General Rule: Liabilities increases the partner(s) basis. When liquidating, liabilities are paid off first and any remaining asset is distributed to the partner(s).

In this question, the $30,000 liability must be taken out first before anything else, then the basis is taken out and whatever remains is above and beyond what he had in the partnership.

Basis is $50,000 including the $30,000 liability (NOT $50,000 +$30,000 as this is incorrect).

$50,000 basis including $30,000 liability : $5000*6months =$30,000 taken out first.

Basis remaining is $20,000 and liquidating partner got $5000*12=$60,000 in 2nd year after receiving his $20,000 investment back he must report $40,000 taxable income of $40,000.

Calculations: 18*$5000 =$90,000

less liability of         &nbs p;      $30,000 = $60,000

Remaining basis is $50,000-$30,000)=$20,000

Taxable income $60,000-$20,000)=$40,000

Stick with the basics and General Rules on these types of questions.

All the best

Fella

This question may contain an error in the initial explanation to the answer.

Apply this technique in liquidating a partner's or partnership share:

General Rule:Basis -Payment =capital gain or capital loss

If basis is $80,000 and partner receives $90,000 in liquidating then he has $10,000 capital gain. Therefore if the liability is in addition to the $50,000 basis would be $80,000 and retiring partner capital gain would be $10,000 not $40,000.

Remember that liability increases the partners basis proportionally and paying off the liability reduces the partners basis likewise.

With the answer choice being $40,000 capital gain then the $30,000 liability must be included in the total basis of $50,000 and not be in addition to that.

Always pay off liabilities first though.

Regards