Formation · Chapters 2–4

Formation: preserve the investment, separate the accounts

Follow an appreciated land contribution from the initial exchange through a later sale. Reconcile outside basis, inside basis, book capital, and the gain that § 721 postpones.

The working method

Read the rule. Reconcile the example. Change one fact. Then return to the authority.

Identify the exchange before computing the basis

Begin with the direction of the transfer. Property contributed to the partnership for a newly issued interest raises §§ 721–723. Buying an existing interest from a departing partner raises a different starting-basis rule, § 742. Receiving a capital interest for services is another transaction again: the property-contribution rule does not shelter compensation merely because the parties call the recipient a partner.

For the ordinary property exchange assumed here, § 721 generally postpones recognition to both the contributor and the partnership. The deferred gain does not disappear. Basis preserves the untaxed difference for a later transaction. Establish the transfer date, the adjusted tax basis immediately before transfer, contribution-date fair market value, and any related cash or debt movements before opening a spreadsheet.

Three questions, three separate measurements

Outside basis asks about the partner’s tax investment in the interest. In this debt-free example, § 722 starts it with contributed cash plus the property’s adjusted basis. Inside basis asks about the partnership’s tax basis in each asset; § 723 generally carries over the contributor’s adjusted basis. Neither calculation substitutes market value for basis simply because the ownership form changed.

A § 704(b) book capital account follows another framework. The contribution increases it by cash and contribution-date property value, net of relevant liabilities. Tax-basis capital is a fourth measure, distinct from book capital and outside basis. It happens to match outside basis in our restricted example. That numerical coincidence is not permission to merge the accounts.

At formation	A	B	Partnership total
Contribution value	$70,000	$70,000	$140,000
Outside basis	$30,000	$70,000	$100,000 combined
§ 704(b) book capital	$70,000	$70,000	$140,000
Inside tax basis	Entity assets only	Entity assets only	$100,000

The difference belongs to a particular contribution

A’s land arrives with $40,000 of appreciation already embedded in it. Giving A and B equal economic interests does not allow that pre-existing tax gain to migrate to B. Section 704(c) requires allocations that account for the contribution-date tax/book disparity. Track the difference by property, contributor, and date; a single net capital figure can conceal the information needed later.

The sale illustration below uses nondepreciable investment land, the traditional method, and a sale price above the contribution-date value. Those facts avoid a ceiling-rule shortfall. The illustration therefore separates pre-contribution gain from later appreciation cleanly. Depreciation, a lower selling price, built-in loss property, and remedial or curative allocations require additional analysis; the arithmetic below is not a universal allocation formula.

Timing changes the questions that must be asked

Record contribution values at contribution, not at year-end. A later increase in the land’s market value does not automatically rewrite its book carrying amount. Permitted book revaluations have their own triggering events and conditions. Also distinguish the holding period of contributed property from the holding period of an interest received for multiple kinds of assets; cash does not carry a pre-existing holding period into the interest.

Debt can change the initial result sharply. Partnership liability assumptions and changes in a partner’s share of liabilities are tested under § 752; they can create deemed money movements and possible gain. Ownership percentage alone does not establish every liability allocation. A cash payment connected with the contribution can raise disguised-sale issues. Never attach a debt adjustment after declaring the entire formation transaction finished.

Keep the evidence that makes the numbers reproducible

Retain the asset description, basis support, valuation support, contribution agreement, ownership terms, debt documents, and an opening book/tax balance sheet. Common errors include using value for outside basis, treating inside basis as an account owned personally by A, or forgetting that the cash partner’s contribution also becomes an entity asset. The table’s $100,000 inside basis consists of $82,000 cash and $18,000 land basis.

This lesson assumes a domestic partnership, qualifying property contributions, no liabilities, no services, no related sale, and no special exception to nonrecognition. It explains the ordinary architecture. Investment-company contributions, cross-border transfers, receivables, inventory, and formation costs introduce distinct rules. Research those facts before extending the example.

Work the case

A contribution followed by a sale

A contributes $12,000 cash and investment land with $18,000 adjusted basis and $58,000 value. B contributes $70,000 cash. They share later appreciation equally. Assume no liabilities, depreciation, expenses, distributions, or exceptions. The partnership later sells the land for $86,000.

Opening outside basis

A: 12,000 + 18,000 = 30,000; B: 70,000

A’s $40,000 pre-contribution gain is deferred, not added to tax basis.

Opening entity assets

Cash 82,000 + land tax basis 18,000 = 100,000

Book assets instead total $140,000 because the land is booked at $58,000.

Separate tax gain from book gain

Tax: 86,000 − 18,000 = 68,000; book: 86,000 − 58,000 = 28,000

The $40,000 difference is the original contribution disparity.

Allocate and reconcile

A tax gain: 40,000 + 14,000 = 54,000; B: 14,000

Outside bases become $84,000 each. Each book capital also becomes $84,000. Total cash and inside basis are $168,000.

The sale converts the deferred $40,000 disparity into tax gain allocated to A. Later $28,000 appreciation is shared equally. The accounts converge because of these facts, not because tax and book are interchangeable.

Pause and test your reasoning

Can you explain the difference?

01 · If A’s land value rises before contribution but its adjusted basis stays $18,000, which starting accounts change?

Book capital and the contribution disparity change. A’s outside basis and the land’s carryover inside tax basis do not increase merely because value increased.

02 · Why does equal ownership not produce an equal split of all $68,000 tax gain?

The first $40,000 arose before B joined the investment and is preserved for A under § 704(c). Only the later $28,000 gain is shared equally under the stated agreement.

03 · Would the same three-line calculation work if the partnership assumed A’s mortgage?

No. Identify liability relief and A’s allocated partnership liabilities under § 752, then test deemed cash movements and possible recognition before finalizing basis.

Read the authority.

Review the text, cross-references, applicable dates, and exceptions. A short example cannot cover every rule.

Reviewed November 15, 2026 · Original educational chapter by Sergey Syso · Not a filing-position determination.