Recognition of Gain or Loss by Contributing Partner on Distribution of Contributed Property or Other Property

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[PS-76-92]; [PS-51-93]

RIN 1545-AR48; RIN 1545-AR93

Recognition of Gain or Loss by Contributing Partner on

Distribution of Contributed Property or Other Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

recognition of gain or loss on certain distributions of contributed

property by a partnership under section 704(c)(1)(B) of the Internal

Revenue Code of 1986 (Code). This document also contains proposed

regulations relating to the recognition of gain on certain

distributions to a contributing partner under section 737. Changes to

the applicable law were made by the Revenue Reconciliation Act of 1989

and the Energy Policy Act of 1992. The proposed regulations affect

partnerships and their partners and are necessary to provide guidance

for complying with the applicable tax law.

DATES: Written comments must be received by April 10, 1995. Requests to

speak (with outlines of oral comments) at a public hearing scheduled

for June 19, 1995, at 10 a.m. must be received by May 29, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (PS-76-92; PS-51-93),

Room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC. 20044. In the alternative, submissions may be hand

delivered between the hours of 8:00 a.m. and 5:00 p.m. to:

CC:DOM:CORP:T:R (PS-76-92; PS-51-93), Courier's Desk, Internal Revenue

Service, 1111 Constitution Avenue NW, Washington, DC. The public

hearing has been scheduled to be held in the Auditorium, Internal

Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Stephen J.

Coleman, (202) 622-3060; concerning submissions and the hearing,

Michael Slaughter, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Introduction

This document proposes to add new Secs. 1.704-4, 1.737-1, 1.737-2,

1.737-3, 1.737-4, and 1.737-5 to the Income Tax Regulations (26 CFR

part 1) under sections 704(c)(1)(B), 704(c)(2), and 737 of the Code.

Background

Section 704(c)(1)(A) of the Internal Revenue Code (Code) requires

that gain or loss with respect to property contributed to a partnership

by a partner be shared among the partners so as to take into account

any built-in gain or loss in the property at the time of the

contribution. Prior to its amendment by the Revenue Reconciliation Act

of 1989 (1989 Act), section 704(c) did not require the recognition of

built-in gain or loss by a contributing partner on a distribution of

contributed property by the partnership. The 1989 Act added sections

704(c)(1)(B) and 704(c)(2) to the Code. Section 704(c)(1)(B) provides

that in the case of a distribution of contributed property to another

partner within five years of its contribution to the partnership, the

contributing partner must recognize gain or loss in an amount equal to

the gain or loss the partner would have been allocated under section

704(c)(1)(A) on a sale of the property by the partnership at its fair

market value at the time of the distribution. Section 704(c)(2)

provides for an exception for distributions of certain like-kind

property. The legislative history of the 1989 Act indicates that

Congress intended section 704(c)(1)(B) to eliminate the inconsistent

treatment of sales and distributions by a partnership and thereby

prevent partners from circumventing the rule requiring pre-contribution

gain or loss on contributed property to be allocated to the

contributing partner by distributing the property to another partner.

H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 406 (1989).

Prior to the enactment of the Energy Policy Act of 1992 (1992 Act),

a partner who contributed appreciated property to a partnership did not

recognize gain on a distribution to the distributee partner of

partnership property other than money. The 1992 Act added section 737

to the Code to require a contributing partner to recognize gain to the

extent of the lesser of (i) the net precontribution gain on property

contributed to the partnership by the partner, or (ii) the excess of

the value of the distributed property over the adjusted basis of the

partner's interest in the partnership. H.R. Rep. No. 102-1018, 102d

Cong., 2d Sess. 428 (1992).

Explanation of Provisions

A. Overview

Section 704(c)(1)(B) generally requires a contributing partner to

recognize gain or loss when the property contributed by that partner is

distributed to another partner within five years of its contribution to

the partnership. Section 737 generally requires a contributing partner

to recognize gain when the partner receives, within five years of the

contribution, a distribution of other property with a fair market value

in excess of the partner's adjusted basis in the partnership. Both

sections apply only to distributions made to a partner in the partner's

capacity as a partner. Section 704(c)(1)(B) and section 737 do not

apply to transactions or distributions in which the partner is not

acting in the capacity of a partner (e.g., transactions or

distributions subject to section 707(a) or section 751(b)).

The proposed regulations provide rules for determining when section

704(c)(1)(B) and section 737 apply and the amount of gain or loss that

must be recognized by the contributing partner under the applicable

section. The proposed regulations also provide rules for determining

the character of such gain or loss and for making the necessary basis

adjustments. The proposed regulations contain several exceptions that

are based on the [[Page 2353]] statutory language and the legislative

history. The proposed regulations also contain special rules dealing

with specific situations such as the partnership's exchange of the

contributed property for other property in a nonrecognition transaction

and the transfer of a contributing partner's interest in the

partnership. The proposed regulations also provide for coordination

between section 704(c)(1)(B) and section 737 in situations in which

both sections may apply to a distribution or distributions by a

partnership. In fashioning these specific rules, the proposed

regulations focus on the purpose of section 704(c)(1)(B) and section

737, rather than simply relying on the literal language of the

provisions in situations that would be inconsistent with the underlying

purpose of the provisions.

The proposed regulations under section 704(c)(1)(B) and section 737

contain an anti-abuse rule providing that the rules of the applicable

section must be applied in a manner consistent with its purpose.

Accordingly, the anti-abuse rules contained in the proposed regulations

provide that, if a principal purpose of a transaction is to achieve a

tax result inconsistent with the purpose of the applicable section, the

Commissioner can recast the transaction for federal tax purposes as

appropriate to achieve tax results that are consistent with such

purpose.

Whether a tax result is inconsistent with the purpose of the

applicable section is determined based on all the facts and

circumstances. The proposed regulations also provide examples

illustrating how these anti-abuse rules apply.

B. Section 704(c)(1)(B)

In General

Under the proposed regulations, the contributing partner must

recognize gain or loss on a distribution of the contributed property to

another partner within five years of its contribution to the

partnership. The amount of gain or loss recognized is the amount that

would have been allocated to the contributing partner under section

704(c)(1)(A) and Sec. 1.704-3 if the distributed property had been sold

by the partnership to the distributee partner at its fair market value

at the time of the distribution. The amount of gain or loss recognized

may vary depending on the particular method used by the partnership in

making allocations under section 704(c)(1)(A) and Sec. 1.704-3 because

the amount of remaining built-in gain or loss may vary depending on the

particular method of allocation adopted. In addition, because the

property is treated as having been sold by the partnership to the

distributee partner, the proposed regulations provide that any loss

that would have been disallowed under section 707(b)(1) if the

distributed property had actually been sold to the distributee partner

is disallowed.

Five-Year Period

Section 704(c)(1)(B) applies only to property distributed within

five years of its contribution to the partnership. The proposed

regulations provide that a new five-year period begins for property

deemed contributed to a new partnership following a termination of the

partnership under section 708(b)(1)(B), but only to the extent that the

pre-termination gain or loss on such property was not already required

to be allocated to the original contributor under section 704(c)(1)(A)

and Sec. 1.704-3. The effect of this provision is to begin a new five-

year period for post-contribution changes in the value of partnership

property whenever there is a termination of the partnership under

section 708(b)(1)(B). This provision is consistent with the legislative

history of section 704(c)(1)(B).

Character of Gain or Loss

The proposed regulations provide that the character of the

contributing partner's gain or loss is the same as the character that

would have been recognized if the property had been sold by the

partnership to the distributee partner. Thus, if the distributee

partner holds more than a 50 percent capital or profits interest in the

partnership, any gain recognized by the contributing partner may be

ordinary income under section 707(b)(2).

Exceptions and Special Rules

The proposed regulations provide that section 704(c)(1)(B) does not

apply to (i) a distribution of property contributed to the partnership

on or before October 3, 1989, or (ii) a distribution of property in

connection with a termination of the partnership under section

708(b)(1)(B). The proposed regulations also provide that section

704(c)(1)(B) does not apply to a distribution of a portion of

contributed property to a noncontributing partner in a complete

liquidation of the partnership if a portion of the contributed property

is distributed to the contributing partner and that portion has

unrecognized gain or loss in the hands of the contributing partner,

determined immediately after the distribution, at least equal to the

built-in gain or loss that would have been allocated to the

contributing partner under section 704(c)(1)(A) on a sale of the

contributed property by the partnership at the time of the

distribution. This exception is consistent with the purpose of section

704(c)(1)(B) to prevent the shifting of built-in gain or loss among

partners because no shift has occurred in this limited situation.

The proposed regulations provide that property received by a

partnership in exchange for contributed property in a nonrecognition

transaction is treated as the contributed property. This result is

consistent with the rule under Sec. 1.704-3(a)(8) of the regulations.

The proposed regulations also provide that the transferee of a

contributing partner is treated as the contributing partner to the

extent of the built-in gain or loss allocated to the transferee

partner. The gain or loss allocated to the transferee partner may be

offset, however, by the basis adjustments to partnership property by a

partnership with a section 754 election in effect. This result is

consistent with the result under Sec. 1.704-3(a)(7) of the regulations.

The proposed regulations also provide a special rule under section

704(c)(2) for cases in which the contributing partner receives like-

kind property no later than the earlier of: (1) 180 days following the

date of the distribution of contributed property to another partner, or

(2) the due date (determined with regard to extensions) of the

contributing partner's income tax return for the taxable year of the

distribution to the other partner. Under this rule, the contributing

partner's gain that otherwise would be recognized under section

704(c)(1)(B) is reduced by the amount of built-in gain or loss in the

distributed like-kind property in the hands of the contributing

partner. The amount of the built-in gain or loss is determined by

reference to the contributing partner's basis in the property

immediately after the distribution under section 732(a) or (b). The

proposed regulations provide that the basis in the distributed like-

kind property in this situation is determined without taking into

account any increase in the basis of the contributing partner's

partnership interest for any gain recognized under section

704(c)(1)(B). This special rule implements the statutory objective of

not requiring gain or loss on distributions where gain or loss would

not have been recognized outside of a partnership. When gain or loss is

not recognized in exchanges of like-kind property outside of

partnerships, the built-in gain or loss on the exchanged property is

generally preserved in the property received in the exchange. To the

extent that this built-in gain or loss [[Page 2354]] is not preserved

in the case of a distribution of property by the partnership, the

exception does not apply.

