IRC 721/722/723 Partnership Contribution Guide

Q: Does IRC 721 apply when a partner contributes cash (rather than property) to a partnership?

Yes. IRC 721(a) uses the word 'property,' and the Internal Revenue Code treats money as property for purposes of this provision. A cash contribution to a partnership in exchange for a partnership interest is fully covered by the IRC 721(a) nonrecognition rule. No gain or loss is recognized by the contributing partner or the partnership. The contributing partner's outside basis under IRC 722 equals the amount of cash contributed, and the partnership's inside basis under IRC 723 is the same amount.

Q: How does the partnership compute depreciation on property contributed with a built-in gain?

When a partner contributes property with a built-in gain (fair market value exceeds the contributor's adjusted basis), the partnership takes a carryover basis under IRC 723 and must apply IRC 704(c) to depreciation, as well as to any gain or loss recognized on a later sale. Under the traditional method (one of several permissible methods under Treas. Reg. 1.704-3, verify current regulatory text at IRS.gov), tax depreciation deductions are first allocated to the contributing partner to the extent of their share of book depreciation, with any ceiling rule limitation potentially resulting in less tax depreciation than book depreciation for the non-contributing partners. The partnership's choice of IRC 704(c) method (traditional, traditional with curative allocations, or remedial) affects both annual depreciation and the ultimate gain or loss recognition on sale. Practitioners advising on the contribution should select the IRC 704(c) method at formation and document it in the partnership agreement.

Q: If a partner contributes services to a partnership in exchange for a 20% profits interest, does IRC 721 apply?

No. Services are not 'property' for purposes of IRC 721. A partner who contributes only services in exchange for a partnership interest is governed by IRC 83, not IRC 721. If the interest is a profits interest that meets the requirements of Rev. Proc. 93-27 and Rev. Proc. 2001-43 (verify current IRS guidance at IRS.gov), the receipt may be excludable from income at grant. If the interest does not meet those requirements, or if the partner receives a capital interest (not merely a profits interest), the fair market value of the interest received is ordinary income at grant or, if the interest is subject to a substantial risk of forfeiture, at the time it vests under IRC 83(a). The service partner's outside basis in the received interest equals the amount included in income plus any amount paid for the interest.

Q: Can a partner avoid the IRC 707(a)(2)(B) disguised sale rules by waiting more than two years after contributing property before taking a distribution?

Waiting more than two years between the contribution and the distribution eliminates the automatic presumption of a disguised sale under Treas. Reg. 1.707-3(c) (verify current regulatory text at IRS.gov). However, a distribution made more than two years after a contribution is still subject to scrutiny if the facts and circumstances indicate that, at the time of the contribution, the parties anticipated the distribution. The two-year safe harbor rebuts the presumption but does not create absolute protection if the IRS can demonstrate the contribution-and-distribution were part of a prearranged plan. Practitioners must document the business purpose and the independent entrepreneurial risk associated with the contribution, and should not rely solely on the two-year timing to establish that a disguised sale did not occur.

Q: What is the IRC 737 seven-year trap and how can practitioners plan around it?

IRC 737 requires a contributing partner to recognize gain if: (1) the partner contributed appreciated property to the partnership, creating a precontribution gain; and (2) the partnership distributes other property (property other than money and other than the original contributed property) to that partner within seven years of the contribution. The gain recognized is the lesser of the partner's net precontribution gain at the time of distribution or the excess of the fair market value of the distributed property over the partner's outside basis immediately before the distribution. Planning considerations include: tracking the seven-year period from each contribution date in partnership records; considering whether a distribution in kind of the original contributed property (rather than other property) can be used, because a distribution of the originally contributed property to the original contributor does not trigger IRC 737; and evaluating whether the IRC 754 election and a corresponding IRC 732 basis adjustment can reduce the impact of the rule. Practitioners should monitor the seven-year window for each contributing partner and flag it in partnership operating agreements.

