Under IRC Section 722, the basis of a contributing partner’s interest equals the cash contributed plus the adjusted basis of any property contributed at the time of the contribution. Fair market value does not enter the calculation. That starting figure, your outside basis, is what controls how much partnership loss you can deduct, whether future distributions are taxable, and the gain or loss you report when you eventually sell the interest.
The Section 722 Formula
The statute itself is short. Your initial outside basis is the sum of two things: cash you put in, and your adjusted basis in any property you contributed, measured on the date of contribution.1Office of the Law Revision Counsel. 26 USC 722 Basis of Contributing Partner’s Interest
Work an example. You contribute equipment currently worth $100,000. You bought it years ago for $60,000 and have depreciated it down to an adjusted basis of $40,000. Your outside basis in the partnership interest is $40,000. The $100,000 fair market value is irrelevant for your basis.
Mix cash and property in the same transaction and you simply add them. A $25,000 cash contribution together with property having a $40,000 adjusted basis produces a $65,000 starting outside basis.
Why Fair Market Value Doesn’t Count
The gap between fair market value and adjusted basis doesn’t disappear when you contribute property. It travels with you as built-in gain attached to your partnership interest. In the equipment example, $60,000 of built-in gain sits there waiting. If the partnership later sells the equipment, or you sell your interest, that gain gets recognized at that point. Section 722 defers the tax; it doesn’t erase it.
How Partnership Liabilities Change the Starting Number
Cash and property basis is only part of the picture. Under Section 752, your share of partnership liabilities is treated as a cash contribution, which increases your outside basis. A decrease in your share of partnership liabilities is treated as a cash distribution, which decreases it.2Office of the Law Revision Counsel. 26 U.S. Code 752 – Treatment of Certain Liabilities
This matters most when you contribute property that carries debt. Suppose you contribute property subject to a $200,000 mortgage and your interest in the partnership is 25%. The partnership assumes the full $200,000, but only $50,000 of it (your 25% share) is allocated back to you. The net effect: you have been relieved of $150,000 in debt, which counts as a $150,000 deemed cash distribution. If that deemed distribution exceeds the basis you otherwise would have had, the excess is taxable gain on the contribution itself.
Recourse liabilities, where at least one partner bears the economic risk of loss, are allocated by asking which partner would be on the hook if the partnership liquidated and could not pay. Nonrecourse liabilities, which no partner is personally responsible for, run through a separate three-step allocation under the regulations.3eCFR. 26 CFR 1.752-3 – Partner’s Share of Nonrecourse Liabilities The practical point for contributing partners: find out your liability share before you assume Section 722 alone tells you where your basis stands.
Holding Period in the Interest You Receive
Your holding period in the partnership interest depends on what you contributed. If you contributed a capital asset or Section 1231 property, your holding period in the contributed asset tacks onto the holding period of your partnership interest. Hold the property three years before contributing it and your partnership interest already has a three-year holding period on day one.4eCFR. 26 CFR 1.1223-3 – Rules Relating to the Holding Periods of Partnership Interests
Cash and ordinary-income property, such as inventory, do not tack. For those, the holding period starts on the contribution date. Contribute a mix at once and your partnership interest can end up with a divided holding period, with each portion determined by comparing the fair market value of the interest attributable to that asset to the fair market value of the whole interest right after the transaction.
Outside Basis vs. Inside Basis
Two basis figures run in parallel from the moment of contribution, and conflating them is the most common error in partnership tax. Outside basis is your personal investment in the partnership interest. Inside basis is the partnership’s basis in the assets it holds.
When you contribute property, the partnership takes a carryover basis equal to your adjusted basis at the time of contribution.5Office of the Law Revision Counsel. 26 U.S. Code 723 – Basis of Property Contributed to Partnership In the equipment example, the partnership records inside basis of $40,000 for the equipment and inherits your holding period for it.6eCFR. 26 CFR 1.723-1 – Basis of Property Contributed to Partnership Inside and outside basis often start at the same number but diverge over time as the partnership buys and sells assets, takes depreciation, or makes special elections.
