Capital Gains Tax for Partners: Rates, Basis, and Distributions

A partnership does not pay federal income tax on its capital gains. Instead, capital gains tax for partners works through pass-through: the partnership reports the gain, and each partner picks up their share on their own return and pays at the individual rate that applies to them. For 2026, that means 0%, 15%, or 20% on long-term gains, ordinary rates up to 37% on short-term gains, and possibly an extra 3.8% surtax and a 25% rate on the piece attributable to real estate depreciation.

How the Pass-Through Works

A partnership is a conduit. It files Form 1065 to tell the IRS what it earned, but it pays no income tax of its own.¹ Every item of income, gain, loss, and deduction flows out to the partners in the shares set by the partnership agreement, and each partner reports their share whether or not any cash actually changed hands that year.

Two features of this system drive the tax result for a partner. First, the character of each item is fixed at the partnership level and carries through unchanged. A long-term capital gain the partnership realizes is a long-term capital gain on the partner’s return. A short-term loss stays short-term. Second, the holding period that decides short-term versus long-term is the partnership’s holding period in the asset, not the partner’s holding period in the partnership interest.

That character-preservation rule is what makes the individual capital gains rates matter here. Ordinary partnership income and capital gains from the partnership sit in different buckets on the partner’s Form 1040 and get taxed differently.

2026 Capital Gains Rates for Partners

If the partnership held the asset one year or less before selling, the partner’s share of the gain is short-term and taxed at ordinary rates, which can reach 37%. If the holding period is more than one year, the gain is long-term and taxed at preferential rates of 0%, 15%, or 20%, depending on the partner’s total taxable income.²

For tax year 2026, the long-term thresholds are:³

0% rate: taxable income up to $49,450 (single), $98,900 (married filing jointly), or $66,200 (head of household).
15% rate: taxable income above those figures but not above $545,500 (single), $613,700 (married filing jointly), or $579,600 (head of household).
20% rate: taxable income above the 15% ceiling.

Two additional charges can layer on top. Gain that traces to depreciation the partnership previously claimed on real estate, called unrecaptured Section 1250 gain, is taxed at a maximum rate of 25%.² And partners with modified adjusted gross income over $200,000 (single) or $250,000 (married filing jointly) owe a 3.8% Net Investment Income Tax on the lesser of their net investment income or the amount above the threshold.⁴ Capital gains flowing through from a partnership count as net investment income for that calculation.⁵

Collectibles gains passed through from a partnership come with their own ceiling of up to 28% and are reported separately on the K-1.⁶

Which Sales Actually Generate Capital Gain

Capital gain treatment depends on the asset being a capital asset in the partnership’s hands. The tax code defines that broadly to include any property the partnership holds, then carves out the main business assets: inventory and property held for sale to customers, depreciable business property, and accounts receivable from ordinary operations.⁷ What is left is largely investment property: investment real estate, stocks, bonds, and similar holdings.

Depreciable business property and real property used in the trade or business are not capital assets, but Section 1231 often gets them to the same place. When sold at a net gain, Section 1231 property is generally taxed at long-term capital gain rates after depreciation recapture is accounted for. That gain flows through and picks up the same 25% cap on the depreciation piece described above.

Outside Basis and Why It Matters for Gains

A partner’s outside basis is their tax investment in the partnership interest. It sets the ceiling on how much loss the partner can deduct in a given year and controls whether a distribution triggers gain, so it directly affects when and how much capital gains tax a partner pays.

Outside basis starts with cash contributed plus the adjusted basis of any property contributed. From there it moves every year. It goes up with the partner’s share of income and gains, additional contributions, and increases in the partner’s share of partnership liabilities. It goes down with distributions, the partner’s share of losses and deductions, and decreases in the partner’s share of liabilities. A partner who does not track this number cannot correctly compute gain on a distribution or on the eventual sale of the interest.

When a Partnership Loss Actually Reduces Tax

A loss on the K-1 does not automatically offset a capital gain elsewhere. Four limits apply in order, and a loss has to clear each one to be deductible in the current year.

The first is the basis limit: a partner can deduct losses only up to outside basis at the end of the partnership’s tax year, with the excess suspended and carried forward until basis is restored.⁸ The second is the at-risk limit, which caps deductions at the amount the partner actually has at economic risk in the activity; nonrecourse debt, for example, can raise basis without raising the at-risk amount.⁹ The third is the passive activity limit: partners who do not materially participate can use partnership losses only against income from other passive activities, with the rest carried forward until they generate passive income or dispose of the interest. The fourth is the excess business loss limit, which caps net business losses non-corporate taxpayers can deduct in a year and converts the excess to a net operating loss carryforward.

