In-Kind Partnership & Real Estate Transactions and the Disguised Sale Rules
Partnerships offer a range of options for transferring property, exchanging interests, or restructuring ownership without immediate tax. However, these transactions often sit near the boundary between nonrecognition and disguised sales. Understanding when §721, §731, §707, and related rules apply—and how the IRS interprets them—helps owners and advisors avoid unwanted gain recognition.
1) The Core Nonrecognition Rule: §721
Under IRC §721(a), no gain or loss is recognized when property is contributed to a partnership in exchange for an interest. This is the foundation of in-kind partnership planning: a partner can contribute appreciated real estate, equipment, or other property and defer tax until later disposition.
- Applies to both formation and later capital contributions.
- Includes property contributions; not services (services create taxable compensation under §707(a)).
- The partnership takes a carryover basis under §723; the contributing partner takes a substituted basis under §722.
2) §731 and §732: Distributions in Kind
When a partnership distributes property to a partner, §731 generally provides nonrecognition except for cash distributions exceeding outside basis. The partner takes a carryover basis under §732, and the partnership reduces its inside basis accordingly.
- Applies to both operating and liquidating distributions.
- Gain recognition limited to cash exceeding basis; loss recognition only in certain liquidations with only cash or unrealized receivables/inventory distributed.
3) Common In-Kind Planning Situations
- Property-for-interest (§721): Contribute appreciated property to defer gain.
- Drop & Swap: Contribute property to a partnership (drop) before a §1031 exchange of an undivided interest (swap).
- Partnership “mixing bowl” transactions: Contribute property and later distribute other property or the original asset to a different partner—potentially triggering anti-abuse provisions under §704(c)(1)(B) and §737.
4) Disguised Sales: §707(a)(2)(B)
The main anti-abuse regime sits in §707(a)(2)(B) and Regs. §1.707-3 through -9. A “disguised sale” occurs when a partner contributes property and receives cash or other consideration within a certain period under circumstances that resemble a sale rather than a contribution and distribution.
- Presumption window: Two years between contribution and related distribution (Reg. §1.707-3(c)).
- Facts & circumstances test: Economic equivalence of sale, debt-financed distributions, and pre-arranged transfers can all trigger sale treatment.
- Debt-financed distributions: Safe harbors exist under Reg. §1.707-5(b) for qualified liabilities and reasonable allocations of debt.
Flowchart: §721 Nonrecognition vs. Disguised Sale
5) Related Guidance and Rulings
- Rev. Rul. 84-52: Partnership-to-partnership conversions qualify for §721 nonrecognition.
- Rev. Rul. 99-5 & 99-6: Address formation and liquidation transactions that resemble asset sales but qualify under §721 or §731 depending on facts.
- Rev. Proc. 2016-47: Useful timing relief in some §1031 contexts combined with partnership planning.
6) Planning Thoughts and When to Call a Pro
- When combining partnership transactions with §1031 exchanges or refinancing events—timing and documentation are critical.
- Understand qualified liability exceptions before refinancing; they can prevent disguised sale treatment if properly structured.
- Mixing-bowl or “swap” transactions within two years of a contribution or distribution are red flags—get technical review.
- Partnership agreement drafting should anticipate allocations under §704(c) and debt allocations under §752 to avoid unintended consequences.