Basis Adjustments

The contributing partner's basis in the partnership interest and

the partnership's basis in the distributed property are increased or

decreased by the amount of gain or loss recognized by the contributing

partner. These adjustments are taken into account in determining (1)

the noncontributing partner's basis in the property distributed to that

partner, (2) the contributing partner's basis in any property

distributed to that partner in the same transaction (except to the

extent that the distributed property is like-kind property subject to

the special rule discussed above), (3) the basis adjustments, if any,

to partnership property by a partnership with a section 754 election in

effect, and (4) the amount of the contributing partner's gain under

section 731 or section 737 on a related distribution of money or

property, respectively, to the contributing partner.

C. Section 737

In General

Under the proposed regulations, a partner that contributes property

with built-in gain to a partnership and receives a distribution of

property other than money within five years of that contribution must

recognize gain in an amount equal to the lesser of (1) the excess (if

any) of the fair market value of the distributed property over the

adjusted basis of the partner's interest in the partnership (excess

distribution); or (2) the net precontribution gain of the partner.

Excess Distribution

In determining the amount of the excess distribution, the proposed

regulations provide that the distributee partner's adjusted basis in

the partnership interest is first adjusted for all basis adjustments

resulting from the distribution subject to section 737 (for example,

basis adjustments under section 752) and any basis adjustments

resulting from any other distribution that is part of the same plan or

arrangement (for example, basis adjustments required under sections

704(c)(1)(B) and 751(b)). Two basis adjustments, however, are not taken

into account in determining whether there is an excess distribution:

(1) the partner's basis is not increased for the gain recognized under

section 737, and (2) is not decreased by the adjustment required under

section 733 for property distributed to the distributee partner in the

transaction (other than property previously contributed to the

partnership by the partner). The first exception is consistent with

section 737(c)(1) and the second is necessary to prevent an

inappropriate decrease in the partner's basis (and corresponding

increase in the partner's gain) under section 737. The reduction in the

partner's adjusted basis for a distribution of property previously

contributed to the partnership by the partner is necessary to give

effect to the statutory requirement that a distribution of previously

contributed property not be taken into account in determining the

amount of an excess distribution.

The proposed regulations also provide that, in determining the

amount of an excess distribution, the fair market value of distributed

property is not reduced by the amount of any liability assumed or taken

subject to by the partner. The distributee partner's basis in the

partnership interest, however, is increased by the amount of any

liability assumed or taken subject to by the distributee partner and

this increase is taken into account in determining the amount of the

excess distribution. (The partner's basis is also adjusted for the

decrease in the partner's share of partnership liabilities as a result

of the distribution for this purpose.) As a result, the gross fair

market value of the property will be offset by the basis increase in

the partner's interest in the partnership under section 752 and, as a

result, the amount of the excess distribution should be limited to the

net value of the distributed property.

Net Precontribution Gain

The distributee partner's net precontribution gain is the net gain

(if any) that the partner would have recognized under section

704(c)(1)(B) if the partnership had distributed to another partner all

property contributed to the partnership by the distributee partner

within five years of the date of the distribution. The amount of gain

or loss that the distributee partner would recognize under section

704(c)(1)(B) is determined under the proposed regulations to section

704(c)(1)(B) contained in this notice.

The proposed regulations under section 737 provide special rules

for determining the amount of the partner's net precontribution gain.

Property contributed on or before October 3, 1989, is not included in

determining the amount of net precontribution gain because net

precontribution gain is determined by reference to section

704(c)(1)(B), and that section does not apply to property contributed

to the partnership on or before October 3, 1989.

Net precontribution gain is reduced as a result of a basis increase

to the contributed property under section 734(b)(1)(A) to reflect gain

recognized by the partner under section 731 on a distribution of money

in the same plan or arrangement as the distribution of property subject

to section 737. This reduction is appropriate because some or all of

the precontribution gain is recognized by the contributing partner

under section 731 on the distribution.

The proposed regulations also provide that a transferee partner

succeeds to the transferor's net precontribution gain in an amount

proportionate to the interest transferred. This provision is consistent

with the provision in Sec. 1.704-3(a)(7) (and Sec. 1.704-4(d)(2) of the

proposed regulations) requiring a transferee partner to succeed to all

or a portion of the transferor's built-in gain or loss. The transferee

partner, however, may not recognize the same amount of gain that the

transferor partner would have recognized on a subsequent distribution

because the transferee's basis in the partnership interest may be

higher or lower than the transferor's basis, and the amount of gain

allocated to the transferee partner under section 704(c)(1)(A) will be

affected by any basis adjustment required under section 754.

Net precontribution gain is also reduced by the amount of gain

recognized by the contributing partner under section 704(c)(1)(B) in a

distribution of contributed property in a related distribution to

another partner, and by the amount of gain that the partner would have

recognized under section 704(c)(1)(B) on the distribution of

contributed property to another partner but for the exception of

section 704(c)(2). This reduction is necessary to avoid gain

recognition under both section 704(c)(1)(B) and section 737 with

respect to the same built-in gain. The reduction for gain not

recognized as a result of the section 704(c)(2) exception only applies

in situations where there is an actual distribution of contributed

property to another partner.

Character of Gain

The character of the contributing partner's recognized gain is

determined by reference to the character of the partner's net

precontribution gain. The character of such gain is determined by

netting all of the precontribution gains and losses according to the

character that such property would have had on a sale by the

partnership to an unrelated third party. The character of the

[[Page 2355]] contributing partner's gain under section 737 is the same

(and in the same proportion) as the character of any net positive

amounts resulting from the netting of the precontribution gains and

losses. Character for this purpose is broadly defined in the proposed

regulations to include any item that the contributing partner would

have been required to take into account separately under section 702(a)

and Sec. 1.702-1(a) had the partnership sold all the property

contributed by that partner.

Because the contributed property is not actually transferred by the

partnership to any particular partner, it is appropriate to treat the

hypothetical dispositions by the partnership as occurring with an

unrelated third party. As a result, the character conversion rule of

section 707(b)(2) does not apply for purposes of determining the

character of the distributee partner's gain. (Compare section

704(c)(1)(B) and Sec. 1.704-4(b)(1) in which the character conversion

rule does apply because the contributed property is actually

distributed to another partner.)

Exceptions and Special Rules

The proposed regulations provide that section 737 does not apply to

a deemed distribution of property on a termination of the partnership

under section 708(b)(1)(B). As noted above (with respect to the

discussion of the proposed regulations under section 704(c)(1)(B)),

however, a new five-year period begins for property to the extent that

the pre-termination gains and losses, if any, were not already required

to be allocated to the original contributor under section 704(c)(1)(A)

and Sec. 1.704-3.

A transferee partner in a transfer that causes a termination under

section 708(b)(1)(B) will generally not have any net precontribution

gain immediately after the deemed formation of the new partnership. The

basis of the property deemed contributed by the transferee partner to

the new partnership is determined under section 732 and, as a result,

the transferee partner may be treated as having contributed built-in

gain and built-in loss property to the new partnership. These built-in

gain and loss properties, however, should net to zero, assuming that

the transferee partner's total basis in the properties is equal to

their total fair market value. Section 737, however, does apply to the

transferee partner and could result in gain recognition on a subsequent

distribution if the distribution occurs at a time when the partner has

a net precontribution gain. The transferee partner could have a net

precontribution gain on a subsequent distribution if, for example, the

partnership sells some or all of the built-in loss property (that is

deemed contributed by that partner to the new partnership in the

section 708(b)(1)(B) termination) and retains the built-in gain

property.

The proposed regulations also provide that section 737 does not

apply to partnership mergers and similar transactions because the

partners have merely converted their interests in the transferor

partnership to an interest in the transferee partnership. As a result

of this treatment, however, distributions by the transferee partnership

are subject to section 737 to the same extent that distributions from

the transferor partnership would have been subject to section 737.

Under the proposed regulations, section 737 applies to an

incorporation of the partnership involving an actual distribution of

property by the partnership to the partners followed by a contribution

to a corporation. (As discussed below, however, section 737 does not

apply to the extent that the property actually distributed to a partner

was previously contributed to the partnership by that partner.) Section

737 does not apply to an incorporation of a partnership by methods not

involving an actual distribution of partnership property to the

partners, provided that the incorporation is followed by a complete

liquidation of the partnership as part of the same plan or arrangement

as the incorporation. Section 737 does not apply in these situations

because the partners are converting their partnership interests into a

stock interest in the corporation in a nonrecognition transaction and,

under the rules of either sections 732 or 358, the built-in gain in a

partner's partnership interest is preserved in the stock received by

the contributing partner. This exception is similar to the general

carry-over treatment provided in Sec. 1.704-3(a)(8) for section 704(c)

property exchanged in a nonrecognition transaction. Incorporation by

means of a distribution of partnership property to the partners also

results in the same conversion of a partnership interest into stock of

a corporation, but that method of incorporation involves an actual

distribution of property to the partners and the form of incorporation

chosen by the partners governs the tax consequences of incorporation,

including the application of section 737.

The proposed regulations provide that a related distribution of

property previously contributed to the partnership by the distributee

partner is not taken into account in determining the amount of the

excess distribution or the partner's net precontribution gain. The

proposed regulations also provide, consistent with section 737(d)(1),

for a limitation in the case of a distribution of a previously

contributed interest in an entity. This limitation is intended to

prevent a partner from avoiding section 737 by contributing an interest

in an entity to the partnership and having the partnership contribute

property to that entity, followed by a distribution of an interest in

the entity to the contributing partner under the previously contributed

property exception. This limitation does not apply to the extent that

the property contributed by the partnership to the entity was

contributed by the same partner that contributed the interest in the

entity because, in that case, the distributee partner is receiving only

a distribution of property that it previously contributed to the

partnership.

The proposed regulations also provide that any property received by

the partnership in exchange for previously contributed property is

treated as previously contributed property to the extent such property

is treated as section 704(c) property with regard to the contributing

partner under Sec. 1.704-3(a)(8). This provision is consistent with the

general treatment of nonrecognition transactions involving section

704(c) property under Sec. 1.704-3(a)(8).

Basis Adjustments

The contributing partner's basis in the partnership interest is

increased by the amount of gain recognized by the partner. This

increase is taken into account in determining a partner's basis in

property received by that partner, but is not taken into account in

determining the amount of gain recognized by the partner under section

737 or the amount of gain recognized under section 731 on any

distribution of money in the same distribution as the distribution of

property subject to section 737.

