It is important to understand the difference between inside and outside basis for tax planning purposes, since a partner cannot receive tax-free distributions exceeding their outside basis. Additionally, loss deductions are limited to a partner's outside basis.

Inside basis refers to the partnership's tax basis in its assets. This amount is determined by the purchase price or the adjusted basis of contributed property. Inside basis impacts depreciation, gain/loss on sales, and taxable income at the partnership level.

Outside basis refers to a partner's tax basis in their partnership interest. This amount adjusts over time based on contributions, distributions, deductible losses, and gain/loss on the sale of the partnership interest.

Example:

Let's say I contributed $50,000 in cash to a partnership, while you contribute a building with a $50,000 adjusted basis but a fair market value of $80,000. Our partnerships inside basis in the building would be $50,000, and we each would have an outside basis of $50,000 each. If our partnership decides to sell the building for $90,000, the partnership then realizes a $40,000 gain, which increases each of our outside bases by $20,000, thus bringing each of our outside bases to $70,000.