Built-In Gain and Built-In Loss: Basis, Boot, and 704(c) Rules

When you move property into a corporation or partnership, the difference between what the asset is worth and its tax basis at the moment of transfer becomes a built-in gain or built-in loss, and the basis implications of that gap follow the asset and your ownership interest for years afterward. The transfer itself is usually tax-free, but the built-in amount doesn’t disappear. It gets recorded on both sides of the transaction, controls how future depreciation and sale proceeds are taxed, and can trigger unexpected tax if you also receive cash, transfer debt-encumbered property, or later take distributions.

Compare the property’s fair market value to its adjusted tax basis at the moment of contribution. Value above basis is built-in gain; basis above value is built-in loss. Equipment worth $100,000 with a $60,000 basis carries $40,000 of built-in gain. Property with a $150,000 basis and $120,000 of value carries $30,000 of built-in loss. No tax is due at contribution, but the number is now on the books.

Why the Transfer Is Tax-Free in the First Place

Section 351 lets you transfer property to a corporation solely in exchange for stock without recognizing gain or loss, provided you (alone or with other transferors) control the corporation immediately after.¹ Section 721 does the same for partnerships: no gain or loss on a contribution of property in exchange for a partnership interest.²

These are deferral rules, not exemptions. The tax code lets the transfer happen now because the basis rules that follow ensure the built-in gain or loss will get taxed later.

Your Basis in the Stock or Partnership Interest

Contribute property to a partnership, and your basis in the partnership interest equals the adjusted basis you had in the property right before the contribution.³ Contribute an asset with a $50,000 basis, and your partnership interest starts at $50,000, whatever the market value.

For a Section 351 corporate transfer, the same substituted-basis idea applies. Your stock basis equals the basis of the property you transferred, reduced by any cash or other property received and increased by any gain you recognized on the exchange.⁴ In a clean stock-for-property swap with no cash, your stock basis is simply your old property basis.

The Entity’s Basis in the Contributed Asset

The receiving entity records the property at the same basis you had. Section 723 sets a partnership’s basis in contributed property equal to the contributing partner’s adjusted basis.⁵ Section 362 does the same for corporations, then adds any gain the transferor recognized.⁶

Because both the owner’s interest and the entity’s asset carry the same starting basis, the built-in gain or loss stays alive on both sides. A $10,000 built-in gain sits on the entity’s books in the asset, and your ownership interest reflects the original cost. The appreciation doesn’t vanish in the transfer, and the character of the asset in your hands controls what happens later: inventory contributed to a partnership produces ordinary income or loss on any sale within five years, and capital loss property produces capital loss on any disposition within five years to the extent of the built-in loss existing at contribution.⁷

Holding Period Tacks On

Because the entity takes a carryover basis, it also inherits your holding period. Section 1223(2) lets the entity count the time you held the asset when deciding whether a future sale is long-term.⁸ The same works for your stock or partnership interest, as long as the property was a capital asset or business-use asset when you exchanged it.

When the Transfer Isn’t Fully Tax-Free

Cash or Other Property (Boot)

If you receive cash or property other than stock along with your shares in a Section 351 exchange, you recognize gain up to the amount of cash plus the fair market value of the other property received. You can never recognize a loss this way.¹ Contribute an asset with $40,000 of built-in gain and take $15,000 cash on top of your stock, and $15,000 of that gain is taxable now. Your stock basis is then adjusted for the gain recognized and the cash received.

Liabilities Bigger Than Basis

When a corporation assumes debt attached to your property, Section 358(d) treats the assumption as money you received, which reduces your stock basis by that amount.⁴ That works fine when the debt is smaller than your basis. The problem is when it isn’t.

Under Section 357(c), any excess of assumed liabilities over the total adjusted basis of the property you transferred is treated as gain from the sale of the property. The character depends on the asset: capital gain for capital assets, ordinary income for the rest.⁹ This catches people out. You can owe tax on a transfer you thought was tax-free simply because you contributed mortgaged property with more debt than remaining basis. And if the IRS finds the liability was assumed to avoid tax or without a real business purpose, the full liability is treated as cash received, not just the excess.¹⁰

The Built-In Loss Guardrail

Built-in losses get extra scrutiny because, without a check, the same economic loss could be deducted twice: once by the shareholder on the stock and again by the corporation on the asset. Section 362(e)(2) blocks the duplication. When the aggregate basis of all contributed assets exceeds their aggregate fair market value, the corporation must step down its basis in those assets to fair market value, allocating the reduction among them in proportion to each asset’s built-in loss.⁶ After the adjustment, the built-in loss lives only in the shareholder’s stock basis.

You have a choice. The transferor and the corporation can jointly elect under Section 362(e)(2)(C) to reduce the shareholder’s stock basis instead, leaving the corporation’s asset basis alone. The election is irrevocable and needs a written, binding agreement between both parties before the filing deadline.¹¹ Which side to reduce depends on who is more likely to eventually realize the loss. Either way, it gets claimed only once.

