IRC §733 requires that partnership distributions reduce your outside basis — dollar for dollar. Your broker ignores this. The IRS does not.
By Lucas Andersen — Last updated April 9, 2026
Under IRC §733, a partner’s adjusted basis in a partnership interest is decreased (but not below zero) by the amount of money distributed by the partnership. This is the core mechanic that makes MLP distributions “tax-deferred” — you receive cash without immediate taxation, but your cost basis shrinks by the same amount. The tax is not eliminated; it is deferred until you sell or until basis reaches zero.
Why brokers don’t track this: Brokers receive 1099-B trade data and your original purchase price. They do not receive your K-1. They have no mechanism to incorporate K-1 adjustments — income allocations, liability changes, or the §733 distribution reductions. The broker’s basis is frozen at your purchase price from the day you bought. The IRS basis moves every year. After 5 years of holding a midstream MLP, the gap between broker basis and IRS basis commonly exceeds 25% of your original purchase price.
Each year, your MLP basis undergoes two opposing adjustments. First, K-1 income and loss allocations: The partnership allocates its taxable income or loss to you on the K-1. Positive income (Box 1 if positive) increases basis. Losses (Box 1 if negative) decrease basis, subject to the §704(d) limitation. Liability changes from Item K also adjust basis — increases under §752 are treated as deemed cash contributions (add basis), decreases are treated as deemed distributions (reduce basis). Second, distributions reduce basis under §733. For midstream MLPs, distributions almost always exceed the net income allocation. The difference is the annual erosion. A typical midstream MLP paying $2.10/unit in distributions might allocate only $0.40/unit of net taxable income, plus $0.15/unit of liability increases — resulting in net erosion of $1.55/unit per year.
Here is the annual per-unit basis movement for a typical midstream MLP like EPD. Beginning basis: $25.00/unit. K-1 income allocation: +$0.40. Liability increase: +$0.15. Cash distributions (Box 19A): −$2.20. Ending basis: $23.35. Net erosion: $1.65/unit (6.6%). The $2.20 distribution is 100% cash in your pocket. Of that, $0.55 is offset by income and liability adjustments. The remaining $1.65 is the return of capital that erodes your basis. At 70–85% ROC, the “tax-deferred” portion of each distribution is the $1.65 that reduced basis. It is not tax-free — it will be taxed when you sell, at your lower basis.
Not all MLPs erode basis at the same rate. The primary drivers are distribution yield and ROC percentage — higher yields and higher ROC mean faster erosion.
| Category | Examples | Annual Erosion | ROC % |
|---|---|---|---|
| Pipeline / Midstream | EPD, MPLX, WES, PAA | ~3–6% | 70–85% |
| Multi-Entity Midstream | ET (3 K-1s) | ~4–7% | 75–90% |
| Fuel Distribution | SUN, CAPL | ~5–9% | 60–75% |
| LNG / Terminal | CQP | ~8–15% | 80–95% |
| Royalty / Mineral | NRP, BSM | ~10–20%+ | 85–95%+ |
A $10,000 starting basis eroding at 3% (pipeline like WES), 5% (midstream like EPD), and 8% (LNG/fuel like CQP). The broker reports $10,000 throughout all 10 years because it never receives K-1 data.
| Year | 3% Erosion | 5% Erosion | 8% Erosion | Broker |
|---|---|---|---|---|
| Purchase | $10,000 | $10,000 | $10,000 | $10,000 |
| Year 3 | $9,100 | $8,500 | $7,600 | $10,000 |
| Year 5 | $8,500 | $7,500 | $6,000 | $10,000 |
| Year 7 | $7,900 | $6,500 | $4,400 | $10,000 |
| Year 10 | $7,000 | $5,000 | $2,000 | $10,000 |
The broker-vs-IRS gap at Year 10: At 5% erosion, the broker shows $10,000 but IRS expects $5,000. If you sell at $12,000, the broker’s 1099-B reports a $2,000 gain. The IRS expects a $7,000 gain. Of that $7,000, a portion — typically 30–50% for midstream MLPs — is §751 ordinary income taxed at up to 37%. The remaining portion is long-term capital gain at 15–20%. Using the broker’s basis underreports your gain by $5,000 and will trigger an IRS CP2000 notice with back taxes, interest, and potential penalties.
Under IRC §731(a)(1), once basis reaches zero, further cash distributions become immediately taxable as capital gain. The tax-deferred treatment ends. You still receive the same quarterly check — but you now owe tax on it in the year received. Timeline varies dramatically by MLP category: pipeline MLPs at 3–5% erosion reach zero in 20–25 years. Fuel distribution MLPs at 7–9% reach zero in 10–15 years. Royalty MLPs at 15–20% can hit zero in 3–5 years. See What Happens When Basis Reaches Zero for the full walkthrough including your five options at that point.
Basis erosion and §751 recapture are two sides of the same coin. The depreciation deductions that flow through your K-1 each year — reducing your Box 1 income allocation and accelerating erosion — create cumulative §751 “hot asset” exposure. When you sell, that accumulated depreciation is recaptured as ordinary income under §751, taxed at up to 37%. Faster erosion means more depreciation has flowed through, which means a larger §751 ordinary income component at sale. A position that eroded from $10,000 to $5,000 (50% erosion) will have substantially more §751 exposure than one that eroded from $10,000 to $7,000 (30% erosion). See Section 751 Recapture Explained for the full mechanics.