Why IRC 721, 722, and 723 Are the Foundation of Every Partnership Formation

Every partnership formation starts with the same question: does the contribution trigger a taxable event? IRC 721 partnership contribution nonrecognition is the answer for most property contributions. IRC 721(a) provides that no gain or loss is recognized by a partner or the partnership when property is contributed to the partnership in exchange for a partnership interest. That rule, however, is only the beginning of the analysis.

The other two pieces lock in for the lifetime of the partnership and every return thereafter. IRC 722 sets the contributing partner's outside basis in their partnership interest equal to the adjusted basis of the contributed property (adjusted for any gain recognized and any deemed distributions from liability assumptions). IRC 723 gives the partnership a carryover basis in the contributed property equal to the contributor's pre-contribution adjusted basis, not the property's fair market value. The spread between that carryover basis and the property's fair market value at contribution becomes the source of every IRC 704(c) built-in gain or loss issue the partnership will ever face on that asset.

These three provisions interact with four high-stakes rules practitioners must evaluate on every formation: the IRC 752 liability-assumption deemed-distribution rule (which can convert a nonrecognition contribution into a gain event), the IRC 707(a)(2)(B) disguised sale presumption (which recharacterizes certain contribution-plus-distribution patterns as taxable sales), the IRC 737 seven-year precontribution gain rule (which can trigger gain on post-formation distributions), and the IRC 721(c) gain deferral method (which applies in cross-border partnership formations involving related foreign persons).

This guide walks through each rule in sequence and closes with a fact-pattern comparison table, a practitioner checklist, and an FAQ covering the questions practitioners encounter most often at partnership formation and in ongoing return preparation.

IRC 721(a): The Nonrecognition Rule

IRC 721(a) states that no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership. The rule covers both the contributing partner (no gain or loss on the exchange) and the partnership (no gain or loss on receipt of the property).

What "In Exchange for a Partnership Interest" Means

The nonrecognition rule applies when the contribution is made in exchange for an equity interest in the partnership -- not in exchange for cash, debt repayment, or any other consideration that is not a partnership interest. A contribution that is, in substance, a sale of property to the partnership in exchange for money or the equivalent is not a contribution "in exchange for a partnership interest" and is not protected by IRC 721(a). The section 721 nonrecognition rule does not convert a disguised sale into a nonrecognition event; it applies to genuine equity contributions.

Why Services Are Not Property Under IRC 721

Services are not "property" for purposes of IRC 721. A partner who contributes services in exchange for a partnership interest is governed by IRC 83, not IRC 721. The key consequence is that the fair market value of the interest received is ordinary income to the service partner (subject to the rules for capital interests versus profits interests described in the FAQ below). This distinction matters most in LLC operating agreements where some members contribute property and others contribute sweat equity: the two classes of contributors are subject to entirely different tax regimes at the moment the interests are issued.

When IRC 721 Does Not Apply

IRC 721(a) does not apply in two principal situations beyond the disguised sale context. First, the investment company exception under IRC 721(b) can require gain recognition when the contribution causes diversification in a fund or vehicle that meets the definition of an investment company. Second, the partnership's assumption of liabilities can generate a deemed cash distribution that, if it exceeds the partner's outside basis, forces gain recognition under IRC 731(a)(1) even though IRC 721(a) would otherwise apply. Both exceptions are addressed in the sections below.

IRC 721(b): The Investment Company Exception

IRC 721(b) overrides the nonrecognition rule of IRC 721(a) when a contribution would result in a diversification of the transferor's interests in a partnership that is an investment company. The practical effect: a partner who contributes a concentrated position in securities to a fund or vehicle that holds a diversified portfolio may recognize gain on the contribution as if the property had been sold at fair market value.

The IRC 721(b) rules are implemented through regulations (verify current regulatory text at IRS.gov, as the regulations implementing this exception have been subject to revision). The investment company definition for IRC 721(b) purposes looks at whether 80 percent or more of the partnership's assets (by value) are held for investment and consist of stock, securities, interests in other entities, or similar assets. Practitioners advising on hedge fund formations, family investment partnerships, or any contribution of a diversified securities portfolio to a partnership entity must analyze IRC 721(b) before concluding that IRC 721(a) nonrecognition applies.

