Partnership property distributions can look simple—cash to one partner, equipment or real estate to another—but the federal basis rules under Subchapter K can change the tax result. This guide is written for partners and advisers in Hilo and throughout Hawaiʻi. It focuses on federal Sections 731, 732, 733, 734, 735, and related Section 751 rules. Hawaiʻi income-tax treatment can require a separate analysis.
Start with Section 731: when is gain or loss recognized?
Under the general rule, a partner does not recognize gain on a distribution unless the money distributed—including marketable securities treated as money—exceeds the partner’s adjusted outside basis in the partnership interest. The excess is generally gain. A partner generally does not recognize loss on a nonliquidating property distribution, and loss in a complete liquidation is limited to specific statutory conditions.
Before applying the rule, update outside basis for the partner’s share of income, deductions, contributions, liabilities, and prior distributions. A K-1 alone is not a complete outside-basis schedule.
Section 732: basis of property received
For a current, nonliquidating distribution, the partner generally takes a carryover basis in distributed property: the partnership’s adjusted basis immediately before distribution. That basis cannot exceed the partner’s remaining outside basis after reducing outside basis for money received. In a complete liquidation, the ordering and allocation rules differ, so do not use the current-distribution shortcut without checking the statute and regulations.
Section 732 also has special rules for contributed property, substituted basis, and certain marketable securities. The property’s fair market value is not automatically its tax basis merely because the property is distributed.
Section 733: reduce the partner’s outside basis
For a nonliquidating distribution, outside basis is reduced—but not below zero—by the money distributed and the basis assigned to distributed property under Section 732. This reduction is central to avoiding double counting: the partner receives property with basis, and the partnership interest correspondingly loses basis.
Ending outside basis = beginning outside basis − money − basis of distributed property
Sample calculation: cash plus equipment
- Hilo partner’s beginning outside basis: $90,000.
- Cash distribution: $20,000.
- Partnership’s adjusted basis in equipment distributed: $30,000; fair market value is $45,000.
- Section 732 property basis is generally $30,000, subject to the partner’s remaining basis limitation.
- Ending outside basis: $90,000 − $20,000 − $30,000 = $40,000.
- No gain is recognized in this simplified example because cash does not exceed beginning outside basis. The equipment’s $30,000 tax basis—not its $45,000 fair market value—generally carries to the partner.
Sample calculation: cash exceeds outside basis
- Beginning outside basis: $25,000.
- Cash distribution: $32,000.
- Section 731 gain: $32,000 − $25,000 = $7,000, before considering special rules.
- Because the cash has exhausted outside basis, a later property-basis calculation may be limited or produce zero basis depending on the transaction and liquidation status.
The character of recognized gain and any Section 751 “hot asset” recharacterization must be reviewed separately.
Section 734: partnership-level basis adjustment
Section 734 can adjust the partnership’s basis in its remaining property after a distribution. A Section 754 election may make an adjustment elective in some situations; an adjustment can be mandatory in others, including certain gain-recognition or basis-disparity situations. Review the partnership agreement, prior elections, and the partnership’s basis schedules before finalizing Form 1065.
Section 735: what happens when the partner later sells distributed property?
Section 735 generally carries character rules into the partner’s later disposition of distributed property. The holding period and character can depend on the type of property and whether the distribution involved unrealized receivables, inventory, or other Section 751 property. A partner should preserve the partnership’s basis, holding-period records, and any built-in gain information.
Hilo and Hawaiʻi checklist
- Reconcile the partner’s federal outside basis before and after every distribution.
- Separate cash, marketable securities, real estate, equipment, inventory, and unrealized receivables.
- Check whether a Section 754 election is in effect and whether Section 734 requires an adjustment.
- Review Section 751 before treating a distribution as entirely capital in character.
- Analyze Hawaiʻi resident, nonresident, and pass-through filing separately; federal Subchapter K results do not automatically determine state tax.
- Keep the partnership agreement, distribution resolution, appraisals, debt schedules, K-1, Forms 731/732/733 workpapers, and Form 1065 records.
Bottom line
Sections 731 through 735 coordinate gain recognition, distributed-property basis, outside-basis reductions, partnership-level adjustments, and later-sale character. The examples above are simplified education—not a legal opinion or filing calculation. Confirm the current Internal Revenue Code, Treasury regulations, IRS Publication 541, and Hawaiʻi requirements with a qualified tax professional.
