Partnership Tax-Basis Capital Accounts on Schedule K-1 (Item L) Versus Outside Basis

Partners ask two different questions and often mix them up: "what is my capital account?" and "what is my basis in the partnership?" On Form 1065, Item L reports the first on the tax-basis method. The second is a different number, and the partner, not the partnership, is responsible for tracking it. In real estate partnerships, where debt is large, the two can be very far apart.

What Item L requires

The Form 1065 instructions provide that the partnership figures each partner's capital account using the transactional approach for the tax-basis method. A partnership is not required to complete Item L if its answer to Schedule B, question 4 is "Yes," which also makes Schedules L, M-1 and M-2 optional. Item L has these lines:

• Beginning capital account. The partner's ending capital account from last year. A partner who joined through a contribution this year starts at zero.
• Capital contributed during the year. Cash plus the adjusted tax basis of property contributed, reduced by liabilities assumed by the partnership or to which the property was subject. The amount can be negative.
• Current year net income (loss). The partner's distributive share of income and gain, including tax-exempt income, less the share of loss and deductions, including nondeductible, noncapital expenditures, figured for tax purposes.
• Other increase (decrease). All other changes to the partner's tax capital for the year, with an attached statement explaining each. When a new partner buys an interest, the transferee's other increase equals the transferor's ending capital account for the interest transferred.
• Withdrawals and distributions. Cash plus the adjusted tax basis of property distributed, reduced by liabilities assumed by the partner or to which the property was subject. The amount can be negative.
• Ending capital account. The sum of the lines above it. The instructions state that it may be negative if the partner's losses and distributions exceed contributions and share of income.

Items M and N sit next to Item L on the Schedule K-1. Item M asks whether the partner contributed property with a built-in gain or loss, and Item N reports the partner's share of net unrecognized section 704(c) gain or loss at the beginning and end of the year.

If a partner is uncertain how to report an event, the instructions say to account for it consistently with figuring the partner's adjusted tax basis in the interest, without regard to partnership liabilities, applying the principles of sections 705, 722, 733 and 742.

Why it is not outside basis

The instructions state that the ending capital account on the tax-basis method might not equal the partner's adjusted tax basis in its partnership interest. A partner's adjusted basis includes the partner's share of partnership liabilities, as well as partner-specific adjustments. Each partner is responsible for maintaining a record of the adjusted tax basis in its interest.

Worked example

Two partners form a real estate partnership. Partner A contributes $500,000 of cash. Partner B contributes land worth $500,000 with an adjusted tax basis of $300,000 and no debt. In year one, the partnership has $100,000 of taxable income, allocated equally. The partnership also borrows $600,000 on a nonrecourse loan. Assume each partner's share of the liability is $300,000.

• A, tax-basis capital: $500,000 plus $50,000, or $550,000.
• B, tax-basis capital: $300,000 plus $50,000, or $350,000.
• A, outside basis: $550,000 plus $300,000 of liabilities, or $850,000.
• B, outside basis: $350,000 plus $300,000, or $650,000.

On a 704(b) book basis, each partner's capital would be $550,000, because land is contributed at $500,000 fair value. The $200,000 gap in B's account between book capital ($550,000) and tax capital ($350,000) is the built-in gain on contributed land, which section 704(c) allocations must account for. The partnership statements should show all three measures, and the reconciliation matters for loss limitation.

Second example: refinancing and a negative capital account

In year two the partnership borrows another $400,000 on a nonrecourse basis and distributes the cash equally. Each partner's share of liabilities rises by $200,000.

• Under section 752(a), the $200,000 increase is treated as a contribution of money to the partner's basis. The $200,000 cash distribution reduces it. Outside basis does not change.
• A, tax-basis capital: $550,000 minus $200,000, or $350,000. Outside basis: $350,000 plus $500,000 of liabilities, or $850,000.
• B, tax-basis capital: $350,000 minus $200,000, or $150,000. Outside basis: $150,000 plus $500,000, or $650,000.

In year three the partnership has a $500,000 tax loss, allocated equally.

• A, tax-basis capital: $350,000 minus $250,000, or $100,000. Outside basis: $850,000 minus $250,000, or $600,000.
• B, tax-basis capital: $150,000 minus $250,000, or negative $100,000. Outside basis: $650,000 minus $250,000, or $400,000.

B's Item L ending balance is negative, which the instructions permit, while B's outside basis is $400,000. Section 704(d) limits B's loss to the adjusted basis of the interest, so the loss is allowed here. The negative Item L figure does not by itself suspend any loss.

Where this bites

• Loss limits. A partner can deduct losses only up to outside basis, so a partner-level basis schedule is needed, not just Item L.
• Negative tax capital. Large cash-out refinancings can drive a partner's tax capital below zero while outside basis is positive because of debt shares. Review the ending balances for negatives and the support.
• Sales of interests. The seller's gain on a sale of the interest is measured from outside basis, not Item L.
• Financial statements. Tax-basis partnership statements, and the differences from GAAP, are discussed in cash and tax basis financial statements.

Common questions

Does a negative Item L balance mean the partner has no basis?

No. Item L excludes the partner's share of partnership liabilities. Section 705 starts basis at the section 722 or 742 amount, and section 752 adds liability shares. A negative tax capital account with debt-share basis is a normal real estate result.

Who keeps the outside basis record?

The partner. The Form 1065 instructions state that each partner is responsible for maintaining a record of the adjusted tax basis in its partnership interest.

Can the partnership skip Item L?

Yes, when the answer to Schedule B, question 4, is "Yes." The partnership must meet all four requirements shown on the form, and Schedules L, M-1 and M-2 become optional.

File checklist

• Partnership agreement and amendments with allocation provisions.
• Contribution schedule with fair value, tax basis and assumed liabilities.
• Item L roll-forward by partner tied to prior-year Schedule K-1s.
• Liability allocation schedule by partner, recourse and nonrecourse.
• A separate outside-basis worksheet delivered to partners with the K-1.

Sources

• Internal Revenue Service, Instructions for Form 1065 (2025), Item L and Schedule B: https://www.irs.gov/pub/irs-pdf/i1065.pdf
• Legal Information Institute, 26 U.S.C. 752, Treatment of certain liabilities: https://www.law.cornell.edu/uscode/text/26/752
• Legal Information Institute, 26 U.S.C. 704, Partner's distributive share (704(c) and 704(d)): https://www.law.cornell.edu/uscode/text/26/704
• Legal Information Institute, 26 U.S.C. 705, Determination of basis of partner's interest: https://www.law.cornell.edu/uscode/text/26/705

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