The Partnership Wrinkle: Section 704(c) Allocations

Partnerships face something corporations don’t. Section 704(c) requires the partnership to allocate depreciation, amortization, and gain or loss on the contributed asset so the built-in gain or loss is borne by the contributing partner, not the others.¹²

Say a partner contributes a building worth $200,000 with a $120,000 tax basis. That $80,000 built-in gain is the contributing partner’s for tax purposes. If the partnership later sells for $250,000, the first $80,000 of gain goes to that partner, and only the remaining $50,000 of post-contribution appreciation is divided under the partnership agreement.

Three methods are allowed:

The traditional method matches tax allocations to book allocations as closely as possible, but the total tax deduction across partners can’t exceed the partnership’s actual deduction. That ceiling rule can shortchange the non-contributing partners on depreciation.
The traditional method with curative allocations offsets the ceiling-rule distortion by shifting tax items from other assets to make the non-contributing partners whole.
The remedial method creates notional tax items that don’t correspond to any actual economic event. The non-contributing partner gets a full remedial allocation and the contributing partner gets an equal and opposite one. It eliminates the distortion but adds bookkeeping.

The partnership agreement should say which method applies. If it doesn’t, the traditional method is the default, and the non-contributing partners may end up with less depreciation than they expected.¹²

Seven-Year Anti-Abuse Rules for Partnerships

Two provisions stop partnerships from being used as “mixing bowls” to move appreciated property between parties.

Section 704(c)(1)(B): if the partnership distributes contributed property to any partner other than the original contributor within seven years, the contributing partner is treated as if the property were sold at fair market value, recognizing the remaining built-in gain or loss.¹³

Section 737 flips the direction. If you contributed property to a partnership within the last seven years and then receive a distribution of other property, you may have to recognize gain equal to the lesser of the excess of the distribution’s fair market value over your partnership basis, or your net precontribution gain (the total remaining built-in gain on property you contributed).¹⁴

Built-In Gains Tax After an S-Corp Conversion

When a C corporation elects S status, the assets carry their existing built-in gains into the new structure. Section 1374 imposes a corporate-level tax on net recognized built-in gain during a five-year recognition period starting on the first day of S status.¹⁵ The rate is the highest corporate rate under Section 11(b), currently 21%.¹⁶ It’s on top of the income that passes through to shareholders.

The amount taxed each year is the smallest of the built-in gain recognized that year on assets that had built-in gain or loss at conversion, the corporation’s total taxable income for the year, and the remaining net unrealized built-in gain not yet recognized.¹⁷ Excess amounts in a low-income year carry forward within the five-year window. Once the window closes, the built-in gains tax no longer applies.

Reporting and What Errors Cost

Section 351 transfers require disclosure. Every “significant transferor” must attach a statement to the return identifying the transferee corporation, the transfer dates, and the fair market value and basis of each category of transferred property.¹⁸ The corporation files a parallel statement. Both sides keep permanent records of amounts, basis, fair market value, and liabilities assumed.

Partnerships have to track each contributed asset’s tax basis and its book value (fair market value at contribution) separately. Those numbers diverge by design, and the partnership uses the gap to run 704(c) allocations every year the asset stays on the books. Most compliance problems start with failing to keep those parallel records.

Getting basis wrong is expensive. Accuracy-related penalties under Section 6662 add 20% of the resulting underpayment.¹⁹ Interest compounds daily on top. For the second quarter of 2026, the IRS underpayment rate is 6%, and large corporate underpayments run at 8%.²⁰ The rates reset quarterly with the federal short-term rate. An error that sits undetected for a few years can cost more than the original tax at stake.

1
Office of the Law Revision Counsel. 26 USC 351 – Transfer to Corporation Controlled by Transferor
2
Office of the Law Revision Counsel. 26 USC 721 – Nonrecognition of Gain or Loss on Contribution
3
Office of the Law Revision Counsel. 26 USC 722 – Basis of Contributing Partner’s Interest
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Office of the Law Revision Counsel. 26 USC 358 – Basis to Distributees
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Office of the Law Revision Counsel. 26 USC 723 – Basis of Property Contributed to Partnership
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Office of the Law Revision Counsel. 26 USC 362 – Basis to Corporations
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Office of the Law Revision Counsel. 26 USC 724 – Character of Gain or Loss on Contributed Unrealized Receivables, Inventory Items, and Capital Loss Property
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Office of the Law Revision Counsel. 26 USC 1223 – Holding Period of Property
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eCFR. 26 CFR 1.357-2 – Liabilities in Excess of Basis
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Office of the Law Revision Counsel. 26 USC 357 – Assumption of Liability
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GovInfo. 26 CFR 1.362-4 – Basis of Loss Duplication Property
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eCFR. 26 CFR 1.704-3 – Contributed Property
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Office of the Law Revision Counsel. 26 USC 704 – Partner’s Distributive Share
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Office of the Law Revision Counsel. 26 USC 737 – Recognition of Precontribution Gain in Case of Certain Distributions to Contributing Partner
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Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains
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Office of the Law Revision Counsel. 26 USC 11 – Tax Imposed
17
eCFR. 26 CFR 1.1374-2 – Net Recognized Built-In Gain
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eCFR. 26 CFR 1.351-3 – Records to Be Kept and Information to Be Filed
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Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
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Internal Revenue Service. Quarterly Interest Rates