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When does a partnership distribution trigger gain for the partner?

Only when the money distributed exceeds the partner's outside basis immediately before the distribution, under section 731(a)(1). Cash of $150,000 against a $120,000 outside basis produces $30,000 of gain; cash of $90,000 against the same basis produces none. Marketable securities count as money at fair market value under section 731(c), and property other than money produces no gain by itself.

Can a partner recognize a loss on a distribution?

Only on a liquidating distribution, and only when the partner receives nothing but money, unrealized receivables and inventory, under section 731(a)(2). The loss equals the outside basis minus the money plus the basis of the receivables and inventory received. A partner who receives $60,000 cash and inventory with a $10,000 basis against a $100,000 outside basis recognizes a $30,000 loss. Any other property in the distribution blocks the loss entirely.

What basis does distributed property take in the partner's hands?

On a current distribution, section 732(a) gives the property the partnership's own basis, capped at the partner's outside basis minus any money distributed in the same transaction. On a liquidating distribution, section 732(b) makes the property a plug: outside basis minus money distributed. When several properties are distributed, section 732(c) allocates basis first to receivables and inventory at partnership basis, then to other property by appreciation and fair market value.

What is the 7-year rule in sections 737 and 704(c)(1)(B)?

Both rules run for 7 years from the contribution, extended from 5 years by the Taxpayer Relief Act of 1997. Under section 704(c)(1)(B), if property a partner contributed is distributed to a different partner within 7 years, the contributing partner recognizes the built-in gain from the contribution. Under section 737, if the contributing partner receives other property while the partnership still holds contributed property, the partner recognizes the lesser of the excess distribution and the net precontribution gain. After 7 years, both tripwires go quiet.

What makes inventory substantially appreciated under section 751(b)?

Inventory is substantially appreciated when its fair market value exceeds 120 percent of its adjusted basis to the partnership, under section 751(b)(3)(A). Inventory with a $100,000 basis and a $130,000 fair market value clears the test, since 120 percent of basis is $120,000. A disproportionate distribution that shifts a partner's share of such hot assets is treated as a sale or exchange, and the gain on the hot-asset slice is ordinary income.

What is a disguised sale of property to a partnership?

Under section 707(a)(2)(B), a contribution of property followed by a related distribution of money or other consideration is recharacterized as a sale of the property to the partnership, so the contributor recognizes gain as if the property had been sold. Treasury Regulation section 1.707-3(c) presumes a sale when both transfers happen within a 2-year period, and presumes no sale when they are more than 2 years apart; the presumptions are rebuttable on the facts and circumstances.

Taxes • 11 min read

Section 731 Partnership Distributions: the Nonrecognition, Basis and Disguised-Sale Playbook

Money comes out of a partnership tax-free until it exceeds the partner's outside basis — then every dollar past the line is gain. This playbook runs the distribution operation end to end: section 731 nonrecognition, section 732 basis, section 737 precontribution gain, section 704(c)(1)(B) and section 751(b) hot assets, with every figure re-computable from stated inputs.

By Enow A. Jovial • Published 2026-11-14

A partnership can hand a partner cash, land, equipment or securities and, most of the time, nobody owes tax. Section 731 treats a distribution as a return of the partner's own investment, not a sale, until the money exceeds the partner's basis. Four tripwires guard it: section 731(c), section 737, section 704(c)(1)(B) and section 751(b).

The default is nonrecognition, and the exceptions are arithmetic. Gain appears only when money — including marketable securities at fair market value — exceeds outside basis. Loss appears only on a liquidation of money and hot assets. Run the tests in order: section 751(b), then section 737, then section 704(c)(1)(B), then section 731.

The section 731(a) gate

Section 731(a)(1) states the partner-side rule in one sentence: gain is not recognized except to the extent that any money distributed exceeds the adjusted basis of the partner's interest immediately before the distribution. Section 731(a)(2) allows a loss only on a liquidating distribution of nothing but money, unrealized receivables and inventory. Gain or loss under section 731(a) is treated as gain or loss from the sale of the partnership interest. Section 731(b) gives the partnership the same nonrecognition.