Practitioner Note The IRC 721(c) gain deferral method applies when a U.S. partnership makes a contribution (or receives a contribution) involving a controlled participant (as defined in the regulations) and a related foreign person. Practitioners advising on cross-border partnership formations must separately evaluate IRC 721(c) compliance in addition to the core IRC 721(a) nonrecognition analysis. The IRC 721(c) regulations (verify current status at IRS.gov) impose an annual compliance obligation and a gain deferral method that differs materially from the straightforward carryover basis framework in IRC 723. See the related guide on IRC 721(c) in the Resources section below.

The IRC 752 Liability-Assumption Trap in Property Contributions

When a partner contributes property that is encumbered by a liability, the partnership assumes that liability and the contributing partner's share of the liability changes under IRC 752. The rules work as follows:

When the partnership takes on a liability (by assuming it on contributed property), all partners are treated as having made a deemed cash contribution equal to their respective shares of the liability under IRC 752(a).
When the contributing partner's share of that liability decreases (because the liability is now shared among all partners rather than borne entirely by the contributor), the net decrease is treated as a deemed cash distribution to the contributing partner under IRC 752(b).
That deemed cash distribution reduces the contributing partner's outside basis under IRC 733.
If the deemed distribution exceeds the contributing partner's outside basis immediately before the distribution, gain equal to the excess is recognized under IRC 731(a)(1).

This is the most common trap in a property-with-debt contribution, and it occurs even though IRC 721(a) would otherwise provide complete nonrecognition. The gain recognized is capital gain in most cases (treated as gain from the sale of the partnership interest), but the character depends on the underlying asset mix and any IRC 751 hot asset analysis.

Critical Alert: Liability-Exceeds-Basis Gain Recognition When a partner contributes property subject to liabilities exceeding the partner's adjusted basis in the property, the excess is treated as a deemed cash distribution under IRC 752(b) and IRC 731(a)(1), resulting in immediate gain recognition even though IRC 721 would otherwise provide nonrecognition. Practitioners must run the IRC 752 liability allocation and IRC 722 outside basis computation before the closing to confirm IRC 721 nonrecognition survives. The computation cannot be deferred to return preparation; by that point, a gain event that could have been restructured has already occurred.

In practice, the IRC 752 computation requires the practitioner to first determine whether each assumed liability is recourse or nonrecourse (under the economic risk of loss analysis of Treas. Reg. 1.752-2) and then allocate it among the partners accordingly. Recourse liabilities are allocated to the partner who bears the economic risk of loss; nonrecourse liabilities are allocated through the three-tier waterfall under Treas. Reg. 1.752-3. Verify current regulatory text at IRS.gov before applying the allocation rules to a specific fact pattern. For a complete treatment of the liability allocation mechanics, see the related guide on IRC 752 in the Resources section below.

IRC 722: The Partner's Outside Basis at Contribution

IRC 722 sets the contributing partner's initial outside basis in the partnership interest. The rule is direct: the partner's basis equals the adjusted basis of the contributed property at the time of contribution, increased by any gain recognized by the partner on the contribution.

Step-by-Step Computation

IRC 722 Outside Basis Computation: Step 1: Start with the partner's adjusted tax basis in the contributed property (immediately before contribution). Step 2: Add any gain recognized by the partner on the contribution (e.g., gain under IRC 731(a)(1) from a deemed distribution exceeding basis). Step 3: Subtract the deemed cash distribution attributable to the net decrease in the partner's liability share under IRC 752(b) (this is a reduction, not addition). Result: IRC 722 outside basis in the partnership interest. Note: Outside basis cannot be reduced below zero. If the deemed distribution exceeds the pre-distribution outside basis, gain is recognized under IRC 731(a)(1) and outside basis is reduced to zero.