The partnership's basis in property contributed by the partner is

also increased by the gain recognized by the partner. The basis

increase is limited to built-in gain property held by the partnership

after the distribution with the same character as the character of the

gain recognized by the contributing partner under section 737. No basis

increase is allocated to any previously contributed property that is

part of the distribution to which section 737 applied. This previously

contributed property is not taken into account in determining the

amount of net precontribution gain and therefore it is not appropriate

to increase the basis of that property. There is also no basis increase

to any property distributed to another partner in a related

distribution [[Page 2356]] to which section 704(c)(1)(B) applies. The

basis in the distributed property in that case will be increased or

decreased for any gain or loss recognized by the contributing partner

under section 704(c)(1)(B) and therefore should not be adjusted for

gain recognized under section 737.

The basis increase is allocated to built-in gain property with the

same character as the character of the gain recognized by the partner.

The amount of the basis increase allocated to property of a particular

character is allocated to the property in the order contributed to the

partnership, starting with the earliest contributed property. This

ordering rule preserves the effect of the five-year rule to the extent

possible. Allocating the adjustment to all property of a similar

character based on any other rule would reduce the net precontribution

gain attributable to later-contributed property before such gain was

entirely eliminated on earlier contributed property.

Any increase to the adjusted tax basis of partnership property

under the proposed regulations is recovered using any applicable

recovery period and depreciation (or other cost recovery) method

(including first-year conventions) available to the partnership for

newly purchased property (of the type adjusted) placed in service at

the time of the distribution.

Proposed Effective Date

These regulations are proposed to apply to distributions of

property by a partnership to a partner on or after January 9, 1995.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in Executive Order

12866. Therefore, a regulatory assessment is not required. It has also

been determined that section 553(b) of the Administrative Procedure Act

(5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C.

chapter 6) do not apply to these regulations and, therefore, a

Regulatory Flexibility Analysis is not required. Pursuant to section

7805(f) of the Internal Revenue Code, this notice of proposed

rulemaking will be submitted to the Chief Counsel for Advocacy of the

Small Business Administration for comment on its impact on small

business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are timely submitted to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for June 19, 1995, at 10 a.m.

in the auditorium of the Internal Revenue Building. Because of access

restrictions, visitors will not be admitted beyond the Internal Revenue

Building lobby more than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by April 10, 1995 and submit an outline of the

topics to be discussed and the time to be devoted to each topic (signed

original and eight (8) copies) by May 22, 1995.

A period of 10 minutes will be allotted for each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

Several persons from the Office of Chief Counsel and the Treasury

Department participated in the development of these regulations.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

the following citation:

Authority: 26 U.S.C. 7805 * * *

Section 1.704-4 also issued under 26 U.S.C. 704(c) * * *

Par. 2. Section 1.704-4 is added to read as follows:

Sec. 1.704-4 Distribution of contributed property.

(a) Determination of gain--(1) In general. A partner that

contributes section 704(c) property to a partnership must recognize

gain or loss under section 704(c)(1)(B) and this section on the

distribution of such property to another partner within five years of

its contribution to the partnership, in an amount equal to the gain or

loss that would have been allocated to such partner under section

704(c)(1)(A) and Sec. 1.704-3 if the distributed property had been sold

by the partnership to the distributee partner for its fair market value

at the time of the distribution. See Sec. 1.704-3(a)(3)(i) for a

definition of section 704(c) property.

(2) Transactions to which section 704(c)(1)(B) applies. Section

704(c)(1)(B) and this section apply only to a distribution that is

properly characterized as a distribution to a partner acting in the

capacity of a partner within the meaning of section 731 and section

737. Section 704(c)(1)(B) and this section do not apply to a

transaction or distribution that is subject to provisions other than

section 731(a) or section 737 (for example, a transaction or

distribution subject to sections 707(a), 736(a), or 751(b)).

(3) Fair market value of property. The fair market value of the

distributed section 704(c) property is the price at which the property

would change hands between a willing buyer and a willing seller at the

time of the distribution, neither being under any compulsion to buy or

sell and both having reasonable knowledge of the relevant facts. The

fair market value that a partnership assigns to distributed section

704(c) property will be regarded as correct, provided that the value is

reasonably agreed to among the partners in an arm's-length negotiation

and the partners have sufficiently adverse interests.

(4) Determination of five-year period--(i) General rule. The five-

year period specified in paragraph (a)(1) of this section begins on and

includes the date of contribution.

(ii) Section 708(b)(1)(B) terminations. A termination of the

partnership under section 708(b)(1)(B) begins a new five-year period

for each partner with respect to the built-in gain and built-in loss

property that the partner is deemed to recontribute to a new

partnership following the termination, but only to the extent that the

pre-termination built-in gain or loss, if any, on such property was not

already required to be allocated to the original contributor under

section 704(c)(1)(A) and Sec. 1.704-3. See Sec. 1.704-3(a)(3)(ii) for

the definitions of built-in gain and built-in loss on section 704(c)

property.

(5) Examples. The following examples illustrate the rules of this

paragraph (a). Unless otherwise specified, partnership income equals

partnership expenses (other than depreciation deductions for

contributed property) for each year of the partnership, the fair market

value of partnership property does not change, all distributions by the

partnership are subject to section 704(c)(1)(B), and all partners are

unrelated.

[[Page 2357]] Example 1. Recognition of gain. (i) On January 1,

1995, A, B, and C form partnership ABC as equal partners. A

contributes $10,000 cash and Property A, nondepreciable real

property with a fair market value of $10,000 and an adjusted tax

basis of $4,000. Thus, there is a built-in gain of $6,000 on

Property A at the time of contribution. B contributes $10,000 cash

and Property B, nondepreciable real property with a fair market

value and adjusted tax basis of $10,000. C contributes $20,000 cash.

(ii) On December 31, 1998, Property A and Property B are

distributed to C in complete liquidation of C's interest in the

partnership.

(iii) A would have recognized $6,000 of gain under section

704(c)(1)(A) and Sec. 1.704-3 on the sale of Property A at the time

of the distribution ($10,000 fair market value less $4,000 adjusted

tax basis). As a result, A must recognize $6,000 of gain on the

distribution of Property A to C. B would not have recognized any

gain or loss under section 704(c)(1)(A) and Sec. 1.704-3 on the sale

of Property B at the time of distribution because Property B was not

section 704(c) property. As a result, B does not recognize any gain

or loss on the distribution of Property B.

Example 2. Effect of post-contribution depreciation deductions.

(i) On January 1, 1995, A, B, and C form partnership ABC as equal

partners. A contributes Property A, depreciable property with a fair

market value of $30,000 and an adjusted tax basis of $20,000.

Therefore, there is a built-in gain of $10,000 on Property A. B and

C each contribute $30,000 cash. ABC uses the traditional method of

making section 704(c) allocations described in Sec. 1.704-3(b) with

respect to Property A.

(ii) Property A is depreciated using the straight-line method

over its remaining 10-year recovery period. The partnership has book

depreciation of $3,000 per year (10 percent of the $30,000 book

basis), and each partner is allocated $1,000 of book depreciation

per year (one-third of the total annual book depreciation of

$3,000). The partnership has a tax depreciation deduction of $2,000

per year (10 percent of the $20,000 tax basis in Property A). This

$2,000 tax depreciation deduction is allocated equally between B and

C, the noncontributing partners with respect to Property A.

(iii) At the end of the third year, the book value of Property A

is $21,000 ($30,000 initial book value less $9,000 aggregate book

depreciation) and the adjusted tax basis is $14,000 ($20,000 initial

tax basis less $6,000 aggregate tax depreciation). A's remaining

section 704(c)(1)(A) built-in gain with respect to Property A is

$7,000 ($21,000 book value less $14,000 adjusted tax basis).

(iv) On December 31, 1998, Property A is distributed to B in

complete liquidation of B's interest in the partnership. If Property

A had been sold for its fair market value at the time of the

distribution, A would have recognized $7,000 of gain under section

704(c)(1)(A) and Sec. 1.704-3(b). Therefore, A recognizes $7,000 of

gain on the distribution of Property A to B.

Example 3. Effect of remedial method. (i) On January 1, 1995, A,

B, and C form partnership ABC as equal partners. A contributes

Property A1, nondepreciable real property with a fair market value

of $10,000 and an adjusted tax basis of $5,000, and Property A2,

nondepreciable real property with a fair market value and adjusted

tax basis of $10,000. B and C each contribute $20,000 cash. ABC uses

the remedial method of making section 704(c) allocations described

in Sec. 1.704-3(d) with respect to Property A1.

(ii) On December 31, 1998, when the fair market value of

Property A1 has decreased to $7,000, Property A1 is distributed to C

in partial liquidation of C's interest in the partnership. If

Property A1 had been sold by the partnership at the time of the

distribution, ABC would have recognized the $2,000 of remaining

built-in gain under section 704(c)(1)(A) on the sale (fair market

value of $7,000 less $5,000 adjusted tax basis). All of this gain

would have been allocated to A. ABC would also have recognized a

book loss of $3,000 ($10,000 original book value less $7,000 current

fair market value of the property). Book loss in the amount of

$2,000 would have been allocated equally between B and C. Under the

remedial method, $2,000 of tax loss would also have been allocated

equally to B and C to match their share of the book loss. As a

result, $2,000 of gain would also have been allocated to A as an

offsetting remedial allocation. A would have recognized $4,000 of

total gain under section 704(c)(1)(A) on the sale of Property A1

($2,000 of section 704(c) recognized gain plus $2,000 remedial

gain). Therefore, A recognizes $4,000 of gain on the distribution of

Property A1 to C under this section.

(b) Character of gain or loss--(1) General rule. Gain or loss

recognized by the contributing partner under section 704(c)(1)(B) and

this section has the same character as the gain or loss that would have

resulted if the distributed property had been sold by the partnership

to the distributee partner at the time of the distribution.

(2) Example. The following example illustrates the rule of this

paragraph (b). Unless otherwise specified, partnership income equals

partnership expenses (other than depreciation deductions for

contributed property) for each year of the partnership, the fair market

value of partnership property does not change, all distributions by the

partnership are subject to section 704(c)(1)(B), and all partners are

unrelated.

Example. Character of gain. (i) On January 1, 1995, A and B form

partnership AB. A contributes $10,000 and Property A, nondepreciable

real property with a fair market value of $10,000 and an adjusted

tax basis of $4,000, in exchange for a 25 percent interest in

partnership capital and profits. B contributes $60,000 cash for a 75

percent interest in partnership capital and profits.