\text{Gain under section 731(a)(1)} = \max(0, \text{Money distributed} - \text{Outside basis before distribution})

Treasury Regulation section 1.731-1(a)(1)(i) gives the textbook illustration: a partner with a $10,000 basis who receives $8,000 cash and property worth $3,000 recognizes no gain, but $11,000 cash would produce $1,000 of gain. A cash distribution wired by ACH is still money for this test.

Worked example one. Partner Dana has an outside basis of $120,000 and receives $150,000 cash — a $30,000 capital gain, and her outside basis falls to zero.

26 U.S.C. section 731 statute text on Cornell LII, showing the section 731(a) gain and loss rules

Source: 26 U.S.C. § 731, Cornell LII, 2026-11-14.

Section 731(c): marketable securities

The most common way founders trip the section 731(a) gate is by distributing something taxed like cash. Section 731(c)(1) provides that, for purposes of section 731(a)(1) and section 737, the term money includes marketable securities, taken into account at fair market value on the date of the distribution. Marketable securities means actively traded financial instruments and foreign currencies, plus interests in common trust funds and regulated investment companies and instruments readily convertible into money.

Worked example two. Partner Eli has an outside basis of $40,000 and receives listed shares worth $55,000. The shares count as $55,000 of money, so Eli recognizes $15,000 of gain with no cash changing hands. Section 731(c)(3)(B) caps that gain by the partner's share of the net gain that would be recognized if all securities of the same class and issuer held by the partnership were sold immediately before the distribution, minus the partner's share of the gain in the securities still held after.

Section 733: the basis ledger

Section 733 is the ledger rule: on a distribution other than in liquidation, the adjusted basis of the partner's interest is reduced, but not below zero, by the money distributed and by the basis to the partner of distributed property other than money, as determined under section 732. A partner with a $120,000 outside basis who receives $90,000 cash and $20,000 of property basis ends the day with a $10,000 outside basis. Distributions never create basis; they only spend it. The partner's Schedule K-1 (Form 1065) reports the income and loss that move outside basis under section 705.

\text{Outside basis after} = \max(0, \text{Outside basis before} - \text{Money} - \text{Basis of distributed property})

Section 732: basis of distributed property

Section 732 answers what basis the property carries into the partner's hands. On a current distribution, section 732(a)(1) gives the property the partnership's own adjusted basis, capped by section 732(a)(2) at the partner's outside basis minus any money distributed in the same transaction. On a liquidating distribution, section 732(b) makes the property a plug: its basis equals the adjusted basis of the partner's interest reduced by any money distributed.

Worked example three, current distribution. Partner Femi has an outside basis of $80,000 and receives $20,000 cash plus equipment with a partnership basis of $45,000 and a fair market value of $70,000. The cap is $60,000 and does not bind, so the equipment takes a $45,000 basis and Femi's outside basis falls to $15,000.

Worked example four, liquidating distribution. Partner Grace liquidates a one-quarter interest with an outside basis of $100,000, receiving $30,000 cash plus land (partnership basis $40,000, fair market value $90,000). The land takes a $70,000 basis — a $30,000 step-up paid for by her own outside basis. The loss variant: $60,000 cash and inventory with a $10,000 basis to her, and nothing else, would produce a $30,000 loss.

Section 732(c) allocates basis when several properties are distributed: first to receivables and inventory at the partnership's basis, then to other property by appreciation and fair market value.

26 U.S.C. section 732 statute text on Cornell LII, showing the section 732(a) basis cap and section 732(b) liquidating basis

Source: 26 U.S.C. § 732, Cornell LII, 2026-11-14.