A hypothetical (for illustration only): Partner A contributes real property with an adjusted basis of $300,000 and a fair market value of $800,000, subject to a $200,000 recourse mortgage. The partnership assumes the mortgage. Assume IRC 752 allocates $50,000 of the recourse liability back to Partner A (based on Partner A's share of economic risk of loss). Partner A's net decrease in liability share is $200,000 minus $50,000, or $150,000. That $150,000 is treated as a deemed cash distribution. Partner A's IRC 722 outside basis is: $300,000 (adjusted basis) minus $150,000 (deemed distribution) plus $0 (no gain recognized) = $150,000. Because the deemed distribution ($150,000) does not exceed the adjusted basis ($300,000), no gain is recognized. Partner A's outside basis in the partnership interest is $150,000.

The outside basis is the partner's tax basis for purposes of all subsequent computations: loss limitations under IRC 704(d), gain recognition on distributions under IRC 731, and gain or loss on a sale of the partnership interest under IRC 741.

IRC 723: The Partnership's Inside Basis (Carryover Basis)

IRC 723 provides that the partnership's basis in contributed property equals the contributing partner's adjusted basis in that property immediately before the contribution, increased by any gain recognized by the partner on the contribution. The partnership does not get a stepped-up, fair market value basis. It gets the contributor's carryover basis -- the same basis the contributor held, with the same holding period tacked on under IRC 1223(2).

This carryover basis rule is the source of every built-in gain and built-in loss issue the partnership will face on that property. In the hypothetical above (Property with $300,000 adjusted basis and $800,000 fair market value), the partnership's inside basis in the property is $300,000. If the partnership sells the property for $800,000, it has $500,000 of gain -- all of which must be allocated back to the contributing partner under IRC 704(c) because it represents precontribution appreciation that the other partners never shared.

Practitioner Note: Built-In Gain and IRC 704(c) The partnership's inside basis under IRC 723 is the contributor's carryover basis, not fair market value. In an appreciated property contribution, this creates a built-in gain that must be allocated back to the contributing partner under IRC 704(c). Failure to make the IRC 704(c) allocation is a common error in partnership return preparation and may trigger a substantial understatement penalty under IRC 6662 if the understatement results from the failure to correctly track and allocate precontribution gain.

IRC 704(c): Addressing the Basis Disparity Created by IRC 723

IRC 704(c) exists precisely because IRC 723 gives the partnership a carryover basis that does not match fair market value. The rule requires that income, gain, loss, and deduction attributable to contributed property be allocated among the partners in a manner that takes into account the variation between the property's adjusted basis and its fair market value at the time of contribution.

In practical terms, this means that when the partnership sells contributed property (or when the property generates tax depreciation), the tax consequences are allocated first to eliminate the precontribution built-in gain or loss before any remaining item is allocated according to the partners' economic (book) interests. The contributing partner absorbs the built-in gain on sale and receives less tax depreciation than their book depreciation share during the holding period (because the partnership is depreciating the property from a lower tax basis than book basis).

There are three permissible methods for making IRC 704(c) allocations under Treas. Reg. 1.704-3 (verify current regulatory text at IRS.gov): the traditional method, the traditional method with curative allocations, and the remedial method. The choice of method affects both the timing and magnitude of the built-in gain allocation, and different methods produce materially different results for the non-contributing partners when the ceiling rule applies. Selecting the IRC 704(c) method at formation and documenting it in the partnership agreement is a foundational step that practitioners cannot defer. For a complete treatment, see the related guide on IRC 704(b)/704(c) in the Resources section below.

IRC 707(a)(2)(B): The Disguised Sale Rule

The disguised sale rule under IRC 707(a)(2)(B) is the primary recharacterization risk in any transaction that combines a property contribution with a subsequent distribution. The rule provides that if a partner transfers property to a partnership and the partnership transfers money or other consideration to that partner, and the transfers are, when viewed together, properly characterized as a sale of property to the partnership, the transfers are treated as a sale, not a contribution-plus-distribution.

