Real Estate Tax · Brief · Working level
Why real estate lives in partnerships: debt basis and Section 752
Real estate is overwhelmingly held in LLCs taxed as partnerships because partners get basis for the entity's debt under Section 752 — supporting loss deductions and tax-free refinancing distributions that S corporations cannot deliver.
Ask why virtually every serious real estate deal sits in an LLC or LP taxed as a partnership and the answer is one section: Section 752. Partners — unlike S corporation shareholders — get outside basis for their share of the entity's debt. On leveraged property that single feature does three things: it lets depreciation losses exceed invested equity and still clear the basis hurdle, it lets a cash-out refinancing be distributed tax-free, and it lets appreciated property move in and out of the entity without entity-level gain. Subchapter K's flexible allocations do the rest.
How debt becomes basis
Under Section 752(a), an increase in a partner's share of partnership liabilities is deemed a cash contribution; under 752(b), a decrease is a deemed distribution. The sharing rules live in the regulations: recourse debt follows economic risk of loss under Treas. Reg. §1.752-2 (who bears the loss if the partnership defaulted and assets were worthless), while nonrecourse debt — the standard mortgage on stabilized property — is shared under §1.752-3, generally tracking profit-sharing percentages after minimum-gain and 704(c) layers. Guarantees can convert nonrecourse to recourse for the guarantor, a lever sponsors pull deliberately when a partner needs basis.
The consequence: a member who invests $100,000 in an LLC that borrows $900,000 (nonrecourse, 10% profit share) has roughly $190,000 of outside basis. When a cost segregation study front-loads depreciation and the K-1 shows a $150,000 loss, Section 704(d)'s basis limitation is cleared. The loss still must survive the at-risk rules of Section 465 — where qualified nonrecourse real estate financing counts as at-risk, another real-estate-specific favor — and then the passive activity rules, which are the usual binding constraint.
The three loss gates, in order.
| Gate | Statute | Real estate treatment |
|---|---|---|
| Outside basis | §704(d) | Debt share counts (§752) |
| At-risk | §465 | Qualified nonrecourse financing counts |
| Passive loss | §469 | Binding unless REP/STR/passive income |
The refinancing distribution
The signature partnership move: property appreciates, the partnership refinances, and the loan proceeds are distributed. The new debt increases every partner's liability share — a deemed contribution boosting basis — and the cash distribution reduces basis under Section 733, taxable under Section 731(a) only to the extent it exceeds basis. Result: cash in the partners' pockets, no current tax, gain deferred until sale. The mirror image bites later: debt relief — on sale, on paydown, or on a partner's exit — is a deemed distribution that can produce gain with no cash attached, especially in negative-capital-account deals where years of debt-financed depreciation have driven outside basis toward zero.
What the S corporation can't do
The comparison drives the planning rule. S corporation shareholders get basis only for direct loans they make themselves — never for entity-level mortgages (Section 1366(d); the regulations require bona fide indebtedness running to the shareholder). Distributing appreciated property from an S corporation triggers corporate-level gain under Section 311(b), so the building can never come out — no tax-free division among heirs, no 1031 restructuring flexibility, and a wasted step-up at death that partnerships capture through a Section 754 election. And S corporations must allocate strictly pro rata — no preferred returns, no promote structures, none of the special allocations (with substantial economic effect under Section 704(b)) that real estate waterfalls are built on. Partnerships carry their own complexity — the allocation regulations, 704(c) layers on contributed property, and K-1 timing are genuine costs — but for leveraged real estate the structural verdict has been settled for decades.
Frequently asked questions
- Why are rental properties held in LLCs instead of S corporations?
- Partnership taxation gives members basis for the entity's debt under Section 752, so depreciation losses on leveraged property remain deductible and refinancing proceeds can be distributed tax-free. S corporation shareholders get no basis for entity-level debt, distributions of appreciated property trigger gain under Section 311(b), and special allocations are impossible. For leveraged real estate, the partnership form wins on every margin.
- How does partnership debt give me basis?
- Section 752(a) treats an increase in a partner's share of partnership liabilities as a cash contribution, increasing outside basis. Nonrecourse mortgage debt is generally shared by profit percentages under Treas. Reg. §1.752-3; recourse debt follows economic risk of loss. That debt basis supports deducting losses in excess of invested equity — subject still to at-risk and passive loss limits.
- Is a cash-out refinance of partnership property taxable?
- Generally no. The new borrowing increases each partner's share of liabilities, and thus outside basis, under Section 752(a); the cash distribution then reduces basis under Section 733. Distributions are taxable only to the extent they exceed outside basis (Section 731(a)), so a distribution matched by the debt-basis increase typically triggers no current gain.