Section 737: the backstop

Section 737 stops a partner from contributing appreciated property and then taking other property out tax-free. It applies when a partner receives property other than money while the partnership still holds property that partner contributed within the last 7 years. The gain is the lesser of the excess of the fair market value of the other property received over the partner's outside basis reduced by money received, and the partner's net precontribution gain — the gain the partner would have recognized under section 704(c)(1)(B) if all property contributed within 7 years had been distributed to another partner. Gain under section 737 is in addition to any gain under section 731.

\text{Gain under section 737} = \min(\text{FMV of other property} - \max(0, \text{Outside basis} - \text{Money}), \text{Net precontribution gain})

Worked example five. Partner Hana contributed land three years ago with a basis of $50,000 and a fair market value of $130,000, so her net precontribution gain is $80,000. The partnership still holds the land. Hana now receives other property with a fair market value of $110,000 plus $10,000 cash, and her outside basis immediately before the distribution is $90,000. The excess is $110,000 minus $80,000, or $30,000, and the gain is the lesser of $30,000 and $80,000 — $30,000. Section 737(c)(1) then increases her outside basis by the $30,000 gain, to $120,000 for the section 732 computation.

26 U.S.C. section 737 statute text on Cornell LII, showing the section 737(a) lesser-of gain rule

Source: 26 U.S.C. § 737, Cornell LII, 2026-11-14.

Section 704(c)(1)(B): the 7-year tripwire

Section 704(c)(1)(B) taxes the contributing partner when the contributed property itself goes out to someone else. If property a partner contributed is distributed to another partner within 7 years of being contributed, the contributing partner is treated as recognizing gain or loss from the sale of the property, in the amount that would have been allocated under section 704(c)(1)(A) by reason of the variation between basis and fair market value at contribution.

Worked example six. Hana's land again: basis $50,000, fair market value $130,000 at contribution, built-in gain $80,000. Three years later the partnership distributes the land to a different partner when its fair market value is $150,000. Hana recognizes $80,000 — the built-in gain, the variation at contribution. If the distribution had happened after 7 years, Hana would recognize nothing. The 7-year period replaced a 5-year period in the Taxpayer Relief Act of 1997.

Section 751(b): hot assets

Section 751(b) is the rule that overrides section 731 entirely. To the extent a partner receives unrealized receivables or substantially appreciated inventory in exchange for other partnership property, or receives other property or money for an interest in receivables or inventory, the transaction is treated as a sale between the distributee and the partnership. Unrealized receivables under section 751(c) are rights to payment for goods or services, to the extent not previously includible in income — the unbilled fees of a cash-method partnership, which carry a zero basis. Inventory is substantially appreciated under section 751(b)(3)(A) when its fair market value exceeds 120 percent of its adjusted basis.

\text{Substantially appreciated if} \quad \text{FMV of inventory} > 1.20 \times \text{Adjusted basis of inventory}

Worked example seven. A partnership holds inventory (basis $100,000, fair market value $130,000), unrealized receivables worth $60,000 with a zero basis, and land worth $410,000 with a basis of $300,000. The 120 percent test: 1.20 times $100,000 is $120,000, and the inventory's $130,000 fair market value exceeds it, so the inventory is substantially appreciated. Hot assets total $190,000. Partner Imani holds a one-third interest and receives $200,000 cash, giving up her $63,333 share of the hot assets, and that slice is treated as a sale. Her ordinary income is her share of the built-in gain — one-third of the $60,000 receivables gain plus one-third of the $30,000 inventory gain — $20,000 plus $10,000, or $30,000 of ordinary income. Section 751(b)(2) excepts two cases: a distribution of property the distributee contributed, and payments under section 736(a) to a retiring partner or a deceased partner's successor.

Section 707(a)(2)(B): disguised sale

Under section 707(a)(2)(B), a contribution of property and a related distribution of money or other consideration are treated as a sale of the property to the partnership. Treasury Regulation section 1.707-3(c) supplies the timing presumptions: transfers within a 2-year period are presumed to be a sale, and transfers more than 2 years apart are presumed not to be a sale. Both presumptions are rebuttable on the facts and circumstances. A contribution of appreciated land followed 18 months later by a cash distribution of nearly the same value, funded by a loan secured by that land, is the classic disguised sale.

