbers that are routinely confused. Outside basis is the partner's adjusted basis in the partnership interest. It begins under section 722 for a partner who contributed money or property, or under section 742 for a partner who acquired the interest some other way, and then moves under section 705 for distributive shares of income and loss, for distributions, and for nondeductible expenditures that are not capital expenditures, decreased but never below zero. Inside basis is the partnership's own adjusted basis in its assets, which for contributed property carries over from the contributor under section 723. The capital account shown on Schedule K-1 is a third figure kept on the partnership's books. At formation the aggregate of the partners' outside bases and the partnership's inside basis generally correspond. They come apart when an interest changes hands, because section 743(a) leaves partnership property basis alone unless a section 754 election is in effect or a mandatory adjustment applies; when a partner's basis stalls at zero while the partnership keeps generating deductions; when a distribution shifts basis with no section 734(b) adjustment; and whenever liabilities move under section 752. Reconciling the two figures is the work product, and the reported capital account cannot stand in for it: the regulation determines a partner's adjusted basis without regard to any amount shown in the partnership books as that partner's capital or equity account.

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Scope

Jurisdiction: United States — federal

Tax periods: Not period-specific; checked 2026-09-15, 2025 Schedule K-1 partner instructions, Publication 541, rev. December 2025

Assumptions

Exclusions

1. Three numbers, three sources

Outside basis lives at the partner level and answers partner-level questions: how much loss is allowed this year, whether a cash distribution triggers gain, and what the gain or loss is on a sale of the interest. Inside basis lives at the entity level and answers entity-level questions: the partnership's depreciation, and its gain or loss when it sells an asset. The section 704(b) or tax-basis capital account on the Schedule K-1 is a book record of the partner's equity, maintained under the partnership agreement and the reporting instructions.

Keeping them separate is not pedantry. Each is computed from a different Code provision, each is updated by different events, and only one of them is the number the partner needs when the question is a loss limitation or a distribution.

2. Where each figure starts

Section 722 gives a contributing partner an interest basis equal to the money contributed plus the adjusted basis of the contributed property in that partner's hands, increased by any gain recognized under section 721(b). Section 723 gives the partnership a basis in the contributed property equal to the contributor's adjusted basis, increased by the same section 721(b) gain. The two provisions are deliberately parallel, which is why a contribution of appreciated property does not, by itself, create a gap between aggregate outside basis and inside basis.

Section 742 covers everything else: an interest acquired other than by contribution takes its basis under part II of subchapter O, section 1011 and following. For a buyer that means cost. Nothing in section 742 touches the partnership's basis in its assets, and that asymmetry is the single largest source of divergence in practice.

3. How outside basis moves after formation

Section 705(a) increases the starting figure by the partner's distributive share of taxable income, of tax-exempt receipts, and of the excess of depletion deductions over the basis of the depletable property. It decreases the figure, but not below zero, by distributions and by the partner's share of partnership losses and of expenditures that are neither deductible in computing partnership taxable income nor capital expenditures. Depletion on oil and gas property covered by section 613A(c)(7)(D) runs through its own decrease rule.

The regulation adds the timing point that most workpapers get wrong. A partner is required to determine adjusted basis only when it is needed to determine a tax liability, and the determination is ordinarily made as of the end of the partnership taxable year. On a sale or exchange of all or part of an interest, or a liquidation of the entire interest, basis is determined as of the date of that event instead.

Liabilities move the number too. An increase in a partner's share of partnership liabilities is treated as a contribution of money, and a decrease is treated as a distribution of money, so a refinancing or a payoff that changes nothing about the partnership's operations can still change every partner's basis.

4. Why the two figures drift apart

Transfer of an interest. A buyer takes a cost basis in the interest under section 742, but the basis of partnership property is not adjusted on a sale, exchange or death of a partner unless a section 754 election is in effect or the partnership has a substantial built-in loss immediately after the transfer. The buyer therefore owns a share of assets carrying the seller's historic basis while holding an interest basis that reflects the price paid. The same mismatch arises on a step-up at death.

The zero floor and suspended losses. Section 705(a)(2) stops at zero and section 704(d) allows a partner's share of loss only to the extent of adjusted basis at the end of the partnership year, with the excess allowed later when basis is restored. The partnership's inside basis keeps declining while the partner's outside basis sits at zero, and the suspended loss is carried outside the partnership's books.

Distributions. A partner recognizes gain to the extent money distributed exceeds the adjusted basis of the interest immediately before the distribution, and the basis the distributee takes in distributed property need not equal the partnership's basis in it. Absent a section 754 election or a substantial basis reduction, the partnership makes no compensating adjustment to the basis of what it still owns.

Liabilities and the measurement convention. Because a partner's share of liabilities is part of outside basis, any comparison to a share of inside basis has to be made on a consistent footing. The regulation under section 743 supplies a usable convention: a partner's share of the adjusted basis of partnership property equals that partner's interest in the partnership's previously taxed capital plus that partner's share of partnership liabilities.

5. The reported capital account is not the answer

The regulation says it directly: the adjusted basis of a partner's interest is determined without regard to any amount shown in the partnership books as the partner's capital, equity or similar account. Its own illustration is a partner who contributes property with an adjusted basis of 400 dollars and a value of 1,000 dollars alongside a partner who contributes 1,000 dollars of cash. Both may show a capital account of 1,000 dollars while the first partner's interest basis is 400 dollars.

The partner instructions for Schedule K-1 take the same position, use the term outside basis themselves, and put the duty on the partner: it is the partner's responsibility to track and maintain the information needed to figure adjusted basis, and the capital account information reported in item L is based on the partnership's books and records and cannot be used to figure the partner's adjusted basis. Those instructions also provide a worksheet for adjusting the basis of a partner's interest, in two parts, one for the basis roll-forward and one for allocating losses and deductions when basis runs out.