Because these run in sequence, a partner can end up with layers of suspended losses that never reach the capital gain on their return until a later year unlocks them.

Distributions: Usually Tax-Free, Sometimes Not

Cash distributions from a partnership are treated as a return of capital up to the partner’s outside basis. A partner recognizes gain only when cash distributed exceeds the adjusted outside basis of the interest immediately before the distribution.¹⁰ That excess is taxed as gain from the sale of the partnership interest, which is generally long-term capital gain if the partner has held the interest for more than a year.

Property distributions behave differently. No gain is recognized by the partner or the partnership on a distribution of property other than money.¹⁰ The property takes a carryover basis from the partnership, capped at the partner’s remaining outside basis after subtracting any cash distributed in the same transaction.¹¹ Loss recognition on a distribution is narrow: only in a liquidating distribution where the partner receives nothing but cash and certain hot assets, and the total is less than outside basis.

Hot Assets Turn Capital Gain Into Ordinary Income

Section 751 recharacterizes the piece of a distribution or sale attributable to the partnership’s unrealized receivables and appreciated inventory. That piece is taxed as ordinary income, not capital gain, even when the rest of the transaction qualifies for the preferential rates.¹² It is the most common way a partner’s expected capital gain becomes something more expensive.

Selling the Partnership Interest

When a partner sells the interest itself, the default rule treats the gain or loss as arising from the sale of a capital asset.¹³ Gain equals sale price minus adjusted outside basis, and holding the interest more than a year puts the gain at long-term rates.

Two carve-outs adjust that clean result. The share of the sale price attributable to the partnership’s hot assets is ordinary income under Section 751, so a selling partner has to look through the partnership to identify what portion relates to unrealized receivables and inventory.¹² And any gain attributable to the partner’s share of the partnership’s depreciable real estate is subject to the 25% unrecaptured Section 1250 rate rather than the standard long-term rate.¹⁴ Treating the entire gain as plain long-term capital gain is a frequent audit issue.

What Capital Gains Tax Does Not Cover

Capital gains flowing through from a partnership are not subject to self-employment tax. Ordinary business income is a different question: a general partner’s share of ordinary partnership income is generally included in net earnings from self-employment and subject to SECA at up to 15.3%.¹⁵ Limited partners are excluded from self-employment income on their distributive share, except for guaranteed payments for services rendered.¹⁶ For LLC members taxed as partnerships, the IRS has never finalized regulations defining “limited partner” for this purpose, so treatment in that gray area is worth reviewing with a tax advisor.

Reporting on Your Return

The partnership files Form 1065 with Schedule D showing the entity’s overall capital gains and losses.¹ For a calendar-year partnership, the return is due March 15, with a six-month automatic extension available on Form 7004.¹⁷

Each partner receives a Schedule K-1 that breaks out their share of every item. For capital transactions, the K-1 reports short-term capital gains and losses, long-term capital gains and losses, collectibles gains, and unrecaptured Section 1250 gain on separate lines.⁶ Those figures move onto Schedule D of Form 1040, where they combine with the partner’s other capital transactions to produce the net figure taxed at the rates above.¹⁸

1
Internal Revenue Service. About Form 1065, U.S. Return of Partnership Income
2
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
3
Internal Revenue Service. Rev. Proc. 2025-32
4
Internal Revenue Service. Net Investment Income Tax
5
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
6
Internal Revenue Service. Schedule K-1 (Form 1065) – Partners Share of Income, Deductions, Credits, Etc.
7
Office of the Law Revision Counsel. 26 USC 1221 – Capital Asset Defined
8
Office of the Law Revision Counsel. 26 USC 704 – Partners Distributive Share
9
Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk
10
GovInfo. 26 USC 731 – Extent of Recognition of Gain or Loss on Distribution
11
GovInfo. 26 USC 732 – Basis of Distributed Property Other Than Money
12
Office of the Law Revision Counsel. 26 USC 751 – Unrealized Receivables and Inventory Items
13
Office of the Law Revision Counsel. 26 USC 741 – Recognition and Character of Gain or Loss on Sale or Exchange
14
Internal Revenue Service. Sale of a Partnership Interest
15
Internal Revenue Service. Self-Employment Tax and Partners
16
Office of the Law Revision Counsel. 26 USC 1402 – Definitions
17
Office of the Law Revision Counsel. 26 USC 6072 – Time for Filing Income Tax Returns
18
Internal Revenue Service. Instructions for Schedule D (Form 1040)