The decision table

Distribution	Partner result	Authority
Cash at or below outside basis	No gain	§ 731(a)(1); Reg. § 1.731-1(a)(1)(i)
Cash above outside basis	Gain equal to the excess	§ 731(a)(1)
Property, current distribution	No gain; capped basis	§ 732(a)
Property, liquidating distribution	No gain; basis is the plug	§ 732(b)
Liquidation, only money, receivables and inventory	Loss of excess basis	§ 731(a)(2)
Marketable securities	Money at FMV	§ 731(c)
Other property to the contributing partner within 7 years	Gain, lesser of excess and precontribution gain	§ 737(a)
Contributed property to another partner within 7 years	Contributor recognizes built-in gain	§ 704(c)(1)(B)
Disproportionate distribution of hot assets	Deemed sale; ordinary income on the slice	§ 751(b)
Contribution plus related distribution within 2 years	Presumed disguised sale	§ 707(a)(2)(B); Reg. § 1.707-3(c)

Who this playbook is for — and who must avoid it

This playbook is for a partner in a US partnership — an LLC taxed as a partnership, a limited partnership, or a general partnership — who is taking cash or property out and needs to know the tax cost before the distribution is made. It assumes the partnership files Form 1065 under its EIN. It also assumes the distribution is not a payment for services, a section 736 retirement payment, or a distribution from an S-Corp or a C-Corp. Avoid this playbook's shortcuts for an eligible partner of an investment partnership, a contribution-and-distribution pair inside 2 years, or a partnership with a section 754 election. A distribution never frees a loss suspended under section 704(d). A distribution never creates an NOL and never triggers FICA withholding.

For the contribution side, read the Section 721 partnership contribution nonrecognition playbook. For debt basis, read the Section 752 partnership debt basis allocation playbook. For capital accounts, see the Section 704(b) capital account maintenance playbook. Before taking a large distribution, estimate the tax with the Self-Employed Tax & Quarterly Estimator.

Founder & CEO Insight — Enow A. Jovial

"Every distribution is a basis decision before it is a cash decision. I have watched founders pull six figures out of a partnership and create a second tax bill, because nobody ran the section 731 test first. The discipline is boring and it is the whole game: know your outside basis to the dollar, know what is hot and what is not, and never let a distribution cross the 7-year line by accident."

— Enow A. Jovial, Founder & Chief Executive Officer

Three failures in this area draw penalties, not just extra tax. A disguised sale reported as tax-free can draw a 20 percent penalty under section 6662. A missed section 737 gain can be assessed for three years, or six if the omission exceeds 25 percent of gross income under section 6501(e). And marketable securities reported at carryover basis instead of fair market value understate the section 731(c) money amount.

Execution checklist

[x] Have your CPA pull the partner's outside basis from the section 705 ledger and confirm it against the latest K-1.
[x] List every property the partner contributed in the last 7 years, with dates and basis.
[x] Test section 751(b) first and compute the ordinary-income slice.
[x] Run the section 737 lesser-of computation and apply the basis increase.
[x] Value marketable securities at fair market value.
[x] Check the 2-year disguised-sale presumption under Regulation section 1.707-3(c).

Run the four tests in the same order every time — section 751(b), section 737, section 704(c)(1)(B), then section 731 — and write the four numbers on one page. Section 751(b) changes character, section 737 changes basis, section 704(c)(1)(B) changes who is taxed, and section 731 changes whether anything is taxed at all.

The IRS Publication 541 chapter on partnership distributions follows the same sequence this playbook uses: effect on the partner's basis, then the partner's gain or loss, then the basis of distributed property.

IRS Publication 541 table of contents showing the Partnership Distributions chapter

Source: IRS Publication 541, 2026-11-14.