Updated · Part of the CRE investment glossary
How a capital account works
Every partner in a partnership — and every member of an LLC taxed as one — has a capital account. It starts with what the partner contributes, grows with the income and gain the operating agreement allocates to them, and shrinks with losses and with what they are paid. It is a ledger of each partner’s claim on the partnership’s equity.
The Treasury regulations under Internal Revenue Code section 704(b) give the rules most agreements adopt. An allocation of income or loss is respected under the regulations’ economic-effect test only if, among other things, capital accounts are kept under §1.704-1(b)(2)(iv) and liquidating distributions follow the partners’ positive capital account balances. Many real estate agreements instead distribute by the waterfall and allocate income and loss so that capital accounts end up matching it, often called target allocations.
This page explains the concept. It is not tax or legal advice: how your partnership keeps capital accounts depends on its operating agreement and the regulations, and your CPA and counsel decide how they apply.
The formula
Under §1.704-1(b)(2)(iv)(b), for one partner, for one period:
Ending capital account = beginning capital account + cash contributed + contributed property at fair market value (net of liabilities) + allocated income and gain − allocated losses and deductions − cash distributed − distributed property at fair market value (net of liabilities)
- Property is recorded at its fair market value when contributed, not at the partner’s tax basis — the main reason book capital and tax capital differ.
- Income, gain, loss and deduction are book amounts, figured from the property’s book value.
- Liabilities: contributed and distributed property both count net of the liabilities that go with them.
Worked example: cash and contributed land
An LP contributes $1,500,000 in cash. The GP contributes land worth $500,000 that it bought years ago for $200,000. The capital accounts open at $1,500,000 and $500,000 — a 75/25 split. In year one the partnership earns $100,000 of book income and distributes $80,000, both shared 75/25.
The GP’s tax capital opens at the land’s $200,000 tax basis, not $500,000. The $300,000 gap is built-in gain; section 704(c) assigns it to the GP when the land is sold, so the LP is not taxed on gain that arose before the land was contributed.
| Line | LP | GP | Total |
|---|---|---|---|
| Contribution at fair market value | $1,500,000 | $500,000 | $2,000,000 |
| Book income (75/25) | $75,000 | $25,000 | $100,000 |
| Distributions (75/25) | −$60,000 | −$20,000 | −$80,000 |
| Ending capital account | $1,515,000 | $505,000 | $2,020,000 |
Book capital vs tax capital vs outside basis
One partner can have several "capital" numbers, each with its own job:
- Section 704(b) book capital: the account described on this page, at fair market values, with revaluations. Many operating agreements tie allocations and liquidating distributions to it.
- Tax basis capital: tax figures, reported in item L of each partner’s Schedule K-1 under the tax-basis method.
- Outside basis: the partner’s tax basis in the interest — roughly tax capital plus the partner’s share of partnership liabilities. It limits deductible losses.
- Unreturned capital: a waterfall balance — contributions minus capital returned — that a preferred return accrues on. It ignores allocated income and loss.
Revaluations when partners come and go
Under §1.704-1(b)(2)(iv)(f), a partnership may restate capital accounts to the current value of its property on certain events, such as a new contribution in exchange for an interest or a distribution that redeems one. If a property bought for $10,000,000 is worth $13,000,000 when a new investor joins, a revaluation books the $3,000,000 of unrealized gain to the existing partners first, so the newcomer does not share in value created before they arrived.
Without a revaluation, capital accounts drift away from what each partner would actually receive. That is one reason sponsors keep a ledger of every contribution, distribution and allocation rather than rebuilding balances at year end.
Primary sources
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.