The Two-Year Presumption

Under Treas. Reg. 1.707-3(c) (verify current regulatory text at IRS.gov), if a partner contributes property to a partnership and receives a distribution within two years of the contribution, the contribution and the distribution are presumed to be a sale, and the contributing partner must treat the transaction as a sale unless the facts and circumstances clearly establish that the transfers do not constitute a sale. The two-year window begins on the date of the original contribution.

Critical Alert: Two-Year Disguised Sale Presumption A contribution followed by a distribution within two years is presumed to be a disguised sale under IRC 707(a)(2)(B). The presumption applies regardless of whether the parties characterize the transaction as a contribution-plus-distribution. Practitioners must affirmatively identify applicable exceptions and document the facts that rebut the presumption. The presumption cannot be rebutted simply by asserting that the parties intended a contribution; the regulations require facts and circumstances that clearly establish the absence of a sale.

Exceptions to the Disguised Sale Presumption

Treas. Reg. 1.707-3(b) (verify current regulatory text at IRS.gov) identifies circumstances under which the two-year presumption may be rebutted, and the regulations also exclude certain distributions from the disguised sale characterization entirely. The principal exceptions include:

Pre-formation expenditure reimbursements. Distributions that reimburse reasonable, documented pre-formation expenditures are excluded from the disguised sale characterization under Treas. Reg. 1.707-4(d), subject to limits.
Operating cash flow distributions. Distributions of operating cash flow (as defined in the regulations) that are made in a manner consistent with the partner's overall interest in partnership profits are generally not treated as part of a disguised sale.
Entrepreneurial risk allocations. Distributions tied to entrepreneurial risk -- allocations of profits rather than guaranteed returns -- are more defensible as genuine equity distributions rather than sale consideration.
Guaranteed payments for the use of capital. Payments that qualify as guaranteed payments under IRC 707(c) rather than disguised sale proceeds follow a different tax treatment.

Practitioners who structure contributions with accompanying distributions must document the business purpose, the absence of a pre-arranged distribution at the time of contribution, and the applicable exception to the disguised sale presumption. Documentation prepared after the fact is substantially less effective. For a complete treatment of the disguised sale rules, see the related guide on IRC 707 in the Resources section below.

IRC 737: The Seven-Year Precontribution Gain Rule

IRC 737 addresses a different timing risk: the scenario where a contributing partner has effectively extracted value from the partnership by receiving a distribution of other partnership property within seven years of the original contribution. The rule requires the contributing partner to recognize gain equal to the lesser of: (1) the partner's net precontribution gain (the excess of fair market value over adjusted basis of all property contributed by that partner, reduced by any precontribution gain previously recognized), or (2) the excess of the fair market value of the distributed property over the partner's outside basis immediately before the distribution.

The seven-year period is statutory. Practitioners should verify whether any pending legislation (including the One Big Beautiful Budget Act, if enacted in a form affecting partnership provisions) has altered the period or the rule mechanics before relying on IRC 737 planning assumptions.

Planning considerations for IRC 737 include:

Distributing the originally contributed property back to the original contributor (a distribution of the contributed property itself does not trigger IRC 737, though it may trigger IRC 704(c)(1)(B) in the reverse direction).
Tracking the seven-year window for each contributor in partnership records from the date of each contribution, not from the formation date (if property is contributed later, the seven-year clock runs from that later contribution).
Evaluating whether an IRC 754 election and a corresponding IRC 732 basis adjustment can reduce the economic impact of the gain recognition if a distribution within the seven-year period is unavoidable.

