Final return in 2 member LLC. One partner has capital balance after all cash/property has been distributed. Do I report the short term capital loss on the M2 line 7 and how do I allocate to specific partner K1 line 8?
You don't.
Each member is responsible for maintaining their basis in the LLC units. Once they receive their final K-1 and adjust the basis schedule for this final K-1 and liquidating distributions they determine the tax impact at their individual level.
However, from what you are saying, it appears that the member's received cash and property. LLC's taxed as partnership are complicated entities. In these instances you would not have any gain or loss to report as you would reduce your basis for any cash received and the remaining basis gets allocated to the assets distributed.
The only time a member can recognize a loss on a liquidating distribution is if they received ONLY cash, unrealized receivables (cash basis LLC) or inventory.
You can do one of two things on your final Form 1065; leave the capital accounts the way they are (this is just an internal book keeping issue) or you can zero out the capital accounts by running any adjustments through the Sch M-2 lines 4 or 7 as applicable. Then run the adjustment through the K-1's Sch L current year increases or decreases as applicable.