When Section 722 Doesn’t Give You the Full Answer
Investment Company Contributions
Contributions to a partnership are usually tax-free under Section 721, which lets Section 722 do its carryover-basis work cleanly. The exception is a partnership that qualifies as an investment company under the Section 351 rules: if the partnership would be treated as an investment company and the contribution results in diversifying the transferors’ investments, any gain on the contributed property is recognized immediately.7Office of the Law Revision Counsel. 26 U.S. Code 721 – Nonrecognition of Gain or Loss on Contribution
A partnership falls into this category when more than 80% of the value of its assets (excluding cash and nonconvertible debt) consists of readily marketable stocks, securities, or interests in regulated investment companies. Two people each contributing a concentrated stock position to the same partnership can trigger the rule because the transfer itself creates diversification neither partner had before.8eCFR. 26 CFR 1.351-1 – Transfer to Corporation Controlled by Transferor When gain is recognized on the contribution, that recognized gain is added to your initial outside basis so you are not taxed twice on the same appreciation.1Office of the Law Revision Counsel. 26 USC 722 Basis of Contributing Partner’s Interest
Interests Received for Services
Section 722 does not apply if you receive your interest in exchange for services rather than cash or property. A capital interest received for services gives you an immediate claim on existing partnership assets, and its fair market value is generally taxable as compensation. Your basis equals the amount you recognized as income, as though you had been paid cash and contributed it back.
A profits interest works differently. Under IRS guidance, receiving a profits interest for services is generally not a taxable event if the interest is not tied to a substantially certain income stream, is not disposed of within two years, and is not a disguised payment for services tied to a specific transaction.9Internal Revenue Service. Rev. Proc. 2001-43 Because a profits interest entitles you only to future profits and appreciation, its value at receipt is typically treated as zero, giving the service partner a zero starting basis. Zero basis means no partnership losses can be absorbed until income allocations or additional contributions build the basis up.
Interests You Bought From an Existing Partner
If you purchased your interest from an existing partner, Section 742 governs, not Section 722. Your basis is your cost under the general cost-basis rules of Section 1012.10Office of the Law Revision Counsel. 26 U.S. Code 742 – Basis of Transferee Partner’s Interest Pay $500,000 for a 20% interest and your starting outside basis is $500,000, plus your share of partnership liabilities assumed in the transaction.
What Happens to That Starting Basis After Year One
Section 722 fixes only the opening balance. From there, Section 705 governs the annual adjustments.11Office of the Law Revision Counsel. 26 USC 705 Determination of Basis of Partner’s Interest Your outside basis increases by your share of taxable income, tax-exempt income, additional contributions, and any net increase in your share of partnership liabilities. It decreases by distributions, your share of losses and deductions, nondeductible noncapital expenses, and any net decrease in your share of liabilities.
Basis cannot go below zero. If losses and distributions in combination would push it below zero, excess losses are suspended and excess distributions become taxable gain. Year-end ordering has increases applied before decreases, which sometimes rescues a loss deduction that would otherwise be suspended.
Keep the Records
You, not the partnership, are responsible for tracking outside basis. The partnership reports your capital account on Schedule K-1 using the tax-basis method, covering contributions, income allocations, and distributions, but the K-1 capital account is not your outside basis because outside basis also includes your share of partnership liabilities.12Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) (2025)
Because contributing property to a partnership is a nontaxable exchange, the IRS expects records on both the originally contributed property and the partnership interest to be kept until the statute of limitations closes for the year you dispose of the interest.13Internal Revenue Service. How Long Should I Keep Records? For a partnership interest held for decades, that is decades of records. If the original contribution basis, liability allocations, and annual adjustments cannot be substantiated, the IRS can treat basis as zero and convert the entire sale price into taxable gain.