What is the Inside and Outside Basis of Your Interest in a Partnership?

When you set up a partnership to operate a business, the assets you contribute to the partnership are set up on the partnership books at their fair market value. But for tax purposes, the basis of the assets is the same as your basis in the assets for tax purposes. According to the IRS, the built-in gain or loss due to the difference between the fair market value and the tax basis is generally not recognized when property is contributed to a partnership.

The partnership's basis in its assets for tax purposes is called the inside basis. The outside basis is the value of the partner's interest in the partnership. The outside basis consists of the partner's capital account for tax purposes and the partner's share of partnership liabilities. The inside basis for the partnership is generally equal to the total of each partner's outside basis.

For example, assume you and a friend decide to form a partnership. You contribute a building that you originally purchased for $75,000 and for which you have claimed $25,000 in depreciation. The fair market value of the building is now $100,000. Your friend contributes $50,000 in cash and equipment with a fair market value of $50,000 that he originally purchased for $80,000 and for which he has claimed depreciation of $20,000.

The book value of the partnership's assets will be cash of $50,000, equipment for $50,000, and a building for $100,000, for total book assets of $200,000 (at their fair market value). You and your friend will each have capital accounts for $100,000 if you are equal partners.

The inside basis for tax purposes is $50,000 for cash, $60,000 for equipment (your friend's cost of $80,000 - $20,000 in accumulated depreciation), and $50,000 for the building (your cost of $75,000 - $25,000 in accumulated depreciation) for a total of $160,000. Your outside basis is $50,000 and your friend's outside basis is $110,000 (cash of $50,000 plus the net depreciated value of the equipment for $60,000).

In this example, you have a built-in gain of $50,000 ($100,000 fair market value of the building less your basis of $50,000) and your friend has a built-in loss of $10,000 ($50,000 fair market value of the equipment less the basis of $60,000). This built-in gain or loss would not be recognized until you sell or transfer your interests in the partnership.

When you sell or transfer your interests in the partnership, your gain or loss would be calculated as the amount you receive for your interest less the outside basis of your partnership interest. The partnership's inside basis and your outside basis would change over time based on the partnership's activities, for example if the partnership acquires additional assets or incurs liabilities.

Sources:

Partnership - Audit Technique Guide - Chapter 1 - Basic Principles (Rev. 3/2008), IRS

Paul J. Streer and Caroline D. Strobel, Tax Effects on Partnership and Limited Liability Company Interests, The CPA Journal

Publication 541, Partnerships, IRS