I have spent the latter part of my career helping tax professionals think through technical positions, reviewing high-risk issues, and training newer professionals on how to read and apply the tax rules in a practical way. 

It has been my experience over the years that the complex rules and reporting requirements surrounding partnership liabilities are a perennial source of confusion for tax professionals. It is therefore not surprising that many tax professionals struggle with the liability reporting on Schedule K-1 (Form 1065), Part II, Item K1: 

 

 

If you’ve ever prepared a partnership return, you will recognize this table immediately. Much of the confusion stems from distinguishing the buckets in Item K1—recourse, nonrecourse, and qualified nonrecourse financing. This is understandable because the labels look simple, but they are tied into three different sets of rules under federal tax law, and each uses the recourse/nonrecourse concept for a different purpose. My hope with this article is to alleviate some of this confusion. 

I have found that the fog tends to clear once you can keep three separate “regimes” straight: 1) the rules that determine gain or loss when debt is discharged on a disposition, 2) the partnership liability allocation rules that drive outside basis, and 3) the at-risk rules that limit loss deductions. The same liability can be treated differently under each regime, so the first step is always to ask: “Which set of rules am I applying right now?” 

It Starts with Basis 

Any discussion of liabilities must start with “basis”. Basis shows up everywhere in the Internal Revenue Code (Code), but there isn’t one universal definition. In plain terms, basis is the running measure of a taxpayer’s investment in an asset—the amount that can generally be recovered tax-free before gain is recognized. Basis also “remembers” prior tax events: capital contributions, distributions, income allocations, loss allocations, and so on. 

Liabilities matter because borrowing can increase the amount a taxpayer is treated as having invested. At a state-law level, the basic split looks like this: 

• Recourse debt: The lender can look beyond the collateral and collect from the borrower’s other assets. 
• Nonrecourse debt: The lender’s remedy is limited to the specific collateral securing the loan. 
  

From there, the tax analysis depends on which rule set you’re in. For example, taxpayers generally have full basis in property acquired with recourse borrowing, and long-standing case law treats the assumption of certain obligations as part of the seller’s amount realized. Those ideas set the stage for the rules that govern dispositions of property subject to debt. 

Discharge of Liabilities Rules: Reg. Section 1.1001-2, Crane, Tufts, and Parker 

Overview and Key Authorities 

When property is sold, exchanged, or otherwise disposed of, the “amount realized” includes liabilities from which the transferor is relieved. Treasury Regulation section 1.1001-2 is the core authority, and the Supreme Court’s decisions in Crane and Tufts explain how its principles apply to nonrecourse debt. 

• Crane v. Commissioner held that a taxpayer’s amount realized on the disposition of encumbered property includes nonrecourse debt, even though the taxpayer is not personally liable. In practice, nonrecourse debt is included in both basis and amount realized for gain/loss purposes.^[1] 
• Commissioner v. Tufts extended Crane by holding that the amount realized includes the full amount of nonrecourse debt that is discharged, even if the property’s fair market value is less than the debt.^[2] 
• Reg. section 1.1001-2 largely codifies these principles: on a sale or other disposition, the amount realized includes the amount of the liability from which the taxpayer is discharged, whether the debt is recourse or nonrecourse.^[3] 
  

Guarantees, the Parker Case, and Why the Determination Is Made at the Entity Level 

A common question in partnerships is whether a partner guarantee changes the analysis. Under the discharge-of-liabilities rules, the key point is that the debt is analyzed at the taxpayer’s level—meaning the partnership’s level for partnership property. A guarantee by a partner or other third party does not change the fact that the partnership is being relieved of the liability for purposes of computing amount realized.^[4] 

The Tax Court’s decision in Parker reinforces this idea: even where there are partner-level guarantees, the Reg. section 1.1001-2 analysis focuses on the partnership’s discharge of the debt on the disposition—it does not “re-label” the debt as recourse to the partnership.^[5] 

Example: A partnership owns property subject to a $1,000,000 nonrecourse mortgage. The partnership transfers the property to a third party, and the lender releases the partnership from the debt. The partnership’s amount realized includes the full $1,000,000—even if the property is worth less than the debt, and even if a partner had guaranteed payment to the lender.^[6] 

Partner Liability Sharing Rules: IRC section 752 and Regs. section 1.752-2 and -3 

What Are These Rules Trying to Do? 

IRC section 752 governs how partnership liabilities are allocated among partners for purposes of computing each partner’s outside basis. This serves a different function than Reg. section 1.1001-2. Under section 752, the question is: “Which partner bears which share of the partnership’s debt while the partnership owns the property?” This contrasts with section 1.1001.2, which asks: “What is the partnership’s amount realized on a disposition?”

It is important to understand that the definitions of recourse and nonrecourse liabilities under these rules are solely for purposes of IRC section 752. 