(ii) On December 31, 1998, Property A is distributed to B in

partial liquidation of B's interest in the partnership. Property A

is used in a trade or business of B.

(iii) A would have recognized $6,000 of gain under section

704(c)(1)(A) on a sale of Property A at the time of the distribution

(the difference between the fair market value ($10,000) and the

adjusted tax basis ($4,000) of the property at that time). Because

Property A is not a capital asset in the hands of Partner B and B

holds more than 50 percent of partnership capital and profits, the

character of the gain on a sale of Property A to B would have been

ordinary income under section 707(b)(2). Therefore, the character of

the gain to A on the distribution of Property A to B is ordinary

income.

(c) Exceptions--(1) Property contributed on or before October 3,

1989. Section 704(c)(1)(B) and this section do not apply to property

contributed to the partnership on or before October 3, 1989.

(2) Certain complete liquidations. Section 704(c)(1)(B) and this

section do not apply to a distribution of an interest in section 704(c)

property to a partner other than the contributing partner in a complete

liquidation of the partnership if--

(i) The contributing partner receives an interest in the

contributed section 704(c) property; and

(ii) The built-in gain or loss in the interest distributed to the

contributing partner, determined immediately after the distribution, is

equal to or greater than the built-in gain or loss on the property that

would have been allocated to the contributing partner without regard to

this paragraph (c)(2).

(3) Section 708(b)(1)(B) termination. Section 704(c)(1)(B) and this

section do not apply to a deemed distribution of property caused by a

termination of the partnership under section 708(b)(1)(B). See

paragraph (a)(4)(iii) of this section for a special rule regarding a

new five-year period for certain property deemed contributed to a new

partnership following a termination of the partnership under section

708(b)(1)(B). See also Sec. 1.737-2(a) for a similar rule in the

context of section 737.

(4) Example. The following example illustrates the rule of

paragraph (c)(2) of this section. Unless otherwise specified,

partnership income equals partnership expenses (other than depreciation

deductions for contributed property) for each year of the partnership,

the fair market value of partnership property does not change, all

distributions by the partnership are subject to section 704(c)(1)(B),

and all partners are unrelated.

Example. Complete liquidation. (i) On January 1, 1995, A and B

form partnership AB, as equal partners. A contributes Property A,

nondepreciable real property with a fair market value and adjusted

tax basis of $20,000. B contributes Property B, nondepreciable real

property with a fair market value of $20,000 and an adjusted tax

basis of $10,000. Property B therefore has a [[Page 2358]] built-in

gain of $10,000 at the time of contribution.

(ii) On December 31, 1998, the partnership completely liquidates

when the fair market value of Property A has not changed, but the

fair market value of Property B has increased to $40,000.

(iii) In the liquidation, A receives Property A and a 25 percent

interest in Property B. This interest in Property B has a fair

market value of $10,000 to A, reflecting the fact that A was

entitled to 50 percent of the $20,000 post-contribution appreciation

in Property B. The partnership distributes to B a 75 percent

interest in Property B with a fair market value of $30,000. B's

basis in this portion of Property B is $10,000 under section 732(b).

As a result, B has a built-in gain of $20,000 in this portion of

Property B immediately after the distribution ($30,000 fair market

value less $10,000 adjusted tax basis). This built-in gain is

greater than the $10,000 of built-in gain in Property B at the time

of contribution to the partnership. B therefore does not recognize

any gain on the distribution of a portion of Property B to A under

this section.

(d) Special rules--(1) Nonrecognition transactions. Property

received by the partnership in exchange for section 704(c) property in

a nonrecognition transaction is treated as the section 704(c) property

for purposes of section 704(c)(1)(B) and this section to the extent

that the property received is treated as section 704(c) property under

Sec. 1.704-3(a)(8). See Sec. 1.737-2(d)(3) for a similar rule in the

context of section 737.

(2) Transfers of a partnership interest. The transferee of all or a

portion of the partnership interest of a contributing partner is

treated as the contributing partner for purposes of section

704(c)(1)(B) and this section to the extent of the share of built-in

gain or loss allocated to the transferee partner. See Sec. 1.704-

3(a)(7).

(3) Distributions of like-kind property. If section 704(c) property

is distributed to a partner other than the contributing partner and

like-kind property (within the meaning of section 1031) is distributed

to the contributing partner no later than the earlier of (i) 180 days

following the date of the distribution to the non-contributing partner,

or (ii) the due date (determined with regard to extensions) of the

contributing partner's income tax return for the taxable year of the

distribution to the noncontributing partner, the amount of gain or

loss, if any, that the contributing partner would otherwise have

recognized under section 704(c)(1)(B) and this section is reduced by

the amount of built-in gain or loss in the distributed like-kind

property in the hands of the contributing partner immediately after the

distribution. The contributing partner's basis in the distributed like-

kind property is determined as if the like-kind property were

distributed in an unrelated distribution prior to the distribution of

any other property distributed as part of the same plan or arrangement

and is determined without regard to the increase in the contributing

partner's adjusted tax basis in the partnership interest under section

704(c)(1)(B) and this section.

(4) Example. The following example illustrates the rules of this

paragraph (d). Unless otherwise specified, partnership income equals

partnership expenses (other than depreciation deductions for

contributed property) for each year of the partnership, the fair market

value of partnership property does not change, all distributions by the

partnership are subject to section 704(c)(1)(B), and all partners are

unrelated.

Example. Distribution of like-kind property. (i) On January 1,

1995, A, B, and C form partnership ABC as equal partners. A

contributes Property A, nondepreciable real property with a fair

market value of $20,000 and an adjusted tax basis of $10,000. B and

C each contribute $20,000 cash. The partnership subsequently buys

Property X, nondepreciable real property of a like-kind to Property

A with a fair market value and adjusted tax basis of $8,000. The

fair market value of Property X subsequently increases to $10,000.

(ii) On December 31, 1998, Property A is distributed to B in

partial liquidation of B's interest in the partnership. At the same

time, Property X is distributed to A in partial liquidation of A's

interest in the partnership. A's basis in Property X is $8,000 under

section 732(a)(1). A therefore has $2,000 of built-in gain in

Property X ($10,000 fair market value less $8,000 adjusted tax

basis).

(iii) A would generally recognize $10,000 of gain under section

704(c)(1)(B) on the distribution of Property A, the difference

between the fair market value ($20,000) of the property and its

adjusted tax basis ($10,000). This gain is reduced, however, by the

amount of the built-in gain of Property X in the hands of A. As a

result, A recognizes only $8,000 of gain on the distribution of

Property A to B under section 704(c)(1)(B) and this section.

(e) Basis adjustments--(1) Contributing partner's basis in the

partnership interest. The basis of the contributing partner's interest

in the partnership is increased by the amount of the gain, or decreased

by the amount of the loss, recognized by the partner under section

704(c)(1)(B) and this section. This increase or decrease is taken into

account in determining (i) the contributing partner's adjusted tax

basis under section 732 for any property distributed to the partner in

a distribution that is part of the same plan or arrangement as the

distribution of the contributed property, other than like-kind property

described in paragraph (d)(3) of this section (pertaining to the

special rule for distributions of like-kind property), and (ii) the

amount of the gain recognized by the contributing partner under section

731 or section 737, if any, on a distribution of money or property to

the contributing partner that is part of the same plan or arrangement

as the distribution of the contributed property. For a determination of

basis in a distribution subject to section 737, see Sec. 1.737-3(a).

(2) Partnership's basis in partnership property. The partnership's

adjusted tax basis in the distributed section 704(c) property is

increased or decreased immediately before the distribution by the

amount of gain or loss recognized by the contributing partner under

section 704(c)(1)(B) and this section. Any increase or decrease in

basis is therefore taken into account in determining the distributee

partner's adjusted tax basis in the distributed property under section

732. For a determination of basis in a distribution subject to section

737, see Sec. 1.737-3(b).

(3) Section 754 adjustments. The basis adjustment to partnership

property made pursuant to paragraph (e)(2) of this section is not

elective and must be made regardless of whether the partnership has an

election in effect under section 754. Any adjustments to the bases of

partnership property (including the distributed section 704(c)

property) under section 734(b) pursuant to a section 754 election must

be made after (and must take into account) the adjustments to basis

made under paragraph (e)(2) of this section. See Sec. 1.737-3(c)(4) for

a similar rule in the context of section 737.

(4) Example. The following example illustrates the rules of this

paragraph (e). Unless otherwise specified, partnership income equals

partnership expenses (other than depreciation deductions for

contributed property) for each year of the partnership, the fair market

value of partnership property does not change, all distributions by the

partnership are subject to section 704(c)(1)(B), and all partners are

unrelated.

Example. Basis adjustment. (i) On January 1, 1995, A, B, and C

form partnership ABC as equal partners. A contributes $10,000 cash

and Property A, nondepreciable real property with a fair market

value of $10,000 and an adjusted tax basis of $4,000. B and C each

contribute $20,000 cash.

(ii) On December 31, 1998, Property A is distributed to B in

partial liquidation of B's interest in the partnership.

(iii) Under paragraph (a) of this section, A recognizes $6,000

of gain on the distribution of Property A because that is the amount

of gain that would have been allocated to A under section

704(c)(1)(A) and Sec. 1.704-3 on [[Page 2359]] a sale of Property A

for its fair market value at the time of the distribution (fair

market value of Property A ($10,000) less its adjusted tax basis at

the time of distribution ($4,000)). The adjusted tax basis of A's

partnership interest is increased from $14,000 to $20,000 to reflect

this gain. The partnership's adjusted tax basis in Property A is

increased from $4,000 to $10,000 immediately prior to its

distribution to B. B's adjusted tax basis in Property A is therefore

$10,000 under section 732(a)(1).

(f) Anti-abuse rule--(1) In general. The rules of section

704(c)(1)(B) and this section must be applied in a manner consistent

with the purpose of section 704(c)(1)(B). Accordingly, if a principal

purpose of a transaction is to achieve a tax result that is

inconsistent with the purpose of section 704(c)(1)(B), the Commissioner

can recast the transaction for federal tax purposes as appropriate to

achieve tax results that are consistent with the purpose of section

704(c)(1)(B) and this section. Whether a tax result is inconsistent

with the purpose of section 704(c)(1)(B) and this section must be

determined based on all the facts and circumstances. See Sec. 1.737-4

for an anti-abuse rule and examples in the context of section 737.

