A debt-financed distribution shows up on your Schedule K-1 (Form 1065) in two places that you have to read together: the cash sits in Box 19 Code A, and any net decrease in your share of partnership liabilities sits in Box 19 Code D. To report a debt-financed distribution from a K-1, add those two amounts, compare the total to your outside basis in the partnership interest, and report any excess as capital gain on Form 8949 and Schedule D. The K-1 by itself does not tell you whether tax is owed. Your basis does.
The K-1 Boxes That Carry a Debt-Financed Distribution
Three codes on the K-1 drive the reporting. Pull all three before you start any math.1Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) (2025)
- Box 19, Code A reports the cash and marketable securities the partnership actually distributed to you during the year. In a debt-financed distribution, this is the money that hit your account after the partnership borrowed.
- Box 19, Code D reports a deemed distribution of money caused by a net decrease in your share of partnership liabilities. No cash moves, but Section 752(b) treats the decrease as if the partnership handed you money.2Office of the Law Revision Counsel. 26 USC 752 – Treatment of Certain Liabilities
- Box 20, Code K reports the opposite — a net increase in your share of partnership liabilities, treated as a constructive cash contribution that raises your basis before the distribution is tested.
In a typical debt-financed distribution year you may see all three. The partnership borrows, your share of the new debt lands in Box 20 Code K, the cash lands in Box 19 Code A, and if other liabilities simultaneously paid down or your allocations shifted, a Code D figure appears as well. Each number belongs in the calculation; none of them substitutes for the others.
Running the Basis Test
Gain on a partnership distribution is recognized only to the extent the money distributed exceeds the partner’s adjusted basis in the partnership interest immediately before the distribution.3GovInfo. 26 USC 731 – Extent of Recognition of Gain or Loss on Distribution That is the whole test. Three steps get you there.
Establish pre-distribution basis. Start with your prior-year ending outside basis. Add your share of current-year partnership income and any liability increase shown in Box 20 Code K. The partnership does not track your outside basis for you, so this number has to come from a ledger you maintain yourself.4Office of the Law Revision Counsel. 26 USC 705 – Determination of Basis of Partner’s Interest
Add the two distribution figures. Combine Box 19 Code A and Box 19 Code D. That sum is the total distribution for Section 731 purposes.
Compare. Subtract the total distribution from pre-distribution basis. If the result is zero or positive, nothing is taxable and your remaining basis carries forward. If the total distribution exceeds basis, the excess is recognized gain. Basis then lands at exactly zero. It cannot go negative.5Internal Revenue Service. Partner’s Outside Basis
A worked example. You enter the year with a $200,000 outside basis. Your share of current-year income is $30,000, and a new partnership loan adds $100,000 to your share of liabilities (Box 20 Code K), lifting pre-distribution basis to $330,000. The partnership distributes $300,000 in cash (Box 19 Code A), and your share of other liabilities fell by $50,000 (Box 19 Code D). Total distribution is $350,000. That exceeds your $330,000 basis by $20,000, so you recognize a $20,000 gain and your remaining basis is zero.
Reporting the Excess on Form 8949 and Schedule D
Gain from a distribution in excess of basis is treated as gain from the sale or exchange of the partnership interest.6eCFR. 26 CFR 1.731-1 – Extent of Recognition of Gain or Loss on Distribution The K-1 instructions direct you to report it on Form 8949 and Schedule D of your Form 1040.1Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) (2025)
On Form 8949, enter the transaction as a constructive sale of your partnership interest. Use the date you acquired the interest as the acquisition date and the distribution date as the sale date. Report the excess amount as proceeds and zero as cost basis, since the non-taxable portion of the distribution already consumed your basis. The gain equals the proceeds figure.7Internal Revenue Service. Instructions for Form 8949
Character depends on holding period. If you have held the partnership interest more than one year, the gain is long-term and belongs in Part II of Form 8949 and Part II of Schedule D. One year or less puts it in Part I and taxes it at ordinary rates.8Office of the Law Revision Counsel. 26 USC 741 – Recognition and Character of Gain or Loss on Sale or Exchange The holding period runs from the date you acquired the interest to the date of the distribution. Schedule D aggregates the result with your other capital gains and losses and carries the net to Form 1040.9Internal Revenue Service. Form 8949 – Sales and Other Dispositions of Capital Assets
When Hot Assets Convert the Gain to Ordinary Income
Capital treatment is the default, but not the whole story. If the partnership holds “hot assets” under Section 751 — unrealized receivables or substantially appreciated inventory — part or all of the gain is recharacterized as ordinary income. Inventory is substantially appreciated when its fair market value exceeds 120% of the partnership’s adjusted basis in that inventory.10Office of the Law Revision Counsel. 26 USC 751 – Unrealized Receivables and Inventory Items
The portion of the excess distribution attributable to your share of those hot assets comes out of capital gain and lands in ordinary income. The K-1 instructions point to Regulation Section 1.751-1(a) for the split.1Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) (2025) This hits service partnerships with large receivables and trading partnerships holding appreciated inventory the hardest; the gain character can shift substantially before anything reaches Schedule D.
The 3.8% Net Investment Income Tax
Capital gain from an excess distribution is generally net investment income. The 3.8% Net Investment Income Tax applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds the threshold for your filing status.11Internal Revenue Service. Instructions for Form 8960 Net Investment Income Tax
- Married filing jointly or qualifying surviving spouse: $250,000
- Single or head of household: $200,000
- Married filing separately: $125,000
These thresholds are not indexed for inflation. The gain escapes NIIT only if the partnership interest is held in a trade or business in which you materially participate and the business is not a passive activity for you.11Internal Revenue Service. Instructions for Form 8960 Net Investment Income Tax Most limited partners do not clear that bar, so plan on the 3.8% applying. Report it on Form 8960.
Interest Expense Tracing Under Notice 89-35
When a partnership borrows specifically to fund distributions, the interest on that debt is not treated as a partnership operating expense. Under IRS Notice 89-35 it is allocated out to each partner, and each partner then traces the interest according to how they used their share of the distributed cash. Investment use produces investment interest expense. Personal use may produce no deduction at all.
The partnership should break this interest out on a statement attached to your K-1. If the statement is missing and your partnership routinely borrows to make distributions, request it. The character of the deduction follows what you did with the money, so two partners in the same partnership can end up with very different results from the same borrowing.
Why Item L Is Not Your Basis
Since the 2020 tax year, partnerships have reported each partner’s capital account on Item L of the K-1 using the tax basis method. That figure is computed in a manner generally consistent with the partner’s adjusted tax basis, but it excludes partnership liabilities.1Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) (2025)
Outside basis equals the tax basis capital account plus your share of partnership liabilities, plus any Section 743(b) adjustment if the partnership made a Section 754 election.5Internal Revenue Service. Partner’s Outside Basis A negative Item L balance does not mean negative basis — it usually means partnership liabilities are carrying the load. In a debt-financed distribution structure that is exactly what you expect to see: the distribution drives the capital account below zero while your share of the funding debt keeps outside basis above it. Use Item L as a checkpoint on the non-liability piece, but run the Section 731 test against the full outside basis number you maintain yourself.