Recourse vs. Nonrecourse Under section 752 

• Recourse liability: A partnership liability is recourse to the extent a partner (or related person) bears the economic risk of loss. The regulations test this through a “constructive liquidation” approach: if the partnership’s assets became worthless and all liabilities came due, who would have to pay?^[7] 
• Nonrecourse liability: A partnership liability is nonrecourse to the extent no partner (or related person) bears the economic risk of loss.^[8] 
  

How the Liabilities Get Allocated 

• Recourse liabilities: Allocated to the partner(s) who bear the economic risk of loss—based on payment obligations, guarantees, and deficit restoration obligations.^[9] 
• Nonrecourse liabilities: Generally allocated using a three-tier approach: 
  • Tier 1: To the extent of each partner’s share of partnership minimum gain (Reg. section 1.704-2). 
  • Tier 2: To the extent of each partner’s share of section 704(c) built-in gain if the property were sold for the amount of the liability. 
  • Tier 3: Any remaining amount in accordance with the partners’ share of partnership profits.^[10] 

Example: A partnership with three equal partners owns property subject to a $900,000 nonrecourse loan, with no 704(c) built-in gain or loss. The property has $600,000 of partnership minimum gain, resulting from the pro rata deductions of $200,000 taken by each partner generated from the nonrecourse debt. Each partner is allocated $200,000 of the nonrecourse liability under Tier 1, and the remaining $300,000 is allocated in accordance with their profit-sharing
ratios.^[11]

This three-tiered mechanism for allocating nonrecourse debt reflects the symmetry articulated in Tufts, which allows the inclusion of nonrecourse debt in basis because the debt is also taken into account on its relief and disposition. This ensures that you don’t get deductions on borrowed money without recognizing the corresponding gain when you walk away from the debt.   

The three tiers under Reg. section 1.752-3(a) preserve this symmetry by inextricably linking the rules for allocating nonrecourse deductions and built-in gain under the 704 regulations to the allocation of partnership nonrecourse debt. The end result matches nonrecourse debt to those partners who will bear the tax consequences when that debt is unwound.^[12]   

Practical Point: Section 752 Is Where Guarantees Often Matter 

Because section 752 is trying to identify who bears the economic risk of loss, partner-level facts can drive the answer. A partner’s guarantee, deficit restoration obligation, or even the partner’s status under the partnership agreement or state law, can affect whether a liability is treated as recourse or nonrecourse for section 752 purposes—and therefore how it affects outside basis.^[13] 

At-Risk Rules: IRC Section 465 and Related Regulations 

The Purpose 

The at-risk rules limit loss deductions to the amount a taxpayer is actually exposed to losing in an activity. In partnerships, this is a partner-level analysis. The result is that a partner can have basis (including basis from section 752 liability allocations) but still be limited because they are not “at risk.” 

What Counts as at Risk 

A partner’s amount at risk generally includes: 

• Cash and property contributed to the partnership. 
• Amounts borrowed for which the partner is personally liable. 
• Amounts borrowed for which the partner has pledged property as security (to the extent of the property’s value). 
• Certain qualified nonrecourse financing used in real estate activities.^[14] 
  

Qualified Nonrecourse Financing (Real Estate) 

Qualified nonrecourse financing is a special carve-out that allows certain real estate nonrecourse borrowing to be treated as at risk. In broad terms, it must be: 

• Borrowed in connection with the activity of holding real property. 

• Borrowed from a “qualified person” (e.g., a regulated financial institution) or a government entity. 
• Nonrecourse—no person is personally liable for repayment. 
• Not convertible debt.^[15] 
  

Example: A partner invests in a real estate partnership that borrows $2,000,000 from a bank on a nonrecourse basis to acquire an apartment building. Because the loan is qualified nonrecourse financing, the partner’s share of that borrowing is included in the partner’s at-risk amount, which can allow deductions that would otherwise be suspended. 

The Common Mismatch: Basis vs. at Risk (and the Ordering of Loss Limitations) 

Here’s the trap: not all nonrecourse debt that increases outside basis under section 752 increases a partner’s at-risk amount. Outside basis and at-risk are related, but they are not the same number. Unless the borrowing is qualified nonrecourse financing (or the partner is otherwise personally exposed), nonrecourse debt is typically excluded from a partner’s amount at-risk.^[16] 

When a partner claims losses, the Code applies multiple limitation rules in the following specific order: 

1. Basis limitation (IRC section 704(d)). 
2. At-risk limitation (IRC section 465). 
3. Passive activity loss limitation (IRC section 469). 
4. Excess business loss limitation (IRC section 461(l)). 
   
   

So, a partner might clear the basis limitation because section 752 allocated them enough nonrecourse debt but still fail the at-risk limitation if they are not personally exposed, or the borrowing is not qualified nonrecourse financing. And even after clearing both hurdles, the other limitation rules may still apply. 