(2) Examples. The following examples illustrate the anti-abuse rule

of this paragraph (f). The examples set forth below do not delineate

the boundaries of either permissible or impermissible types of

transactions. Further, the addition of any facts or circumstances that

are not specifically set forth in an example (or the deletion of any

facts or circumstances) may alter the outcome of the transaction

described in the example. Unless otherwise specified, partnership

income equals partnership expenses (other than depreciation deductions

for contributed property) for each year of the partnership, the fair

market value of partnership property does not change, all distributions

by the partnership are subject to section 704(c)(1)(B), and all

partners are unrelated.

Example 1. Distribution in substance made within five-year

period; results inconsistent with the purpose of section

704(c)(1)(B). (i) On January 1, 1995, A, B, and C form partnership

ABC as equal partners. A contributes Property A, nondepreciable real

property with a fair market value of $10,000 and an adjusted tax

basis of $1,000. B and C each contributes $10,000 cash.

(ii) On December 31, 1998, the partners tentatively agree to

distribute Property A to B in complete liquidation of B's interest

in the partnership. If Property A were distributed at that time, A

would recognize $9,000 of gain under section 704(c)(1)(B), the

difference between the $10,000 fair market value and the $1,000

adjusted tax basis of Property A, because Property A was contributed

to the partnership less than five years before December 31, 1998. On

becoming aware of this potential gain recognition, and with a

principal purpose of avoiding such gain, the partners amend the

partnership agreement on December 31, 1998, and take any other steps

necessary to provide that substantially all of the economic risks

and benefits of Property A are allocated to B as of December 31,

1998, and that substantially all of the economic risks and benefits

of all other partnership property are allocated to A and C. The

partnership holds Property A until January 5, 2000, at which time it

is distributed to B in complete liquidation of B's interest in the

partnership.

(iii) The distribution of Property A occurred more than five

years after the contribution of the property to the partnership. The

steps taken by the partnership on December 31, 1998, however, are

the functional equivalent of an actual distribution of Property A to

B in complete liquidation of B's interest in the partnership as of

that date. Section 704(c)(1)(B) requires recognition of gain when

contributed section 704(c) property is in substance distributed to

another partner within five years of its contribution to the

partnership. Allowing a contributing partner to avoid section

704(c)(1)(B) through arrangements such as those in this Example 1

that have the effect of a distribution of property within five years

of the date of its contribution to the partnership would effectively

undermine the purpose of section 704(c)(1)(B) and this section. As a

result, the steps taken by the partnership on December 31, 1998, are

treated as causing a distribution of Property A to B for purposes of

section 704(c)(1)(B) on that date, and A recognizes gain of $9,000

under section 704(c)(1)(B) and this section at that time.

(iv) Alternatively, if on becoming aware of the potential gain

recognition to A on a distribution of Property A on December 31,

1998, the partners had instead agreed that B would continue as a

partner with no changes to the partnership agreement or to B's

economic interest in partnership operations, the distribution of

Property A to B on January 5, 2000, would not have been inconsistent

with the purpose of section 704(c)(1)(B) and this section. In that

situation, Property A would not have been distributed until after

the expiration of the five-year period specified in section

704(c)(1)(B) and this section. Deferring the distribution of

Property A until the end of the five-year period for a principal

purpose of avoiding the recognition of gain under section

704(c)(1)(B) and this section is not inconsistent with the purpose

of section 704(c)(1)(B). Therefore, A would not have recognized gain

on the distribution of Property A in that case.

Example 2. Suspension of five-year period in manner consistent

with the purpose of section 704(c)(1)(B). (i) A, B, and C form

partnership ABC on January 1, 1995, to conduct bona fide business

activities. A contributes Property A, nondepreciable real property

with a fair market value of $10,000 and an adjusted tax basis of

$1,000, in exchange for a 49.5 percent interest in partnership

capital and profits. B contributes $10,000 in cash for a 49.5

percent interest in partnership capital and profits. C contributes

cash for a 1 percent interest in partnership capital and profits. A

and B are wholly owned subsidiaries of the same affiliated group and

continue to control the management of Property A by virtue of their

controlling interests in the partnership. The partnership is formed

pursuant to a plan a principal purpose of which is to minimize the

period of time that A would have to remain a partner with a

potential acquiror of Property A.

(ii) On December 31, 1997, D is admitted as a partner to the

partnership in exchange for $10,000 cash.

(iii) On January 5, 2000, Property A is distributed to D in

complete liquidation of D's interest in the partnership.

(iv) The distribution of Property A to D occurred more than five

years after the contribution of the property to the partnership. On

these facts, however, a principal purpose of the transaction was to

minimize the period of time that A would have to remain partners

with a potential acquiror of Property A, and treating the five-year

period of section 704(c)(1)(B) as running during a time when

Property A was still effectively owned through the partnership by

members of the contributing affiliated group of which A is a member

is inconsistent with the purpose of section 704(c)(1)(B). Prior to

the admission of D as a partner, the pooling of assets between A and

B, on the one hand, and C, on the other hand, although sufficient to

constitute ABC as a valid partnership for federal income tax

purposes, is not a sufficient pooling of assets for purposes of

running the five-year period with respect to the distribution of

Property A to D. Allowing a contributing partner to avoid section

704(c)(1)(B) through arrangements such as those in this Example 2

would have the effect of substantially nullifying the five-year

requirement of section 704(c)(1)(B) and this section and elevating

the form of the transaction over its substance. As a result, with

respect to the distribution of Property A to D, the five-year period

of section 704(c)(1)(B) is tolled until the admission of D as a

partner on December 31, 1997. Therefore, the distribution of

Property A occurred before the end of the five-year period of

section 704(c)(1)(B), and A recognizes gain of $9,000 under section

704(c)(1)(B) on the distribution.

(g) Effective date. This section applies to distributions by a

partnership to a partner on or after January 9, 1995.

Par. 3. Sections 1.737-1, 1.737-2, 1.737-3, 1.737-4, and 1.737-5

are added under the heading ``Distributions by a Partnership'' to read

as follows:

Sec. 1.737-1 Recognition of precontribution gain.

(a) Determination of gain--(1) In general. A partner that receives

a distribution of property (other than money) must recognize gain under

section 737 and this section in an amount equal to the lesser of the

excess distribution (as defined in paragraph (b) of this section) or

the partner's net precontribution gain (as defined in

[[Page 2360]] paragraph (c) of this section). Gain recognized under

section 737 and this section is in addition to any gain recognized

under section 731.

(2) Transactions to which section 737 applies. Section 737 and this

section apply only to a distribution that is properly characterized as

a distribution to a partner acting in the capacity of a partner within

the meaning of section 731. Section 737 does not apply to a transaction

or distribution that is subject to provisions other than sections

731(a) or 737 (for example, a transaction or distribution subject to

sections 707(a), 736(a), or 751(b)).

(b) Excess distribution--(1) Definition. The excess distribution is

the amount (if any) by which the fair market value of the distributed

property (other than money) exceeds the distributee partner's adjusted

tax basis in the partner's partnership interest.

(2) Fair market value of property. The fair market value of the

distributed property is the price at which the property would change

hands between a willing buyer and a willing seller at the time of the

distribution, neither being under any compulsion to buy or sell and

both having reasonable knowledge of the relevant facts. The fair market

value that a partnership assigns to distributed property will be

regarded as correct, provided that the value is reasonably agreed to

among the partners in an arm's-length negotiation and the partners have

sufficiently adverse interests.

(3) Distributee partner's adjusted tax basis--(i) General rule. In

determining the amount of the excess distribution, the distributee

partner's adjusted tax basis in the partnership interest includes any

basis adjustment resulting from the distribution that is subject to

section 737 (for example, adjustments required under section 752) and

from any other distribution or transaction that is part of the same

plan or arrangement, except for--

(A) The increase required under section 737(c)(1) for the gain

recognized by the partner under section 737; and

(B) The decrease required under section 733(2) for any property

distributed to the partner other than property previously contributed

to the partnership by the distributee partner. See Sec. 1.704-4(e)(1)

for a rule in the context of section 704(c)(1)(B). See also Sec. 1.737-

3(b)(2) for a special rule for determining a partner's adjusted tax

basis in distributed property previously contributed by the partner to

the partnership.

(ii) Advances or drawings. The distributee partner's adjusted tax

basis in the partnership interest is determined as of the last day of

the partnership's taxable year if the distribution to which section 737

applies is properly characterized as an advance or drawing against the

partner's distributive share of income. See Sec. 1.731-1(a)(1)(ii).

(c) Net precontribution gain--(1) General rule. The distributee

partner's net precontribution gain is the net gain (if any) that the

partner would have recognized under section 704(c)(1)(B) and

Sec. 1.704-4 if, at the time of the distribution to which section 737

applies, the partnership had actually distributed to another partner

all section 704(c) property contributed to the partnership by the

distributee partner. See Sec. 1.704-4 for provisions determining a

contributing partner's gain or loss under section 704(c)(1)(B) on an

actual distribution of contributed section 704(c) property to another

partner.

(2) Special rules--(i) Property contributed on or before October 3,

1989. Property contributed to the partnership on or before October 3,

1989, is not taken into account in determining a partner's net

precontribution gain. See Sec. 1.704-4(c)(1) for a similar rule in the

context of section 704(c)(1)(B).

(ii) Section 734(b)(1)(A) adjustments. For distributions to a

distributee partner of money by a partnership with a section 754

election in effect that are part of the same plan or arrangement as the

distribution of property subject to section 737, for purposes of

paragraph (a) and (c)(1) of this section the distributee partner's net

precontribution gain is reduced by the basis adjustments (if any) made

to section 704(c) property contributed by the distributee partner under

section 734(b)(1)(A). See Sec. 1.737-3(c)(4) for rules regarding basis

adjustments for partnerships with a section 754 election in effect.

(iii) Transfers of a partnership interest. The transferee of all or

a portion of a contributing partner's partnership interest succeeds to

the transferor's net precontribution gain, if any, in an amount

proportionate to the interest transferred. See Sec. 1.704-3(a)(7) and

Sec. 1.704-4(d)(2) for similar provisions in the context of section

704(c)(1)(A) and section 704(c)(1)(B).

(iv) Section 704(c)(1)(B) gain recognized in related distribution.