Practitioner Note: Services Contribution and IRC 83 Services contributed in exchange for a partnership interest are not eligible for IRC 721 nonrecognition. They are governed by IRC 83, and the fair market value of the interest received is ordinary income to the service partner at grant (or at vesting, if subject to a substantial risk of forfeiture). The service partner's outside basis in the received interest equals the amount included in income plus any amount paid for the interest. If the interest is a profits interest meeting the requirements of Rev. Proc. 93-27 and Rev. Proc. 2001-43 (verify current IRS guidance at IRS.gov), the receipt may be excludable at grant. Capital interests received for services do not qualify for this exclusion.

Contribution Fact-Pattern Comparison: 10 Scenarios

The table below summarizes the tax treatment of ten common contribution fact patterns under IRC 721, 722, and 723. All entries reflect the default statutory result for the described fact pattern; the actual result in any specific transaction depends on facts and circumstances. Verify applicable regulations at IRS.gov before applying these generalizations to a client matter.

Contribution Type	IRC 721 Applies?	Gain Recognized	IRC 722 Partner Basis	IRC 723 Inside Basis	Trap / Risk
Cash contribution	Yes	None	Amount of cash contributed	Same as partner basis (cash amount)	Minimal; verify no deemed distribution arises from unrelated liability shifts
Appreciated property, no debt	Yes	None	Contributor's adjusted basis in property	Carryover basis (contributor's adjusted basis); built-in gain exists	Built-in gain must be allocated to contributor under IRC 704(c) on sale or depreciation
Appreciated property with recourse debt (debt less than basis)	Yes	None (assuming deemed distribution does not exceed basis)	Contributor's adjusted basis minus net deemed distribution from IRC 752(b)	Carryover basis (contributor's adjusted basis)	Run IRC 752 liability allocation; if net deemed distribution exceeds basis, gain recognized under IRC 731(a)(1)
Appreciated property with nonrecourse debt	Yes	None (typically; depends on IRC 752 allocation)	Contributor's adjusted basis, adjusted for IRC 752(b) deemed distribution	Carryover basis; built-in gain subject to IRC 704(c)	Nonrecourse debt allocated under three-tier waterfall; Tier 1 minimum gain protects contributor in most cases but verify IRC 752 allocation result
Services only	No	FMV of interest received is ordinary income under IRC 83 (unless profits interest meets Rev. Proc. 93-27 safe harbor)	Amount included in income under IRC 83, plus any amount paid	Not applicable (no property contributed)	Capital interest vs. profits interest distinction; IRC 83(b) election considerations; verify current IRS guidance at IRS.gov
Property plus services	Partial	None on property portion; IRC 83 applies to services portion	Adjusted basis of contributed property for that portion; IRC 83 amount for services portion	Carryover basis for contributed property; no inside basis for services component	Must bifurcate property and services components; allocate partnership interest between property and services consideration for proper tax treatment
Property with IRC 704(c) built-in gain	Yes	None at contribution (deferred under IRC 721)	Contributor's adjusted basis	Carryover basis; built-in gain tracked separately for IRC 704(c) allocations	IRC 704(c) method must be selected at formation; ceiling rule can disadvantage non-contributing partners under the traditional method; IRC 704(c)(1)(B) applies if contributed property distributed to another partner within 7 years
Property qualifying for IRC 721(c) gain deferral (related foreign person)	Modified	Deferred (not recognized at contribution if gain deferral method adopted); recognized annually or on triggering event	Contributor's adjusted basis at time of contribution	Carryover basis; annual adjustments required under gain deferral method	IRC 721(c) compliance requires annual reporting and gain deferral method election; check current regulations at IRS.gov; failure triggers immediate gain recognition
Encumbered property where IRC 752(b) deemed distribution exceeds contributor's basis	Partial	Gain recognized under IRC 731(a)(1) equal to excess of deemed distribution over adjusted basis	Zero (reduced to zero by deemed distribution, then no further reduction)	Carryover basis, increased by any gain recognized by contributor	Most dangerous formation trap; must be identified and restructured before closing; options include contributing additional property to increase basis, having contributing partner retain a portion of the liability, or restructuring the debt as nonrecourse
Property contributed within 7 years triggering IRC 737 on later distribution	Yes	None at contribution; gain recognized under IRC 737 when other property distributed within 7-year window	Contributor's adjusted basis at contribution; reduced by any distributions received	Carryover basis at contribution date	Seven-year clock runs from each contribution date; track in partnership records; consider distributing original contributed property to avoid IRC 737; verify whether pending legislation has modified the rule

