Taking Money Out of a Partnership: Distributions and Basis
Why a draw is usually tax-free, when it becomes gain, the hot-asset and debt-shift rules that surprise partners, and the new reporting for property distributions.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
A partnership distribution is tax-free to the partner up to their outside basis, because the income was already taxed when earned. Cash above basis is capital gain. Property distributions generally carry no gain. Two exceptions surprise partners: hot assets, and a reduced share of partnership debt, which counts as a cash distribution.
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How is a distribution taxed?
| Distribution | Tax to the partner | Effect on basis |
|---|---|---|
| Cash up to outside basis | None | Reduces basis |
| Cash above outside basis | Capital gain on the excess | Basis to zero |
| Property (current distribution) | Generally none | Partner takes the partnership's basis, limited to outside basis |
| Property (liquidating distribution) | Generally none; loss possible if only cash, receivables, and inventory are received | Partner takes remaining outside basis in the property |
| Marketable securities | Treated as cash at fair market value for gain purposes, with exceptions | Outside basis reduced as for property; the securities' basis is increased by any gain recognized |
| Reduction in partner's share of liabilities | Treated as a cash distribution | Reduces basis; can create gain |
Why do draws and K-1 income differ?
Partners are taxed on their share of income whether or not it is distributed. A partner who leaves profit in the business builds basis; a partner who draws more than their share consumes basis and can eventually trigger gain. Reconciling draws to K-1 income each year keeps the basis schedule accurate.
What are hot assets?
Unrealized receivables and inventory (for distributions, only inventory that has appreciated substantially — fair market value above 120 percent of the partnership's basis). If a distribution changes a partner's share of hot assets relative to other assets, Section 751 recharacterizes part of the transaction as a sale, producing ordinary income. The same rule converts part of the gain on selling a partnership interest from capital to ordinary.
How does debt create a deemed distribution?
A partner's share of partnership liabilities is included in basis. When the partnership pays down debt, refinances with less, or changes how liabilities are allocated, each affected partner is treated as receiving cash equal to the reduction. If that exceeds basis, there is gain even though no money changed hands. Real estate partnerships refinancing or admitting new partners see this often.
What changed in reporting?
Starting with tax years beginning in 2024, a partner who receives a distribution of property must attach Form 7217 to their return — a separate form for each distribution date — reporting the partnership's basis in the property and the partner's resulting basis under Section 732. A distribution of only cash or marketable securities treated as cash does not require the form.
Frequently asked questions
Is a tax distribution taxable?
A distribution labeled "tax distribution" is taxed like any other distribution — tax-free to basis — even though it is meant to cover the partner's tax on their share of income.
Can a partnership distribute property without gain to the partnership?
Generally yes, unlike a corporation. The exceptions shift gain to a partner: if property one partner contributed is distributed to another partner within seven years of the contribution, the contributing partner recognizes the built-in gain (Section 704(c)(1)(B)); a contributing partner who receives other property within seven years can recognize gain under Section 737; and some contribution-and-distribution pairs are taxed as disguised sales.
What happens when a partner retires?
Liquidating payments are split between payments for the partner's share of partnership property (distribution rules) and other payments, which are ordinary income — the Section 736 rules.
How do I know my basis?
Reconstruct it from contributions, K-1 income and losses, distributions, and liability shares each year. The tax-basis capital account on the K-1 is a starting point but excludes liabilities.
Official sources
The IRS explains: “A partner generally recognizes gain on a partnership distribution only to the extent any money (and marketable securities treated as money) included in the distribution exceeds the adjusted basis of the partner’s interest in the partnership. Any gain recognized is generally treated as capital gain from the sale of the partnership interest on the date of the distribution.” — Internal Revenue Service, Publication 541 (12/2025), Partnerships, https://www.irs.gov/publications/p541
The IRS explains: “Form 7217 is filed by any partner receiving a distribution of property from a partnership in a non-liquidating or liquidating distribution to report the basis of the distributed property, including any basis adjustment to such property as required by section 732(a)(2) or (b).” — Internal Revenue Service, About Form 7217, Partner’s Report of Property Distributed by a Partnership, https://www.irs.gov/forms-pubs/about-form-7217
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk maintains partner basis schedules and checks every refinance and admission for deemed distributions. See pricing or book a free fit call.
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