July 17, 2025
The tax rules for partnerships give partners a lot of flexibility in how they split up items like income, gains, losses, and deductions. But that flexibility has limits. The key rule comes from Internal Revenue Code (IRC) Section 704(b), which says allocations must reflect the partners’ actual economic deal.
Under IRC 704(b), a partnership’s allocation plan—usually described in its agreement—is only valid for tax purposes if it has what's called “substantial economic effect” (SEE). If it doesn’t meet this test, or if the agreement doesn’t cover it, the IRS will reallocate the item based on the “partner’s interest in the partnership” (PIP). This means looking at the facts to figure out how the partners truly share the economics.
The SEE rules assume partners take on real economic risks from the partnership. But in real estate deals, a common tool—nonrecourse debt—complicates things. Since partners may not be personally liable for these loans, it challenges that assumption. As a result, a special set of complex regulations is needed to handle these situations.
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