Our commercial-property partnership refinanced and paid owners cash. Is the distribution taxable?
A cash-out refinance is not automatically tax-free for every partner. The partnership's receipt of loan proceeds is generally borrowing, not a property sale. The subsequent cash payment to an owner is a partnership distribution that can create gain under Section 731 to the extent money distributed exceeds that owner's adjusted outside basis immediately before the distribution. A new liability can increase outside basis under Section 752, but it must be allocated to the actual partner under the recourse or nonrecourse rules—not simply divided according to the checks sent to owners. IRS Publication 541 describes both the cash-distribution limit and the liability-basis rules.
For a managing partner planning a substantial commercial-property cash-out, the right question is whether each partner has basis for the proposed payout after the loan closes and all liability changes are modeled. The same transaction can be nontaxable to one owner and produce recognized gain for another.
Separate the borrowing from the distribution
Do not describe the check as “tax-free refinance proceeds” on the K-1. The partnership borrows from the lender; then it distributes cash to partners. A partner's share of partnership liabilities can increase outside basis as a deemed contribution under Section 752(a). Cash paid to the partner reduces that basis, and any excess over adjusted basis can be gain under Section 731. A later decrease in the partner's liability share is itself treated as a deemed cash distribution under Section 752(b), even if no new check arrives. The IRS partner K-1 instructions distinguish cash distributions and deemed distributions from liability decreases.
The debt allocation is a legal and economic-risk calculation. Recourse debt generally follows the partners who bear economic risk of loss under the governing agreements and enforceable guarantees; nonrecourse debt follows different rules. A 50/50 profit split or equal cash payment does not prove a 50/50 debt share. AE's recourse-versus-nonrecourse guide addresses the general Section 752 mechanics; this page focuses on the actual cash-out payout and what to reconcile before it is made.
Worked example: equal cash, different tax results
Assume two equal owners of a commercial-property partnership each have $200,000 of correctly computed outside basis just before a new loan. The partnership borrows $1 million, then pays $500,000 cash to each owner. For this simplified example, the entire new debt is validly allocated to Owner A under the recourse liability rules because A alone bears the economic risk of loss; Owner B is not allocated any of it. Ignore other income, losses, debt and distributions, and assume no disguised-sale issue.
A's basis rises from $200,000 to $1.2 million when A's $1 million debt share is taken into account; A's $500,000 cash distribution is within basis and leaves $700,000 basis. B's basis stays at $200,000 before receiving $500,000, so B recognizes a simplified $300,000 Section 731 gain and has no basis left from this calculation. The partnership did not sell the building, and both owners received the same cash. Their tax results differ because their liability shares differ. Actual guarantees, state law, lender rights, other Section 752 liabilities, and the ordering of same-year adjustments can alter both numbers. This example is not an assertion that signing any guarantee automatically gives A the full $1 million allocation.
If the new debt instead were properly allocated $500,000 to each partner, each would have $700,000 of pre-distribution outside basis on these assumptions and the $500,000 cash payment alone would not create Section 731 gain. That comparison is why the allocation workpaper—not the lender's gross mortgage balance or tax-basis capital account—must support the conclusion. The IRS's liability-allocation practice unit illustrates that nonrecourse allocations can involve several layers, rather than a simple ownership percentage.
Decision sequence before funds leave the partnership
- Rebuild outside basis for every recipient. Start with the prior Form 1065 and K-1, contributions, allocated income and loss, earlier cash and property distributions, Section 743(b) adjustments where relevant, and each partner's opening liability share. Tax-basis capital is not a substitute for outside basis because it excludes the partner's debt share. See Publication 541's basis discussion.
- Model the debt before and after closing. Read the old and new loan agreements, guaranties, contribution obligations, ownership agreement and lender covenants. Identify whether the refinance replaces an existing liability, who bears economic risk on any recourse portion, and how a nonrecourse portion is allocated. Net changes may differ from the new loan's face amount.
- Test each actual and deemed cash distribution. Put the proposed check and any Section 752(b) decrease beside that partner's adjusted basis at the transaction date. Do not let one partner's unused basis protect another partner. Section 731 gain can arise even while the partnership retains the real estate.
- Review connected rules, then file consistently. If an owner recently contributed appreciated property and cash returns soon afterward, the Section 707 disguised-sale rules may require a separate analysis; the IRS debt-financed-distribution discussion shows why a loan-funded payout is not an all-purpose safe harbor. Interest expense and its possible partner-level limitations depend on use-of-proceeds tracing and other rules; a tax-free principal receipt does not itself establish an interest deduction. Reconcile final liability shares, cash payments and gain to Form 1065, K-1s, and state returns.
Documents to gather and mistakes to avoid
- Current and prior loan closing statements, payoff and draw schedules, guarantees, lender covenants, debt-allocation workpapers, and partnership or operating agreement.
- Each partner's outside-basis rollforward, Forms 1065 and K-1, tax-basis capital detail, contributed-property history, and prior distribution ledger.
- Board or manager approvals, wire records showing who actually received cash, proposed K-1 reporting, and any planned property sale or ownership change.
Common failure points are calling all refinance cash “tax-free,” assigning debt pro rata without testing the loan terms, using capital-account balances as outside basis, ignoring the payoff of an old loan that reduces a partner's liability share, or assuming the absence of a property sale means no owner-level gain. Also do not assume new debt makes every prior passive loss deductible: Section 465 at-risk, Section 469 passive-activity, and other limits are separate from Section 752 basis. An owner drawing more than available basis can have gain even though the partnership's cash flow remains healthy.
This is a federal decision framework, not a return position for every cash-out. Recourse status, guarantees, nonrecourse minimum gain, earlier contributions, debt tracing, partner-specific basis, state law, and timing can change the result. AE can review the lender and partner workpapers and model the payout before the manager authorizes wires or signs Form 1065. For the general distribution limit, see AE's Section 731 guide.