Updated · Part of the CRE investment glossary
How a tax basis capital account works
Every partnership tracks what each partner has put in and taken out. The Form 1065 instructions require item L to be figured with the tax-basis method, using a transactional approach: start from last year’s ending balance and post each year’s events as they happen, measured the way you would measure a partner’s tax basis in the interest, but without partnership liabilities (sections 705, 722, 733 and 742).
Item L has fixed lines: beginning capital account, capital contributed during the year (cash plus the adjusted tax basis of contributed property, reduced by any liabilities the partnership takes on with it), current-year net income or loss as figured for tax purposes, other increase or decrease, withdrawals and distributions, and the ending capital account. Item L is not required when the partnership answers "Yes" to question 4 of Schedule B, the small-partnership test.
The formula
For one partner, for one tax year:
Ending tax capital = beginning tax capital + contributions + share of income and gain − share of losses and deductions − distributions ± other items
- Contributions: cash plus the adjusted tax basis of property contributed, net of liabilities the partnership assumes. The amount can be negative.
- Income and losses: as figured for tax purposes, including tax-exempt income and nondeductible expenses.
- Distributions: cash plus the adjusted tax basis of property distributed.
Worked example: one partner, one year
An LP contributes $100,000 in cash to a partnership that buys an apartment property. In year one the LP’s share of operating income before depreciation is $10,000. Tax depreciation is accelerated by a cost segregation study and bonus depreciation, so the LP’s share is $40,000; the GAAP financial statements depreciate over useful lives, so the LP’s share there is $10,000. The LP receives $8,000 of distributions.
The tax basis capital account ends at $62,000 while the GAAP capital account ends at $92,000 — same deal, same cash, different depreciation. The LP’s share of the property’s mortgage, reported in item K1, is $150,000, so the LP’s outside basis is roughly $62,000 + $150,000 = $212,000 before any partner-specific adjustments. That outside basis, not item L, is what limits the losses the LP can deduct.
| Line | Tax basis capital | GAAP capital |
|---|---|---|
| Capital contributed | $100,000 | $100,000 |
| Operating income before depreciation | $10,000 | $10,000 |
| Depreciation | −$40,000 | −$10,000 |
| Distributions | −$8,000 | −$8,000 |
| Ending capital account | $62,000 | $92,000 |
Tax capital vs 704(b) capital vs outside basis
A partner can have four different "capital" numbers at once, each with a job:
- Tax basis capital (item L): tax figures, no liabilities. The IRS uses it to see each partner’s tax equity year over year.
- Section 704(b) book capital: kept under the capital-account rules of Treasury Regulations §1.704-1(b), using the value of contributed property and revaluations when partners come and go. Many operating agreements tie liquidating distributions to these accounts.
- GAAP capital: what the financial statements show, with depreciation over useful lives.
- Outside basis: the partner’s tax basis in the interest — roughly tax capital plus the partner’s share of partnership liabilities, plus partner-specific adjustments. The partner, not the partnership, is responsible for tracking it.
Negative tax capital
Tax capital goes negative when a partner’s losses and distributions exceed what they contributed plus their share of income — common in leveraged real estate, where depreciation and debt-financed distributions run ahead of income. A negative balance is reported as it is. It often signals that a sale, refinance payout or foreclosure could produce taxable gain larger than the cash the partner receives, because relief from the partner’s share of the debt counts as an amount realized. Partners should ask their CPA to model it before a sale.
Primary sources
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.