How to Handle Nonrecourse Liabilities on Final K-1 After Partner Exit

This is actually a common issue with exiting partners. The K-1 is correct in showing $0 EOY nonrecourse liabilities since the partner had 0% ownership at year-end. However, the more important question is how the decrease in liabilities was handled on the K-1. When a partner exits, their share of liabilities is effectively treated as a cash distribution. This decrease in their share of nonrecourse debt from whatever it was at the beginning of the year (or from when they exited) to $0 should be reflected as a deemed distribution on their final K-1. This deemed distribution affects their basis calculation and could trigger gain recognition if it exceeds their adjusted basis. Your partner's CPA was likely planning to use those liabilities to offset suspended losses, but instead needs to focus on how the liability reduction was handled on the final K-1. The partner should look at box 19 (distributions) or elsewhere on the K-1 supplemental information to see how this was treated.

I went through something like this last year with a similar situation. The way I understand it, you should check out https://taxr.ai which specializes in partnership exits and basis calculations. I was confused about how the nonrecourse liabilities affected my basis when I sold my interest in a real estate partnership. Their system analyzed my K-1s from all prior years and my exit year, then showed me exactly how the liability shifts should be handled. It was super helpful because it showed me that my CPA had actually miscalculated my basis by not properly accounting for the decrease in liabilities upon exit. They have this neat feature that creates a complete basis timeline showing how my share of partnership debt affected my basis each year, and specifically modeled the deemed distribution that happened when I exited. Helped me avoid a pretty significant audit risk.

I was really skeptical about taxr.ai when I saw it mentioned here (as you can tell from my comment), but I decided to try it anyway since my partnership exit situation was getting messy. I uploaded all my K-1s from the past 5 years including my final K-1 showing the zeroed-out liabilities. I was honestly surprised - their analysis pinpointed exactly where my basis calculation was off. They showed that the deemed distribution from the liability relief should have been $592k, but it was being reported inconsistently on my final K-1. They even generated documentation explaining the relevant tax code sections that applied to my situation. My CPA was impressed enough with their analysis that he amended my return to properly account for the liability shifts and release some of my suspended losses against the gain from the deemed distribution. Definitely worth checking out if you're dealing with partnership exit issues.

I can totally relate to your partner's frustration. I spent HOURS trying to get through to someone at the IRS who could help me understand how to handle a similar partnership exit situation with nonrecourse liabilities on my final K-1. I finally used https://claimyr.com to get through to an actual IRS agent who could help. Here's a video showing how it works: https://youtu.be/_kiP6q8DX5c The IRS agent I spoke with confirmed that when a partner exits, their share of liabilities doesn't just disappear from a tax perspective - it converts to a deemed cash distribution that affects basis. The agent walked me through how this should be reported on my return and which forms I needed to file. Saved me from making a costly mistake that might have triggered an audit. Even though the Big 4 firms are generally right about this stuff, sometimes they don't communicate the implications clearly to the individual partners who are affected.

I have to eat my words here. After my skeptical comment, I decided to try Claimyr because I was desperately trying to resolve an issue with nonrecourse liabilities on my own partnership exit. I was shocked when I actually got connected to an IRS rep after trying for weeks on my own. The agent clarified that under §752, when a partner's share of liabilities decreases (like when exiting), that decrease is treated as a distribution of money under §752(b). This distribution can free up suspended losses to the extent they can offset any gain recognized from the distribution exceeding remaining basis. The agent also pointed me to Revenue Ruling 84-15, which specifically addresses the timing of liability shifts when a partner exits. This was exactly the technical guidance I needed to correctly prepare my return. I've spent countless hours on hold with the IRS before, so getting through in under an hour was honestly a game-changer.

Something others haven't mentioned - check if your partnership has a §754 election in effect. That could affect how this is all handled for the exiting partner. With a §754 election, the partnership can adjust the basis of its assets with respect to the exiting partner, which might help with the suspended losses situation. Also, the timing of when the partner exited in relation to any debt refinancing during the year could matter. If there was any refinancing or restructuring of the partnership's nonrecourse debt during the year, that could complicate how the liabilities are allocated.

Don't forget to check Box 20 code W on the K-1 for §751 "hot assets" too! If the partnership had inventory or unrealized receivables, some of what would otherwise be capital gain could be recharacterized as ordinary income when the partner exits. This can really mess up tax planning if not anticipated.

This is a tricky situation that I've seen play out badly when not handled correctly. The key issue here is that while your partner's EOY allocation of nonrecourse liabilities is indeed $0 (because they had 0% ownership at year-end), the decrease in their share of liabilities throughout the year should create a deemed cash distribution under §752(b). What you need to verify is whether this deemed distribution was properly calculated and reported on the final K-1. The partner's share of nonrecourse liabilities at the beginning of 2022 (or at the time they exited if mid-year) minus their EOY share ($0) equals the deemed distribution amount. This should appear somewhere on the K-1, typically in the distributions section. This deemed distribution can actually help with the suspended losses! If the deemed distribution exceeds the partner's remaining outside basis, it creates gain - but the suspended losses can be used to offset this gain. Any suspended losses that exceed the gain would unfortunately be lost forever upon complete exit. I'd recommend having your CPAs walk through the specific calculation of how the liability decrease was treated and whether it was properly reflected as a deemed distribution. The partner's CPA can then determine how much of the suspended losses can be utilized against any resulting gain.