A distributee partner's net precontribution gain is determined after

taking into account any gain or loss recognized by the partner under

section 704(c)(1)(B) and Sec. 1.704-4 (or that would have been

recognized by the partner except for the like-kind exception in section

704(c)(2) and Sec. 1.704-4(d)(3)) on an actual distribution to another

partner of section 704(c) property contributed by the distributee

partner that is part of the same plan or arrangement as the

distribution to the distributee partner.

(v) Section 704(c)(2) disregarded. A distributee partner's net

precontribution gain is determined without regard to the provisions of

section 704(c)(2) and Sec. 1.704-4(d)(2) in situations in which the

property contributed by the distributee partner is not actually

distributed to another partner in a distribution related to the section

737 distribution.

(d) Character of gain. The character of the gain recognized by the

distributee partner under section 737 and this section is determined

by, and is proportionate to, the character of the partner's net

precontribution gain. For this purpose, all gains and losses on section

704(c) property taken into account in determining the partner's net

precontribution gain are netted according to their character. Any

character with a net negative amount is disregarded. The character of

the partner's gain under section 737 is the same as, and in proportion

to, any character with a net positive amount. Character for this

purpose is determined as if the section 704(c) property had been sold

by the partnership to an unrelated third party at the time of the

distribution and includes any item that would have been taken into

account separately by the contributing partner under section 702(a) and

Sec. 1.702-1(a).

(e) Examples. The following examples illustrate the provisions of

this section. Unless otherwise specified, partnership income equals

partnership expenses (other than depreciation deductions for

contributed property) for each year of the partnership, the fair market

value of partnership property does not change, all distributions by the

partnership are subject to section 737, and all partners are unrelated.

Example 1. Calculation of excess distribution and net

precontribution gain. (i) On January 1, 1995, A, B, and C form

partnership ABC as equal partners. A contributes Property A,

depreciable real property with a fair market value of $30,000 and an

adjusted tax basis of $20,000. B contributes Property B,

nondepreciable real property with a fair market value and adjusted

tax basis of $30,000. C contributes $30,000 cash.

(ii) Property A has 10 years remaining on its cost recovery

schedule and is depreciated using the straight-line method. The

partnership uses the traditional method for allocating items under

section 704(c) described in Sec. 1.704-3(b)(1) for Property A. The

partnership has book depreciation of $3,000 per year (10 percent of

the $30,000 book basis in Property A) and each partner is allocated

$1,000 of book depreciation per [[Page 2361]] year (one-third of the

total annual book depreciation of $3,000). The partnership also has

tax depreciation of $2,000 per year (10 percent of the $20,000

adjusted tax basis in Property A). This $2,000 tax depreciation is

allocated equally between B and C, the noncontributing partners with

respect to Property A.

(iii) At the end of 1997, the book value of Property A is

$21,000 ($30,000 initial book value less $9,000 aggregate book

depreciation) and its adjusted tax basis is $14,000 ($20,000 initial

tax basis less $6,000 aggregate tax depreciation).

(iv) On December 31, 1997, Property B is distributed to A in

complete liquidation of A's partnership interest. The adjusted tax

basis of A's partnership interest at that time is $20,000. The

amount of the excess distribution is $10,000, the difference between

the fair market value of the distributed Property B ($30,000) and

A's adjusted tax basis in A's partnership interest ($20,000). A's

net precontribution gain is $7,000, the difference between the book

value of Property A ($21,000) and its adjusted tax basis at the time

of the distribution ($14,000). A recognizes gain of $7,000 on the

distribution, the lesser of the excess distribution and the net

precontribution gain.

Example 2. Determination of distributee partner's basis. (i) On

January 1, 1995, A, B, and C form general partnership ABC as equal

partners. A contributes Property A, nondepreciable real property

with a fair market value of $10,000 and an adjusted tax basis of

$4,000. B and C each contribute $10,000 cash.

(ii) The partnership purchases Property B, nondepreciable real

property with a fair market value of $9,000, subject to a $9,000

nonrecourse liability. This nonrecourse liability is allocated

equally among the partners under section 752, increasing A's

adjusted tax basis in A's partnership interest from $4,000 to

$7,000.

(iii) On December 31, 1998, A receives $2,000 cash and Property

B, subject to the $9,000 liability, in partial liquidation of A's

interest in the partnership.

(iv) In determining the amount of the excess distribution, the

adjusted tax basis of A's partnership interest is adjusted to take

into account the distribution of money and the shift in liabilities.

A's adjusted tax basis is therefore increased to $11,000 for this

purpose ($7,000 initial adjusted tax basis, less $2,000 distribution

of money, less $3,000 (decrease in A's share of the $9,000

partnership liability), plus $9,000 (increase in A's individual

liabilities)). As a result of this basis adjustment, the adjusted

tax basis of A's partnership interest ($11,000) is greater than the

fair market value of the distributed property ($9,000) and

therefore, there is no excess distribution. A recognizes no gain

under section 737.

Example 3. Net precontribution gain reduced for gain recognized

under section 704(c)(1)(B). (i) On January 1, 1995, A, B, and C form

partnership ABC as equal partners. A contributes Properties A1 and

A2, nondepreciable real properties each with a fair market value of

$10,000 and an adjusted tax basis of $6,000. B contributes Property

B, nondepreciable real property, with a fair market value and

adjusted tax basis of $20,000. C contributes $20,000 cash.

(ii) On December 31, 1998, Property B is distributed to A in

complete liquidation of A's interest and, as part of the same

distribution, Property A1 is distributed to B in partial liquidation

of B's interest in the partnership.

(iii) A's net precontribution gain before the distribution is

$8,000 ($20,000 fair market value of Properties A1 and A2 less

$12,000 adjusted tax basis of such properties). A recognizes $4,000

of gain under section 704(c)(1)(B) and Sec. 1.704-4 on the

distribution of Property A1 to B ($10,000 fair market value of

Property A1 less $6,000 adjusted tax basis of Property A1). This

gain is taken into account in determining A's excess distribution

and net precontribution gain. As a result, A's net precontribution

gain is reduced from $8,000 to $4,000, and the adjusted tax basis in

A's partnership interest is increased by $4,000 to $16,000.

(iv) A recognizes gain of $4,000 on the receipt of Property B

under section 737, an amount equal to the excess distribution of

$4,000 ($20,000 fair market value of Property B less $16,000

adjusted tax basis of A's interest in the partnership) and A's

remaining net precontribution gain of $4,000.

Example 4. Character of gain. (i) On January 1, 1995, A, B, and

C form partnership ABC as equal partners. A contributes the

following nondepreciable property to the partnership:

------------------------------------------------------------------------

Fair

market Adjusted

value tax basis

------------------------------------------------------------------------

Property A1....................................... $30,000 $20,000

Property A2....................................... 30,000 38,000

Property A3....................................... 10,000 9,000

------------------------------------------------------------------------

(ii) The character of gain or loss on Property A1 and Property

A2 is long-term, U.S.-source capital gain or loss. The character of

gain on Property A3 is long-term, foreign-source capital gain. B

contributes Property B, nondepreciable real property with a fair

market value and adjusted tax basis of $70,000. C contributes

$70,000 cash.

(iii) On December 31, 1998, Property B is distributed to A in

complete liquidation of A's interest in the partnership. A

recognizes $3,000 of gain under section 737, an amount equal to the

excess distribution of $3,000 ($70,000 fair market value of Property

B less $67,000 adjusted tax basis in A's partnership interest) and

A's net precontribution gain of $3,000 ($70,000 aggregate fair

market value of properties contributed by A less $67,000 aggregate

adjusted tax basis of such properties).

(iv) In determining the character of A's gain, all gains and

losses on property taken into account in determining A's net

precontribution gain are netted according to their character and

allocated to A's recognized gain under section 737 based on the

relative proportions of the net positive amounts. U.S.-source and

foreign-source gains must be netted separately because A would have

been required to take such gains into account separately under

section 702. As a result, A's net precontribution gain of $3,000

consists of $2,000 of net long-term, U.S.-source capital gain

($10,000 gain on Property A1 and $8,000 loss on Property A2) and

$1,000 of net long-term, foreign-source capital gain ($1,000 gain on

Property A3).

(v) The character of A's gain under paragraph (d) of this

section is therefore $2,000 long-term, U.S.-source capital gain

($3,000 gain recognized under section 737 x $2,000 net long-term,

U.S.-source capital gain/$3,000 total net precontribution gain) and

$1,000 long-term, foreign-source capital gain ($3,000 gain

recognized under section 737 x $1,000 net long-term, foreign-source

capital gain/$3,000 total net precontribution gain).

Sec. 1.737-2 Exceptions and special rules.

(a) Section 708(b)(1)(B) terminations. Section 737 and this section

do not apply to a deemed distribution of property on a termination of

the partnership under section 708(b)(1)(B). See Sec. 1.704-4(c)(3) for

a similar rule in the context of section 704(c)(1)(B).

(b) Complete transfer to another partnership. Section 737 and this

section do not apply to a transfer by a partnership (transferor

partnership) of all of its assets and liabilities to a second

partnership (transferee partnership) in an exchange described in

section 721, followed by a distribution of the interest in the

transferee partnership in complete liquidation of the transferor

partnership as part of the same plan or arrangement. In addition,

section 737 and this section do not apply to any transaction, such as a

partnership merger under section 708(b)(2)(A), that is treated in a

similar manner. A subsequent distribution of property by the transferee

partnership to the partners of the transferee partnership who were

formerly partners of the transferor partnership is subject to section

737 to the same extent that a distribution from the transferor

partnership would have been subject to section 737.

(c) Incorporation of a partnership. Section 737 and this section do

not apply to an incorporation of a partnership by any method of

incorporation (other than a method involving an actual distribution of

partnership property to the partners followed by a contribution of that

property to a corporation), provided that the partnership is completely

liquidated as part of the same plan or arrangement as the incorporation

transaction.

(d) Distribution of previously contributed property--(1) General

rule. Any portion of the distributed property that consists of property

previously contributed by the distributee partner (including property

treated as contributed by the partner in connection with a termination

of the partnership [[Page 2362]] under section 708(b)(1)(B))

(previously contributed property) is not taken into account in

determining the amount of the excess distribution or the partner's net

precontribution gain. See Sec. 1.737-3(b)(2) for a special rule for

determining the basis of previously contributed property in the hands

of a distributee partner who contributed the property to the

partnership.

