What Is a 731 Exchange for Partnership Distributions?

A “731 exchange” refers to the tax rules under Internal Revenue Code (IRC) Section 731 that govern when a partnership distributes cash or property to a partner. While the name sounds similar to a Section 1031 like-kind exchange, a Section 731 distribution is different. It deals with transfers from a partnership entity to one of its owners, not an exchange with an unrelated third party.

The core of Section 731 determines the tax implications of a partner withdrawing their investment from the partnership. It establishes whether a distribution is a tax-free return of capital or a taxable event. The rules apply to various scenarios, from a simple cash withdrawal to a complete liquidation of a partner’s interest.

Tax Treatment of Partnership Distributions

The general principle of Section 731 is tax deferral. When a partnership makes a distribution to a partner, the partner does not recognize an immediate gain or loss. The tax code treats the distribution as a return of the partner’s investment in the partnership, not a sale of their interest.

An exception to this rule arises when a partner receives cash exceeding their adjusted basis in the partnership interest. This adjusted basis, or “outside basis,” represents the partner’s total investment. If a cash distribution is greater than this basis, the excess amount is a taxable capital gain. For example, a partner with an outside basis of $10,000 receiving a $12,000 cash distribution recognizes a $2,000 capital gain.

Distributions of property other than cash are treated differently and generally do not trigger immediate gain recognition. The partner takes the property with a specific tax basis, which defers any potential gain until the partner sells that property. The tax treatment also depends on whether the distribution is current (non-liquidating) or liquidating. A current distribution reduces a partner’s interest, while a liquidating distribution terminates it entirely.

Determining Partner and Property Basis

Calculating a partner’s adjusted basis in their partnership interest, or “outside basis,” is necessary for determining tax consequences. This figure is dynamic and reflects the partner’s economic investment. The calculation starts with the initial basis from the partner’s contribution. This amount is then increased by additional contributions and the partner’s share of partnership income, and decreased by distributions and the partner’s share of losses.

For instance, if a partner starts with a basis of $50,000, adds a $10,000 contribution, is allocated $15,000 of income, and receives a $5,000 distribution, their adjusted basis becomes $70,000. This calculation is governed by IRC Section 705. This tax basis is distinct from the partner’s capital account, which is an accounting measure and may not reflect tax basis.

The rules for determining the partner’s basis in received property are in IRC Section 732. In a non-liquidating distribution, the partner’s basis in the property is the same as the partnership’s basis in that asset (“inside basis”). However, this carryover basis cannot exceed the partner’s outside basis, reduced by any cash received. In a liquidating distribution, the basis of the property received equals the partner’s outside basis, reduced by any cash distributed.

Exceptions and Special Considerations

While the rules of Section 731 provide for tax-deferred distributions, several exceptions can override this treatment and create a taxable event. These special considerations address specific situations to prevent partners from avoiding taxes on certain types of income.

Hot Assets (Section 751)

An exception involves “hot assets,” governed by IRC Section 751. This rule applies when a distribution disproportionately changes a partner’s share of unrealized receivables or substantially appreciated inventory. Unrealized receivables are rights to payment for goods or services not yet included in income. When such a distribution occurs, the transaction may be treated as a taxable sale or exchange, preventing partners from converting ordinary income into a capital gain.

Marketable Securities

Under Section 731, distributions of marketable securities are often treated as distributions of cash at their fair market value. This means a partner can recognize a gain if the value of the securities, plus any other cash received, exceeds their outside basis. Marketable securities include actively traded financial instruments like stocks and bonds. An exception exists for securities that the receiving partner originally contributed.

Loss Recognition

A partner can only recognize a loss on a distribution in limited circumstances. A loss is possible only in a liquidating distribution that completely terminates the partner’s interest. Furthermore, the distribution must consist solely of cash, unrealized receivables, and inventory. If any other type of property is distributed, no loss can be recognized. The loss is the amount by which the partner’s outside basis exceeds the assets received.

Disguised Sales

The disguised sale rules under IRC Section 707 are designed to prevent partners from structuring a taxable sale as a tax-free contribution and distribution. If a partner contributes property to a partnership and soon after receives a distribution, the IRS may recharacterize the events as a single, taxable sale. Transfers made within a two-year period are presumed to be a disguised sale.