Practitioner Formation Checklist Use this sequence on every partnership formation or property contribution closing:

Identify all contributed property and liabilities for each contributing partner.
Compute the IRC 722 outside basis for each partner, running the IRC 752 liability allocation first.
Compute the IRC 723 inside basis for each contributed asset.
Identify any IRC 704(c) built-in gain or loss on each asset and select the IRC 704(c) method in the partnership agreement.
Confirm that no IRC 752(b) deemed distribution exceeds any partner's outside basis; restructure if necessary to prevent IRC 731(a)(1) gain recognition.
Evaluate whether the IRC 721(b) investment company exception applies if the partnership holds diversified investment assets.
Confirm no disguised sale risk under IRC 707(a)(2)(B) if any distribution will be made to a contributing partner within two years; document exceptions.
Document any services contribution separately under IRC 83 and confirm the correct tax treatment (capital interest vs. profits interest, and whether an IRC 83(b) election is warranted).

Frequently Asked Questions

Does IRC 721 apply when a partner contributes cash (rather than property) to a partnership?

Yes. IRC 721(a) uses the word "property," and the Internal Revenue Code treats money as property for purposes of this provision. A cash contribution to a partnership in exchange for a partnership interest is fully covered by the IRC 721(a) nonrecognition rule. No gain or loss is recognized by the contributing partner or the partnership. The contributing partner's outside basis under IRC 722 equals the amount of cash contributed, and the partnership's inside basis under IRC 723 is the same amount. Because cash is contributed at its face value, no built-in gain or IRC 704(c) issue arises on a pure cash contribution.

What is the contributing partner's outside basis if they contribute property worth $500,000 with an adjusted basis of $200,000 and no debt?

Under IRC 722, the contributing partner's outside basis equals the partner's adjusted basis in the contributed property at the time of contribution, plus any gain recognized on the contribution. In this hypothetical (for illustration only), the partner's adjusted basis is $200,000. There is no debt, so no deemed cash distribution arises under IRC 752(b), and no gain is recognized. The partner's outside basis in the partnership interest is $200,000 -- even though the property's fair market value is $500,000. The $300,000 appreciation is deferred until the partner disposes of the partnership interest or the partnership sells the property. The partnership's inside basis in the property under IRC 723 is also $200,000 (the carryover basis), creating a $300,000 built-in gain subject to IRC 704(c) allocation on any subsequent sale or depreciation computation.

What happens to the contributing partner's basis if the contributed property has a $300,000 mortgage and the partner's adjusted basis is $200,000?

This is the liability-exceeds-basis trap under IRC 752(b) and IRC 731(a)(1). When the partnership assumes a $300,000 liability, the contributing partner's share of that liability shifts, and the net decrease in the contributor's liability share is treated as a deemed cash distribution. If, for example, the recourse liability is allocated entirely to other partners after the contribution (in a hypothetical worst-case allocation for illustration only), the full $300,000 decrease is a deemed distribution. That $300,000 deemed distribution exceeds the partner's $200,000 adjusted basis, so gain of $100,000 is recognized under IRC 731(a)(1), and the partner's outside basis is reduced to zero. Practitioners must run the IRC 752 liability allocation and the IRC 722 basis computation before the closing to confirm whether the transaction can be structured to avoid this result.

How does the partnership compute depreciation on property contributed with a built-in gain?