(2) Limitation for distribution of previously contributed interest

in an entity. An interest in an entity previously contributed to the

partnership is not treated as previously contributed property to the

extent that the value of the interest is attributable to property

contributed to the entity after the interest was contributed to the

partnership. The preceding sentence does not apply to the extent that

the property contributed to the entity was contributed to the

partnership by the partner that also contributed the interest in the

entity to the partnership.

(3) Nonrecognition transactions. Property received by the

partnership in exchange for contributed section 704(c) property in a

nonrecognition transaction is treated as the contributed property with

regard to the contributing partner for purposes of section 737 to the

extent that the property received is treated as section 704(c) property

under Sec. 1.704-3(a)(8). See Sec. 1.704-4(d)(1) for a similar rule in

the context of section 704(c)(1)(B).

(e) Examples. The following examples illustrate the rules of this

section. Unless otherwise specified, partnership income equals

partnership expenses (other than depreciation deductions for

contributed property) for each year of the partnership, the fair market

value of partnership property does not change, all distributions by the

partnership are subject to section 737, and all partners are unrelated.

Example 1. Distribution of previously contributed property. (i)

On January 1, 1995, A, B, and C form partnership ABC as equal

partners. A contributes the following nondepreciable real property

to the partnership:

------------------------------------------------------------------------

Fair

market Adjusted

value tax basis

------------------------------------------------------------------------

Property A1....................................... $20,000 $10,000

Property A2....................................... 10,000 6,000

------------------------------------------------------------------------

(ii) A's total net precontribution gain on the contributed

property is $14,000 ($10,000 on Property A1 plus $4,000 on Property

A2). B contributes $10,000 cash and Property B, nondepreciable real

property with a fair market value and adjusted tax basis of $20,000.

C contributes $30,000 cash.

(iii) On December 31, 1998, Property A2 and Property B are

distributed to A in complete liquidation of A's interest in the

partnership. Property A2 was previously contributed by A and is

therefore not taken into account in determining the amount of the

excess distribution or A's net precontribution gain. The adjusted

tax basis of Property A2 in the hands of A is also determined under

section 732 as if that property were the only property distributed

to A.

(iv) As a result of excluding Property A2 from these

determinations, the amount of the excess distribution is $10,000

($20,000 fair market value of distributed Property B less $10,000

adjusted tax basis in A's partnership interest). A's net

precontribution gain is also $10,000 ($14,000 total net

precontribution gain less $4,000 gain with respect to previously

contributed Property A2). A therefore recognizes $10,000 of gain on

the distribution, the lesser of the excess distribution and the net

precontribution gain.

Example 2. Distribution of a previously contributed interest in

an entity. (i) On January 1, 1995, A, B, and C form partnership ABC

as equal partners. A contributes Property A, nondepreciable real

property with a fair market value of $10,000 and an adjusted tax

basis of $5,000, and all of the stock of Corporation X with a fair

market value and adjusted tax basis of $500. B contributes $500 cash

and Property B, nondepreciable real property with a fair market

value and adjusted tax basis of $10,000. Partner C contributes

$10,500 cash. On December 31, 1996, ABC contributes Property B to

Corporation X in a nonrecognition transaction under section 351.

(ii) On December 31, 1998, all of the stock of Corporation X is

distributed to A in complete liquidation of A's interest in the

partnership. The stock is treated as previously contributed property

with respect to A only to the extent of the $500 fair market value

of the Corporation X stock contributed by A. The fair market value

of the distributed stock for purposes of determining the amount of

the excess distribution is therefore $10,000 ($10,500 total fair

market value of Corporation X stock less $500 portion treated as

previously contributed property). The $500 fair market value and

adjusted tax basis of the Corporation X stock is also not taken into

account in determining the amount of the excess distribution and the

net precontribution gain.

(iii) A recognizes $5,000 of gain under section 737, the amount

of the excess distribution ($10,000 fair market value of distributed

property less $5,000 adjusted tax basis in A's partnership interest)

and A's net precontribution gain ($10,000 fair market value of

Property A less $5,000 adjusted tax basis in Property A).

Sec. 1.737-3 Basis adjustments; Recovery rules.

(a) Distributee partner's adjusted tax basis in the partnership

interest. The distributee partner's adjusted tax basis in the

partnership interest is increased by the amount of gain recognized by

the distributee partner under section 737 and this section. This

increase is not taken into account in determining the amount of gain

recognized by the partner under section 737(a)(1) and this section or

in determining the amount of gain recognized by the partner under

section 731(a) on the distribution of money in the same distribution or

any related distribution. See Sec. 1.704-4(e)(1) for a determination of

the distributee partner's adjusted tax basis in a distribution subject

to section 704(c)(1)(B).

(b) Distributee partner's adjusted tax basis in distributed

property--(1) In general. The distributee partner's adjusted tax basis

in the distributed property is determined under section 732(a) or (b)

as applicable. The increase in the distributee partner's adjusted tax

basis in the partnership interest under paragraph (a) of this section

is taken into account in determining the distributee partner's adjusted

tax basis in the distributed property other than property previously

contributed by the partner. See Sec. 1.704-4(e)(2) for a determination

of basis in a distribution subject to section 704(c)(1)(B).

(2) Previously contributed property. The distributee partner's

adjusted tax basis in distributed property that the partner previously

contributed to the partnership is determined as if it were distributed

in a separate and independent distribution prior to the distribution

that is subject to section 737 and Sec. 1.737-1.

(c) Partnership's adjusted tax basis in partnership property--(1)

Increase in basis. The partnership's adjusted tax basis in eligible

property is increased by the amount of gain recognized by the

distributee partner under section 737.

(2) Eligible property. Eligible property is property that--

(i) Entered into the calculation of the distributee partner's net

precontribution gain;

(ii) Has an adjusted tax basis to the partnership less than the

property's fair market value at the time of the distribution;

(iii) Would have the same character of gain on a sale by the

partnership to an unrelated party as the character of any of the gain

recognized by the distributee partner under section 737; and

(iv) Was not distributed to another partner in a distribution

subject to section 704(c)(1)(B) and Sec. 1.704-4 that was part of the

same plan or arrangement as the distribution subject to section 737.

(3) Method of adjustment. For the purpose of allocating the basis

increase under paragraph (c)(2) of this section among the eligible

property, all eligible property of the same character is treated as a

single group. Character for this purpose is determined in the same

[[Page 2363]] manner as the character of the recognized gain is

determined under Sec. 1.737-1(d). The basis increase is allocated among

the separate groups of eligible property in proportion to the character

of the gain recognized under section 737. The basis increase is then

allocated among property within each group in the order in which the

property was contributed to the partnership by the partner, starting

with the property contributed first, in an amount equal to the

difference between the property's fair market value and its adjusted

tax basis to the partnership at the time of the distribution. For

property that has the same character and was contributed in the same

(or a related) transaction, the basis increase is allocated based on

the respective amounts of unrealized appreciation in such properties at

the time of the distribution.

(4) Section 754 adjustments. The basis adjustment to partnership

property made pursuant to paragraph (c)(1) of this section is not

elective and must be made regardless of whether the partnership has an

election in effect under section 754. Any adjustments to the bases of

partnership property (including eligible property as defined in

paragraph (c)(2) of this section) under section 734(b) pursuant to a

section 754 election (other than basis adjustments under section

734(b)(1)(A) described in the following sentence) must be made after

(and must take into account) the adjustments to basis made under

paragraph (a) and paragraph (c)(1) of this section. Basis adjustments

under section 734(b)(1)(A) that are attributable to distributions of

money to the distributee partner that are part of the same plan or

arrangement as the distribution of property subject to section 737 are

made before the adjustments to basis under paragraph (a) and paragraph

(c)(1) of this section. See Sec. 1.737-1(c)(2)(ii) for the effect, if

any, of basis adjustments under section 734(b)(1)(A) on a partner's net

precontribution gain. See also Sec. 1.704-4(e)(3) for a similar rule

regarding basis adjustments pursuant to a section 754 election in the

context of section 704(c)(1)(B).

(d) Recovery of increase to adjusted tax basis. Any increase to the

adjusted tax basis of partnership property under paragraph (c)(1) of

this section is recovered using any applicable recovery period and

depreciation (or other cost recovery) method (including first-year

conventions) available to the partnership for newly purchased property

(of the type adjusted) placed in service at the time of the

distribution.

(e) Examples. The following examples illustrate the rules of this

section. Unless otherwise specified, partnership income equals

partnership expenses (other than depreciation deductions for

contributed property) for each year of the partnership, the fair market

value of partnership property does not change, all distributions by the

partnership are subject to section 737, and all partners are unrelated.

Example 1. Partner's basis in distributed property. (i) On

January 1, 1995, A, B, and C form partnership ABC as equal partners.

A contributes Property A, nondepreciable real property with a fair

market value of $10,000 and an adjusted tax basis of $5,000. B

contributes Property B, nondepreciable real property with a fair

market value and adjusted tax basis of $10,000. C contributes

$10,000 cash.

(ii) On December 31, 1998, Property B is distributed to A in

complete liquidation of A's interest in the partnership. A

recognizes $5,000 of gain under section 737, an amount equal to the

excess distribution of $5,000 ($10,000 fair market value of Property

B less $5,000 adjusted tax basis in A's partnership interest) and

A's net precontribution gain of $5,000 ($10,000 fair market value of

Property A less $5,000 adjusted tax basis of such property).

(iii) A's adjusted tax basis in A's partnership interest is

increased by the $5,000 of gain recognized under section 737. This

increase is taken into account in determining A's basis in the

distributed property. Therefore, A's adjusted tax basis in

distributed Property B is $10,000 under section 732(b).

Example 2. Partner's basis in distributed property in connection

with gain recognized under section 704(c)(1)(B). (i) On January 1,

1995, A, B, and C form partnership ABC as equal partners. A

contributes the following nondepreciable real property to the

partnership:

------------------------------------------------------------------------

Fair

market Adjusted

value tax basis

------------------------------------------------------------------------

Property A1....................................... $10,000 $5,000

Property A2....................................... 10,000 2,000

------------------------------------------------------------------------

(ii) B contributes $10,000 cash and Property B, nondepreciable

real property, with a fair market value and adjusted tax basis of

$10,000. C contributes $20,000 cash.

