• Explanation

A partner's contribution of property in exchange for a partnership (P/S) A formal or informal arrangement in which two or more parties agree to operate a for-profit business as co-owners. interest generally results in no gain or loss recognized by the partner. Because the exchange is generally nontaxable, the outside basisThe tax basis of an individual partner's interest in a partnership. It is adjusted each period for the partner's share of the partnership's income and liabilities, additional contributions, and distributions received.  of the partner's  P/S interest equals the adjusted tax basisThe amount used to value property in tax transactions. It is the property's purchase price (ie, cost) less accumulated depreciation. The cost may be adjusted for subsequent capitalized costs or recoveries. (not FMV) of the property contributed. A partner's basis can never be negative.

If property contributed is subject to a liability (eg, mortgage) assumed by the P/S, the contributing partner's basis is reduced by the liability. Each partner's basis is then increased by their pro rataA term meaning "in proportion" used to describe the fractional share of ownership by which an amount will be divided or distributed. share of the new P/S liability.

However, if the property contributed has a liability exceeding its adjusted tax basis, a negative basis could result for the contributing partner. If this occurs, the partner will recognize The reportable gain or loss included in a taxable income calculation. It may differ from the realized gain or loss.  a capital gainThe difference between the amount realized and an asset's adjusted tax basis when disposing of a capital asset. equal to the required adjustment to bring the basis up to $0.

In this scenario, Strom's contribution creates a negative basis. Because basis cannot be negative, the basis is increased to $0, and a $5,000 gain is recognized.

Things to remember:
When a partner contributes property with a liability assumed by the partnership, the liability reduces the partner's basis. This basis is then increased by the partner's pro rata share of the liability. If the liability exceeds the property's adjusted basis, a negative basis could result for the partner. If this occurs, the partner will recognize a capital gain equal to the adjustment required to bring the basis up to $0.