Capital Accounts, Basis, and What Happens at Exit
Nobody tracks your basis for you. It decides whether losses are deductible, whether a distribution is taxable, and what the number on the final K-1 means.
Two running balances follow a partnership interest through its life. They look similar on the Schedule K-1, they are calculated differently, and they decide different things.
Neither is a valuation, and confusing either with what your interest is worth is the most common mistake in this area.
Outside basis¶
Your basis in the partnership interest is your tax investment in it. It is what limits the losses you may deduct, and it determines the gain or loss on disposition.
It starts at what you contributed, and then:
Increases by your share of partnership income, by additional contributions, and by increases in your share of partnership liabilities.
Decreases by distributions, by your share of partnership losses, and by decreases in your share of liabilities.
The liabilities component is the one that surprises people, and it is the reason leveraged real estate can generate deductible losses at all. Under section 752, an increase in your share of partnership liabilities is treated as though you had contributed that amount of money. A partner who contributed $100,000 to a deal with substantial mortgage debt can have a basis well above $100,000, and that headroom is what allows early depreciation losses to be deducted rather than deferred.
When basis reaches zero, further losses are suspended until basis is restored, and distributions beyond it generally produce gain.
The capital account¶
The capital account is a partnership accounting record, reported in Part II of the K-1: beginning balance, contributions, allocated income or loss, distributions, ending balance.
It does not include your share of liabilities. That single difference is why the two figures diverge, often substantially, in a leveraged deal.
| Outside basis | Capital account | |
|---|---|---|
| Includes share of partnership debt | Yes, under section 752 | No |
| Reported to you | No; you track it | Yes, on the K-1 |
| Limits deductible losses | Yes | No |
| Determines gain at disposition | Yes | No |
| May govern the liquidating distribution | No | Frequently yes, depending on the agreement |
Why a negative or zero capital account is not necessarily bad news¶
In a deal with accelerated depreciation, allocated losses can reduce a capital account to zero or below within a few years while the property is performing perfectly well.
That is an accounting consequence of the deductions, not a statement about the investment. What it does signal is that the interaction between the capital account, the basis and the eventual liquidation is now doing real work, and it is worth having a preparer who is following it.
At exit¶
Two things happen at the end, and they are separate.
The economics are determined by the waterfall — or, in many agreements, by liquidation in accordance with positive capital account balances. Where the agreement uses the second formulation, the allocation provisions determine who receives what, and the waterfall summary in the memorandum is describing a result rather than a mechanism. Which formulation your agreement uses is worth checking, because they can produce different outcomes in unusual cases.
The tax is determined by basis. Gain or loss on disposition is the difference between what you receive, including relief from your share of liabilities, and your basis. Suspended passive losses attributable to the activity are generally released on a fully taxable disposition of the entire interest, which is why the final year often produces a very different tax result from every year before it.
That release is a significant event and it lands in one year. Anybody who has been accumulating suspended losses across several deals should know it is coming.
Why nobody else tracks this for you¶
The partnership tracks its own books. Your preparer works from the K-1 you hand them, which reports the capital account and not your basis. The sponsor has no visibility into what you paid, what you have received, or what happened in years you were with a different preparer.
So the running basis calculation is genuinely yours to keep, and it takes about five minutes a year: start with last year's figure, add allocated income and any increase in your share of liabilities, subtract distributions and allocated losses and any decrease in liabilities.
Two moments where having it matters. A large refinance distribution, where the question is whether it exceeds basis. And the exit, where basis determines the gain and where the suspended losses of the whole hold are released at once.
What to keep¶
The last item takes a few minutes a year and is nearly impossible to reconstruct five years later. It is also the item nobody else is keeping.
Everything on this page describes mechanisms. What any of it means for your return is a question for a tax professional licensed where you file.
Primary sources
Every factual claim above is traceable to a filing, a rule or an agency publication. These are the ones this article relies on.
- IRS, Publication 541 on partnershipsirs.gov
- IRS, Partner's Instructions for Schedule K-1 (Form 1065)irs.gov
- Legal Information Institute, 26 US Code 705 on determining the basis of a partner's interestlaw.cornell.edu
- Legal Information Institute, 26 US Code 752 on the treatment of partnership liabilitieslaw.cornell.edu
- Legal Information Institute, 26 US Code 731 on distributions by a partnershiplaw.cornell.edu
Questions readers ask
What is the difference between a capital account and basis?
The capital account is a partnership accounting record of contributions, allocations and distributions. Outside basis is your tax investment in the interest and includes your share of partnership liabilities, which the capital account does not.
Why does my share of the mortgage increase my basis?
Under section 752, an increase in a partner's share of partnership liabilities is treated as a contribution of money by that partner. In a leveraged deal this is often what makes early losses deductible at all.
Can a distribution be taxable?
A distribution exceeding your basis in the partnership interest generally produces gain. Ordinary distributions in a performing deal usually do not, but a large refinance distribution can, which is why basis tracking matters.
Does the partnership track my basis?
No. The partnership tracks the capital account it reports on the K-1. Outside basis is the partner's own responsibility, and the two figures differ, principally because of liabilities.
What happens to my capital account at the end?
Many agreements liquidate in accordance with positive capital account balances, which means the allocation provisions rather than the summary waterfall determine the final split. It is worth checking which your agreement does.
Read next
- TaxThe Schedule K-1 a Syndication Sends You, Box by BoxThe form reports your allocated share of the partnership's income, deductions and capital. It will not match the cash you received, and it is not supposed to.
- TaxDepreciation, Cost Segregation and Bonus DepreciationA deduction requiring no cash outlay, accelerated into the early years. It changes the timing of deductions, not the total, and it enlarges recapture at sale.
- TaxPassive Activity Loss Rules: Why Your Losses May Be SuspendedThe rule that decides whether a syndication's first-year paper loss reduces your tax bill. For most W-2 investors, the answer is not this year.