A section 704(b) capital account diverges for a further reason: it records contributed property at fair market value net of liabilities, while sections 722 and 723 record adjusted basis. That difference is precisely the built-in gain that section 704(c) then has to allocate.

6. A reconciliation workpaper

Set up three columns for one partner and one year end. Column one, outside basis: start from the section 722 or section 742 figure, then roll forward every year with the section 705 increases and decreases and the section 752 liability movements, and show suspended section 704(d) losses separately rather than netting them into basis.

Column two, the partner's share of inside basis: compute previously taxed capital the way the section 743 regulation does it. Assume the partnership disposes of all of its assets in a fully taxable transaction for cash equal to fair market value, take the cash the partner would receive on a liquidation following that hypothetical transaction, increase it by the tax loss that would be allocated to the partner and decrease it by the tax gain that would be allocated to the partner, then add the partner's share of partnership liabilities.

Column three, the reported capital account from item L, carried only as a reconciling reference. Then list every difference between columns one and two with the provision that produced it: a purchase or inherited interest with no section 754 election, a suspended loss, a distribution with no section 734(b) adjustment, a section 743(b) adjustment that belongs to this partner alone, or an unreconciled gap that means a record is missing. The last category is the honest answer when contribution records for an older partnership cannot be produced.

Note the limit of the convention in column two. The previously taxed capital computation is written for determining a transferee's share in a section 743(b) adjustment. Used as a general bridge it is a research device that makes the two columns comparable, not a rule that applies to every partner in every year.

7. What would change the reconciliation

A section 754 election in effect for a year of transfer or distribution changes column two directly, and a mandatory adjustment can change it even without an election. A companion page in this library, Section 754 election: what to decide before the partnership files, works through that decision and its filing mechanics; this page stops at measuring the gap the election would close.

Contributed property with built-in gain, a revaluation of partnership property, a tiered partnership, and debt that shifts between recourse and nonrecourse all move one column without moving the other. Each is a reason to date the workpaper and to name the event, not simply to carry a balance forward.

Once the columns are drawn, ask Taxterity a research question about the specific provision behind a difference you cannot explain, or run a Federal Tax Memo on the basis position, and confirm each authority against the partnership's own records before relying on the number.

Related research

Official sources

  1. 26 U.S.C. 705 — Determination of basis of partner's interest — Section 705(a)(1)-(3) and the decreased but not below zero limitation; U.S. Code prelim, laws in effect on 2026-09-14
  2. 26 U.S.C. 722 — Basis of contributing partner's interest — Full text; money plus adjusted basis of contributed property plus section 721(b) gain; as in effect 2026-09-14
  3. 26 U.S.C. 723 — Basis of property contributed to partnership — Full text; carryover of the contributor's adjusted basis plus section 721(b) gain; as in effect 2026-09-14
  4. 26 U.S.C. 742 — Basis of transferee partner's interest — Full text; basis of an interest acquired other than by contribution determined under part II of subchapter O; as in effect 2026-09-14
  5. 26 U.S.C. 743 — Special rules where section 754 election or substantial built-in loss — Section 743(a), no adjustment to partnership property on transfer absent a section 754 election or substantial built-in loss; as in effect 2026-09-14
  6. 26 U.S.C. 731 — Extent of recognition of gain or loss on distribution — Section 731(a)(1), gain to the extent money distributed exceeds the adjusted basis of the interest immediately before the distribution; as in effect 2026-09-14
  7. 26 U.S.C. 732 — Basis of distributed property other than money — Section 732(a)(1)-(2) and 732(b), the distributee's basis in distributed property and the interest-basis ceiling; as in effect 2026-09-14
  8. 26 U.S.C. 734 — Adjustment to basis of undistributed partnership property — Section 734(a), no adjustment to partnership property on a distribution absent a section 754 election or a substantial basis reduction; as in effect 2026-09-14
  9. 26 U.S.C. 704 — Partner's distributive share — Section 704(d)(1)-(2), loss allowed only to the extent of adjusted basis at the end of the partnership year, with carryover; as in effect 2026-09-14
  10. 26 U.S.C. 752 — Treatment of certain liabilities — Section 752(a) and 752(b), increases and decreases in a partner's share of liabilities treated as contributions and distributions of money; as in effect 2026-09-14
  11. 26 CFR 1.705-1 — Determination of basis of partner's interest — Paragraph (a)(1), timing and the rule that basis is determined without regard to the book capital account, with the 400 dollar and 1,000 dollar illustration; (a)(2)-(3), increases and decreases
  12. 26 CFR 1.743-1 — Optional adjustment to basis of partnership property — Paragraph (d)(1)(i)-(iii), previously taxed capital plus share of liabilities; (d)(2), the hypothetical transaction
  13. 26 CFR 1.704-1 — Partner's distributive share — Paragraph (b)(2)(iv)(b), capital accounts record contributed and distributed property at fair market value net of liabilities
  14. IRS Partner's Instructions for Schedule K-1 (Form 1065), tax year 2025 — Heading Basis Limitations: partner's responsibility to track adjusted basis (outside basis), citing Reg. 1.705-1(a)(1); item L cannot be used to figure adjusted basis; Worksheet for Adjusting the Basis of a Partner's Interest
  15. IRS Publication 541, Partnerships (rev. December 2025) — Basis of Partner's Interest, and its Adjusted Basis subsection (Increases.; Decreases.; Book value of partner's interest.; When determined.); Effect of Partnership Liabilities (Partner's basis increased.; Partner's basis decreased.)

Limitations