In real estate and partnership investing, a common question comes up: Can I take cash out without triggering tax?
In certain situations, the answer is yes.
IRC Section 731 governs how partnership distributions are taxed. Under the right conditions, investors may receive cash or property without immediate tax liability. The rule applies specifically to partnerships and entities taxed as partnerships, including many real estate syndications and joint ventures.
But there is a limit, and once you cross it, the tax consequences change quickly.
What Is Section 731?
Section 731 addresses how distributions from a partnership to a partner are treated for tax purposes.
At a high level:
- A partner does not typically recognize gain on a distribution
- Unless the cash or value of property received exceeds the partner’s adjusted basis in the partnership
If distributions exceed basis, the excess is treated as a capital gain, similar to selling a portion of the partnership interest.
The Key Concept: Basis
The ability to take cash out tax-free comes down to one thing: basis.
A partner’s basis typically includes:
- Initial capital contributions
- Additional contributions over time
- Allocated income (which increases basis)
- Allocated losses and prior distributions (which decreases basis)
Think of basis as a yardstick to measure your tax investment in the partnership.
Section 731 allows you to recover that investment without tax, but only up to that amount.
How It Works:
Under Section 731:
- Distributions up to your basis are generally not taxable
- Distributions above your basis trigger capital gain
- Loss recognition is limited and typically applies only in certain liquidating scenarios
This creates a clear line: Tax-free until you run out of basis.
A Simple Example
Let’s say:
- Your basis in a partnership is $500,000
- You receive a $400,000 distribution
Result:
No tax is triggered. Your basis is reduced to $100,000.
Now consider:
- Same $500,000 basis
- You receive a $600,000 distribution
Result:
- $500,000 is a return of basis (non-taxable)
- $100,000 is recognized as capital gain
(This example is hypothetical and for educational purposes only.)
Why This Matters for Investors
Section 731 can create real flexibility for investors who want to access liquidity without fully exiting an investment.
This often comes into play when:
- A partnership refinances a property and distributes proceeds
- Capital is returned during the hold period
- Investors rebalance across opportunities
- Investors want to divide up property between partners
In these situations, investors may be able to pull cash out without immediate tax, as long as sufficient basis remains.
In more complex structures, such as certain UPREIT partnerships (often resulting from DSTs completing a Section 721 contribution) or other partnership-based arrangements, additional planning opportunities may exist. In some cases, investors may have the ability, after a period of time, to redeem operating partnership units for REIT shares and then sell those shares to access liquidity.
However, the underlying principle remains the same: distributions are generally tax-free only to the extent of basis, and different steps in the process may carry different tax consequences.
While the concept is straightforward, the application is not always simple. In certain situations, “mixing bowl” rules under the Internal Revenue Code may apply, which are designed to prevent partners from contributing property and then quickly receiving different property in a non-recognition transaction.
Strategic Considerations
1. Basis Drives Everything
Your ability to receive tax-free distributions depends entirely on your basis. Misunderstanding it can lead to unexpected tax liability.
2. Debt Impacts Basis
A partner’s share of partnership debt increases basis. If debt is reduced, basis may decrease, which can affect future distributions.
3. Timing Matters
Distributions that seem similar on the surface can have very different tax outcomes depending on timing, structure, and prior allocations.
4. This Is About Deferral, Not Elimination
Section 731 allows for tax-efficient distributions, but it does not eliminate tax. Once distributions exceed basis, gain is recognized.
How Section 731 Fits Into a Broader Strategy
For many investors, partnerships are a core part of their portfolio, through syndications, joint ventures, or fund structures.
Section 731 supports:
- Liquidity planning
- Capital recycling
- Managing tax exposure over time
It is not a replacement for other tax strategies, but it can be an important complement within a broader investment approach.
Final Takeaway
You can generally receive distributions tax-free up to your basis, but anything beyond that may trigger capital gain. Understanding where you stand relative to that line is critical.
Unlike a 1031 exchange, there is no intermediary involved. Section 731 is driven entirely by tax reporting and partnership structure. Because outcomes depend on basis and partnership accounting, investors should work closely with their CPA or tax advisor, and in more complex situations, a tax attorney.
With proper planning, Section 731 can be a useful tool for accessing capital efficiently while staying aligned with your overall investment strategy.
Jeff Peterson is a Minnesota attorney and former adjunct professor of tax law. He serves as President of Minneapolis’ Commercial Partners Exchange Company, LLC, where he facilitates forward, reverse, and build-to-suit 1031 exchanges nationwide. Jeff regularly collaborates with attorneys, accountants, and real estate professionals on exchange strategies. Reach him at 612-643-1031 or [email protected] or on the web at www.cpec1031.com.