The partnership takes the contributor's carryover basis under IRC 723 and depreciates the property from that lower tax basis. Under IRC 704(c), the partnership must use one of the three permissible methods under Treas. Reg. 1.704-3 (verify current regulatory text at IRS.gov) -- traditional, traditional with curative allocations, or remedial -- to allocate the difference between book and tax depreciation. Under the traditional method, tax depreciation is first allocated to the contributing partner to match their share of book depreciation, and the ceiling rule can limit the tax deductions available to non-contributing partners when the property's tax basis generates less depreciation than the book amount. The remedial method eliminates the ceiling rule problem by creating notional items but results in the contributing partner recognizing remedial income. The IRC 704(c) method must be selected at formation and documented in the partnership agreement; it cannot generally be changed without IRS consent.

If a partner contributes services to a partnership in exchange for a 20% profits interest, does IRC 721 apply?

No. Services are not property for purposes of IRC 721. The tax treatment of a profits interest received for services depends on whether the interest meets the requirements of Rev. Proc. 93-27 and Rev. Proc. 2001-43 (verify current IRS guidance at IRS.gov). If the profits interest meets those requirements, the receipt is generally excludable from income at the time of grant. If the interest fails the safe harbor requirements, or if the partner receives a capital interest rather than a profits interest, the fair market value of the interest received at grant is ordinary income under IRC 83(a) (or at vesting if subject to a substantial risk of forfeiture). The service partner's outside basis equals the amount included in income plus any amount paid for the interest. The partnership receives no inside basis in the services component.

Can a partner avoid the IRC 707(a)(2)(B) disguised sale rules by waiting more than two years after contributing property before taking a distribution?

Waiting more than two years eliminates the automatic presumption of a disguised sale under Treas. Reg. 1.707-3(c) (verify current regulatory text at IRS.gov). However, a distribution made more than two years after a contribution is still subject to recharacterization if the facts and circumstances show that the parties anticipated the distribution at the time of the contribution. The two-year safe harbor rebuts the presumption but does not create absolute protection when a pre-arranged plan can be demonstrated. Practitioners must document the business purpose of the contribution and the independent entrepreneurial risk involved, and should not rely solely on the two-year timing window. Written contemporaneous documentation prepared before or at the time of contribution is far more effective than documentation assembled after the IRS raises a disguised sale argument.

What is the IRC 737 seven-year trap and how can practitioners plan around it?

IRC 737 requires a contributing partner to recognize gain when the partnership distributes other property (property other than money and other than the originally contributed property) to that partner within seven years of the original contribution. The gain recognized is the lesser of the partner's net precontribution gain or the excess of the distributed property's fair market value over the partner's outside basis immediately before the distribution. Planning options include: (1) distributing the originally contributed property back to the original contributing partner, because the IRC 737 exclusion applies to the contributed property itself; (2) tracking the seven-year window from each contribution date in partnership records so the risk is flagged before any distribution decision; and (3) evaluating whether an IRC 754 election and the resulting IRC 732 basis adjustment can reduce the impact of the gain recognition if a distribution within the window is unavoidable. Practitioners should confirm that no pending legislation has modified the seven-year period before relying on IRC 737 planning assumptions.

When a partner contributes encumbered property and receives a deemed cash distribution under IRC 752(b), does that reduce the partner's IRC 722 outside basis?

Yes. The IRC 722 outside basis computation starts with the partner's adjusted basis in the contributed property. When the partnership assumes a liability and the contributing partner's share of that liability decreases under IRC 752(b), the net decrease is a deemed cash distribution under IRC 733, which reduces the partner's outside basis (but not below zero). Accordingly, the IRC 722 starting basis is reduced by the net deemed distribution. If the deemed distribution exceeds the outside basis, gain equal to the excess is recognized under IRC 731(a)(1), and outside basis is reduced to zero. The resulting IRC 722 outside basis after the contribution equals: the adjusted basis of the contributed property, plus any gain recognized, minus the deemed cash distribution from the IRC 752(b) liability decrease. Practitioners must run this computation -- using the actual IRC 752 liability allocation results -- before the closing to confirm the transaction structure produces the intended nonrecognition result.

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IRC 721/722/723: Partnership Contribution Nonrecognition and Basis