Bringing It Together (and What Item K1 Is Really Telling You) 

One Liability, Three Answers 

At a high level, the three regimes line up like this: 

• Disposition / amount realized (Reg. section 1.1001-2; Crane; Tufts): Focuses on the debt from which the taxpayer is discharged on a disposition; for nonrecourse debt, the full liability is generally included in the amount realized.^[17] 
• Partnership liability allocation (section 752): Focuses on economic risk of loss and the matching of debt to tax consequences when allocating liabilities among partners to determine each partner’s outside tax basis. ^[18] 
• At-risk (section 465): Focuses on the partner’s real exposure to loss and generally excludes nonrecourse debt, except qualified nonrecourse financing in real estate.^[19] 
  

Why Item K1 Has Three Buckets 

Now we can go back to the table that started this discussion. Item K1 reports each partner’s share of liabilities, and those amounts feed directly into outside basis. At the same time, the format is designed to help partners start their at-risk computation by breaking out qualified nonrecourse financing separately. 

 

The Schedule K-1 instructions capture the dual purpose succinctly: 

• Use the total of the three amounts to figure the adjusted basis of your partnership interest. 
• Generally, you may use only the amounts shown next to “qualified nonrecourse financing” and “recourse” to figure your amount at risk. Don’t include any amounts that aren’t at risk if they are included in either of these categories. 
  

In practice, preparing Item K1 is usually a two-step process: 

• Step 1: Classify each partnership liability as recourse or nonrecourse under section 752 and identify any portion that is qualified nonrecourse financing for section 465. 
• Step 2: Apply the section 752 allocation rules to determine each partner’s share of the liabilities in the appropriate bucket(s) for the beginning and ending of the year. 
  

Final Thoughts 

To report Item K1 correctly, you first need to gain a thorough understanding of the liability arrangements you are dealing with, and second, you need to apply the section 752 liability allocation framework and the section 465 at-risk concepts—without mixing them up. Once you keep the three regimes separate (disposition rules, section 752, and section 465), the table becomes much easier to read, prepare, and explain to partners.^[20]   

I’ve only scratched the surface when it comes to the application and full understanding of the various tax concepts discussed here. I hope that, at a minimum, this article helps tax professionals separate and distinguish these concepts so it’s easier to grasp and more practical to work with. From that foundation, you can build a deeper understanding and apply these principles more confidently across the wide range of situations you’re likely to encounter in practice. 

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DISCLAIMER

 

This article is provided for general informational purposes only. Wiss & Company LLP and its affiliates are not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect you or your business. Before making any decision or taking any action that may affect you or your business, you should consult a qualified professional adviser. 

The views expressed in this article are those of the author and do not necessarily reflect the views of Wiss & Company LLP or its affiliates. 

Wiss & Company LLP and its affiliates shall not be responsible for any loss sustained by any person who relies on this article. 

Michael Bodrato, CPA, JD, LLM, is a tax director with Wiss & Company LLP, an accounting firm based in Florham Park, New Jersey. 

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Footnotes

 

^[1] Crane v. Commissioner, 331 U.S. 1 (1947); Reg. §1.1001-2(a). 

^[2] Commissioner v. Tufts, 461 U.S. 300 (1983); Reg. §1.1001-2(a). 

^[3] Reg. §1.1001-2(a). 

^[4] See, Parker v. Commissioner, TC Memo 2023-104. 

^[5] Parker v. Commissioner, T.C. Memo 2023-104. 

^[6] Reg. §1.1001-2(c), Example 7. 

^[7] Reg. §1.752-2(a). 

^[8] Reg. §1.752-1(a)(2). 

^[9] Reg. §1.752-2(b). 

^[10] Reg. §1.752-3(a).  

^[11] This example assumes no built-in gain under IRC §704(c). 

^[12] The IRS has explained that the “[t]hree tiers of Reg. §1.752-3(a) are structured to allocate liabilities to those partners who generally would be allocated income or gain upon the relief of those liabilities.” 26 CFR Part 1, REG-103831-99 (preamble to proposed regulations issued in 1991 to revise provisions under Reg. §1.752-3, relating to the allocation of nonrecourse liabilities by a partnership). 

^[13] Reg. §1.752-1. This includes the legal effect of the entity’s status on a partner’s economic risk of loss.  For example, limited liability company (“LLC”) members are only liable under state law (unless otherwise agreed to) for the LLC’s liabilities to the extent of their individual contributions and thus do not have the economic risk of loss for either entity level nonrecourse or recourse liabilities. Thus, in general, for purposes of the 752 partnership liability sharing rules, all liabilities of an LLC are treated as nonrecourse liabilities with respect to the members, because no partner bears the economic risk of loss. Recourse liabilities of an LLC in these circumstances are sometimes referred to as exculpatory liabilities, which are obligations for which the creditor’s only recourse is to the asset of the partnership/LLC, not to the personal assets of the members/partners.

^[14] IRC §465(b); Reg. §1.465-27(b). 

^[15] IRC §465(b)(6); Reg. §1.465-27(b). 

^[16] IRC §465(b). 

^[17] Reg. §1.1001-2(a). 

^[18] Reg. §1.752-2(a), (b). 

^[19] IRC §465(b). 

^[20] Reg. §1.752-1(a); IRC §465(b).