(iii) On December 31, 1998, Property B is distributed to A in

partial liquidation of A's interest in the partnership and Property

A1 is distributed to B in partial liquidation of B's interest in the

partnership. A recognizes $5,000 of gain under section 704(c)(1)(B)

and Sec. 1.704-4 on the distribution of Property A1 to B, the

difference between the fair market value of such property ($10,000)

and the adjusted tax basis in distributed Property A1 ($5,000). The

adjusted tax basis of A's partnership interest is increased by this

$5,000 of gain under section 704(c)(1)(B) and Sec. 1.704-4(e)(1) .

(iv) The increase in the adjusted tax basis of A's partnership

interest is taken into account in determining the amount of the

excess distribution. As a result, there is no excess distribution

because the fair market value of Property B ($10,000) is less than

the adjusted tax basis of A's interest in the partnership at the

time of distribution ($12,000). A therefore recognizes no gain under

section 737 on the receipt of Property B. A's adjusted tax basis in

Property B is $10,000 under section 732(a)(1). The adjusted tax

basis of A's partnership interest is reduced from $12,000 to $2,000

under section 733. See Example 3 of Sec. 1.737-1(e).

Example 3. Partnership's basis in partnership property after a

distribution with section 737 gain. (i) On January 31, 1995, A, B,

and C form partnership ABC as equal partners. A contributes the

following nondepreciable property to the partnership:

------------------------------------------------------------------------

Fair

market Adjusted

value tax basis

------------------------------------------------------------------------

Property A1....................................... $1,000 $500

Property A2....................................... 4,000 1,500

Property A3....................................... 4,000 6,000

Property A4....................................... 6,000 4,000

------------------------------------------------------------------------

(ii) The character of gain or loss on Properties A1, A2, and A3

is long-term, U.S.-source capital gain or loss. The character of

gain on Property A4 is long-term, foreign-source capital gain. B

contributes Property B, nondepreciable real property with a fair

market value and adjusted tax basis of $15,000. C contributes

$15,000 cash.

(iii) On December 31, 1998, Property B is distributed to A in

complete liquidation of A's interest in the partnership. A

recognizes gain of $3,000 under section 737, an amount equal to the

excess distribution of $3,000 ($15,000 fair market value of Property

B less $12,000 adjusted tax basis in A's partnership interest) and

A's net precontribution gain of $3,000 ($15,000 aggregate fair

market value of the property contributed by A less $12,000 aggregate

adjusted tax basis of such property).

(iv) $2,000 of A's gain is long-term, foreign-source capital

gain ($3,000 total gain under section 737 x $2,000 net long-term,

foreign-source capital gain/$3,000 total net precontribution gain).

$1,000 of A's gain is long-term, U.S.-source capital gain ($3,000

total gain under section 737 x $1,000 net long-term, U.S.-source

capital gain/$3,000 total net precontribution gain).

(v) The partnership must increase the adjusted tax basis of the

property contributed by A by $3,000. All property contributed by A

is eligible property. Properties A1, A2, and A3 have the same

character and are grouped into a single group for purposes of

allocating this basis increase. Property A4 is in a separate

character group.

(vi) $2,000 of the basis increase must be allocated to long-

term, foreign-source capital assets because $2,000 of the gain

recognized by A was long-term, foreign-source capital gain. The

adjusted tax basis of Property A4 is therefore increased from $4,000

to $6,000. $1,000 of the increase must be allocated to Properties A1

and A2 because $1,000 of the gain recognized by A is long-term,

U.S.-source capital gain. No basis increase is allocated to Property

A3 because its fair market value is less than its adjusted tax

basis. The $1,000 basis increase is allocated between Properties A1

and A2 based on the [[Page 2364]] unrealized appreciation in each

asset before such basis adjustment. As a result, the adjusted tax

basis of Property A1 is increased by $167 ($1,000 x $500/$3,000) and

the adjusted tax basis of Property A2 is increased by $833

($1,000 x $2,500/3,000).

Sec. 1.737-4 Anti-abuse rule.

(a) In general. The rules of section 737 and Secs. 1.737-1, 1.737-

2, and 1.737-3 must be applied in a manner consistent with the purpose

of section 737. Accordingly, if a principal purpose of a transaction is

to achieve a tax result that is inconsistent with the purpose of

section 737, the Commissioner can recast the transaction for federal

tax purposes as appropriate to achieve tax results that are consistent

with the purpose of section 737. Whether a tax result is inconsistent

with the purpose of section 737 must be determined based on all the

facts and circumstances. See Sec. 1.704-4(f) for an anti-abuse rule and

examples in the context of section 704(c)(1)(B). The anti-abuse rule

and examples under section 704(c)(1)(B) and Sec. 1.704-4(f) are

relevant to section 737 and Secs. 1.737-1, 1.737-2, and 1.737-3 to the

extent that the net precontribution gain for purposes of section 737 is

determined by reference to section 704(c)(1)(B).

(b) Examples. The following examples illustrate the rules of this

section. The examples set forth below do not delineate the boundaries

of either permissible or impermissible types of transactions. Further,

the addition of any facts or circumstances that are not specifically

set forth in an example (or the deletion of any facts or circumstances)

may alter the outcome of the transaction described in the example.

Unless otherwise specified, partnership income equals partnership

expenses (other than depreciation deductions for contributed property)

for each year of the partnership, the fair market value of partnership

property does not change, all distributions by the partnership are

subject to section 737, and all partners are unrelated.

Example 1. Increase in distributee partner's basis by temporary

contribution; results inconsistent with the purpose of section 737.

(i) On January 1, 1995, A, B, and C form partnership ABC as equal

partners. A contributes Property A1, nondepreciable real property

with a fair market value of $10,000 and an adjusted tax basis of

$1,000. B contributes Property B, nondepreciable real property with

a fair market value of $10,000 and an adjusted tax basis of $10,000.

C contributes $10,000 cash.

(ii) On January 1, 1999, pursuant to a plan a principal purpose

of which is to avoid gain under section 737, A contributes to the

partnership Property A2, nondepreciable real property with a fair

market value and adjusted tax basis of $9,000. A, therefore,

increased the adjusted tax basis of A's partnership interest from

$1,000 to $10,000. The partnership agreement is amended and all

other necessary steps are taken so that substantially all of the

economic risks and benefits of Property A2 are retained by A. On

February 1, 1999, Property B is distributed to A in partial

liquidation of A's interest in the partnership. If the contribution

of Property A2 is taken into account for purposes of section 737,

there is no excess distribution because the fair market value of

distributed Property B ($10,000) does not exceed the adjusted tax

basis of A's interest in the partnership ($10,000), and therefore

section 737 does not apply. A's adjusted tax basis in distributed

Property B is $10,000 under section 732(a)(1) and the adjusted tax

basis of A's partnership interest is reduced to zero under section

733.

(iii) On March 1, 2000, A receives Property A2 from the

partnership in complete liquidation of A's interest in the

partnership. A recognizes no gain on the distribution of Property A2

because the property was previously contributed property. See

Sec. 1.737-2(d).

(iv) Although the contribution of Property A2 increases the

adjusted tax basis of A's interest in the partnership (assuming it

was a valid contribution to the partnership under section 721), it

would be inconsistent with the purpose of section 737 to recognize

the contribution of Property A2 to the partnership as in substance a

bona fide contribution of an asset used in the conduct of joint

business activity. Section 737 requires recognition of gain when the

value of distributed property exceeds the distributee partner's

adjusted tax basis in the partnership interest. Section 737 assumes

that any contribution or other transaction that affects a partner's

adjusted tax basis in the partnership interest is not a transitory

contribution or transaction engaged in with a principal purpose of

avoiding recognition of gain under section 737. Because the

contribution of Property A2 was a transitory contribution made with

a principal purpose of avoiding recognition of gain under section

737, the Commissioner can disregard the contribution of Property A2

for this purpose. As a result, A recognizes gain of $9,000 under

section 737 on the receipt of Property B, an amount equal to the

lesser of the excess distribution of $9,000 ($10,000 fair market

value of distributed Property B less the $1,000 adjusted tax basis

of A's partnership interest, determined without regard to the

transitory contribution of Property A2) or A's net precontribution

gain of $9,000 on Property A1.

Example 2. Increase in distributee partner's basis; section 752

liability shift; results consistent with the purpose of section 737.

(i) On January 1, 1995, A and B form general partnership AB as equal

partners. A contributes Property A, nondepreciable real property

with a fair market value of $10,000 and an adjusted tax basis of

$1,000. B contributes Property B, nondepreciable real property with

a fair market value and adjusted tax basis of $10,000. The

partnership also borrows $10,000 on a recourse basis and purchases

Property C. The $10,000 liability is allocated equally between A and

B under section 752, thereby increasing the adjusted tax basis in

A's partnership interest to $6,000.

(ii) On December 31, 1998, the partners agree that A is to

receive Property B in partial liquidation of A's interest in the

partnership. If A were to receive Property B at that time, A would

recognize $4,000 of gain under section 737, an amount equal to the

lesser of the excess distribution of $4,000 ($10,000 fair market

value of Property B less $6,000 adjusted tax basis in A's

partnership interest) or A's net precontribution gain of $9,000

($10,000 fair market value of Property A less $1,000 adjusted tax

basis of Property A).

(iii) With a principal purpose of avoiding such gain, A and B

agree that A will be solely liable for the repayment of the $10,000

partnership liability and take the steps necessary so that the

entire amount of the liability is allocated to A under section 752.

The adjusted tax basis in A's partnership interest is thereby

increased from $6,000 to $11,000 to reflect A's share of the $5,000

of liability previously allocated to B. As a result of this increase

in A's adjusted tax basis, there is no excess distribution because

the fair market value of distributed Property B ($10,000) is less

than the adjusted tax basis of A's partnership interest. Recognizing

A's increased adjusted tax basis as a result of the shift in

liabilities is consistent with the purpose of section 737 and this

section. Section 737 requires recognition of gain only when the

value of the distributed property exceeds the distributee partner's

adjusted tax basis in the partnership interest. The $10,000 recourse

liability is a bona fide liability of the partnership and A's and

B's agreement that A will assume responsibility for repayment of

that debt has substance. Therefore, the increase in A's adjusted tax

basis in A's interest in the partnership due to the shift in

partnership liabilities under section 752 is respected, and A

recognizes no gain under section 737.

Sec. 1.737-5 Effective date.

Sections 1.737-1, 1.737-2, 1.737-3, and 1.737-4 apply to

distributions by a partnership to a partner on or after January 9,

1995.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95-171 Filed 1-6-95; 8:45 am]

BILLING CODE 4830-01-U