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

[T.D. 8642]

RIN 1545-AR48; 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: Final regulations.

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SUMMARY: This document contains final 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 final

regulations relating to the recognition of gain on certain

distributions to a contributing partner under section 737. The final

regulations affect partnerships and their partners and are necessary to

provide guidance for complying with the applicable tax law.

EFFECTIVE DATE: These regulations are effective for January 9, 1995.

FOR FURTHER INFORMATION CONTACT: Stephen J. Coleman, (202) 622- 3060

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The Revenue Reconciliation Act of 1989 added section 704(c)(1)(B)

and section 704(c)(2) to the Internal Revenue 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, 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 an exception for distributions of certain

like-kind property.

The Energy Policy Act of 1992 added section 737 to the Code.

Section 737 requires a partner who contributes appreciated property to

recognize gain on a subsequent distribution of other property to the

contributing partner to the extent of the lesser of (i) the net

precontribution gain on property contributed 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.

On January 9, 1995, a notice of proposed rulemaking (PS-76-92; PS-

51-93) under section 704(c)(1)(B) and section 737 was published in the

Federal Register (60 FR 2352). Written comments responding to this

notice were received. No public hearing was held because no hearing was

requested. After consideration of all comments received, the proposed

regulations under section 704(c)(1)(B) and section 737 are adopted as

revised by this Treasury decision.

Summary of Significant Comments and Revisions

The significant comments on the proposed regulations and the

revisions made in the final regulations are discussed below.

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

Determination of Gain and Loss

The proposed regulations provide that section 704(c)(1)(B) applies

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, and not to a transaction or distribution

that is subject to provisions other than section 731(a) or section 737.

Comments requested that the provision be clarified. The final

regulations clarify that section 704(c)(1)(B) applies only to the

extent that a transaction is a distribution under section 731.

References to transactions and distributions not subject to section

704(c)(1)(B) have been deleted.

One commentator suggested certain clarifying revisions to the

proposed regulations' definition of fair market value. The definition

in the proposed regulations, however, is identical to the definition of

fair market value in the 704(b) regulations, and distributed property

should have the same fair market value for purposes of determining gain

and loss under section 704(c)(1)(B) and determining capital account

adjustments under section 704(b). The final regulations therefore adopt

the definition in the proposed regulations without change.

The proposed regulations provide that the amount of gain or loss

resulting from a distribution of partnership property is determined as

if the distributed property had been sold by the partnership to the

distributee partner. As a result, if built-in loss property is

distributed to a partner that holds more than a 50 percent interest in

partnership capital or profits, the built-in loss that otherwise would

be recognized is disallowed under section 707(b)(1)(A). One commentator

suggested that section 704(c)(1)(B) was intended to address disguised

sales between partners and that, therefore, a loss should be disallowed

on a distribution only if it would be disallowed on a direct sale

between the partners. Section 704(c)(1)(B), however, respects the form

of the transaction as between the partnership and a partner and does

not recast the transaction as a disguised sale. See H.R. Rep. No. 247,

101st Cong., 1st Sess. 406 (1989). The final regulations therefore

adopt the proposed regulations without change.

Several of the provisions in the proposed regulations refer to

distributions that are part of ``the same plan or arrangement.''

Commentators requested clarification of this term. The reference to

distributions that are part of the same plan or arrangement was

[[Page 66728]]

intended to reflect the fact that distributions of multiple properties

to one partner or distributions of different properties to more than

one partner over a period of time may be treated as part of the same

distribution under general principles of taxation, such as the step

transaction doctrine. The final regulations remove the reference to

``same plan or arrangement'' and refers to distributions that are part

of the same distribution. This change is made for simplification only

and is not intended as a substantive change to the scope of a

distribution for tax purposes. As under current law, distributions do

not need to be contemporaneous to be part of the same distribution.

Several comments were received regarding the effect of a

partnership termination under section 708(b)(1)(B). One comment

suggested that it was not clear whether property that had previously

been contributed to the partnership (and was therefore already subject

to a five-year period) was subject to a new five- year period after the

termination. The final regulations clarify that a new five-year period

does not begin to the extent of any pre-termination gain or loss that

would have been allocated to a contributing partner under section

704(c)(1)(A) on a sale of contributed property immediately before the

termination.

The legislative history of section 704(c)(1)(B) indicates that a

constructive termination does not change the application of section

704(c) to pre-contribution gain or loss on property contributed to the

partnership before termination. One comment read this legislative

history as possibly suggesting that a pro rata distribution is deemed

to occur under section 708(b)(1)(B) for section 704(c)(1)(A) purposes,

but a different distribution is deemed to occur for section

704(c)(1)(B) purposes. The comment expressed concern about the

complexity of such a system. Section 704(c)(1)(B), however, does not

require or impose such a ``hybrid system.'' The amount of gain or loss

under section 704(c)(1)(B) is determined by reference to the amount of

gain or loss that would have been allocated to the partner under

section 704(c)(1)(A) if the property had been sold. Thus, property of a

partnership that terminates under section 708(b)(1)(B) is deemed to be

distributed to the partners in the same manner for both sections.

Another comment suggested it was unclear whether section

704(c)(1)(B) could apply to property that had not been contributed by a

partner to the partnership prior to the termination. The final

regulations confirm that a new five-year period begins for all property

that is deemed contributed to the new partnership after the termination

(which would include property not actually contributed to the

partnership), except to the extent that such built-in gain or loss

would have been allocated to the contributing partner under section

704(c)(1)(A) on a sale of the contributed property immediately before

the termination.

Commentators also requested guidance on the interaction of section

708(b)(1)(B) and section 704(c) in general. The IRS and Treasury

recognize the need for additional guidance on this issue, but such

guidance is beyond the scope of these regulations. The IRS and Treasury

are considering a separate project involving the interaction of section

704(c) and section 708(b)(1)(B) and invite additional comments and

suggestions regarding the project.

Exceptions

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

apply to property contributed to the partnership on or before October

3, 1989. One commentator requested an exception for property required

to be contributed under a binding contract entered into on or before

October 3, 1989. The statutory effective date provisions, however, do

not contain a binding contract exception. Accordingly, the final

regulations adopt the proposed regulations without change.

One commentator suggested an additional exception for distributions

of an undivided interest in property. The final regulations provide

that section 704(c)(1)(B) does not apply to such a distribution to the

extent that the distributed interest does not exceed the undivided

interest contributed by the distributee partner.

One commentator also requested an additional exception for

distributions of fungible property because the partners may not be able

to track the specific contributed property. The final regulations do

not provide such an exception. Contributed property may be fungible

from an economic perspective, but such property is generally not

fungible for tax purposes because each contributed property will have

its own individual tax basis.

The proposed regulations provide an exception for distributions of

section 704(c) property to a noncontributing partner in liquidation of

the partnership if the contributing partner receives an interest in the

contributed property and the built-in gain or loss in that property is

equal to or greater than the built-in gain or loss that would have

otherwise been allocated to the contributing partner. One commentator

suggested that the exception more clearly indicate the amount of built-

in gain or loss that must be reflected in the property distributed to

the contributing partner. The final regulations clarify that the amount

of the built-in gain or loss must be equal to the gain or loss that

would have been allocated to the contributing partner under section

704(c)(1)(A) if the contributed property had been sold immediately

before the distribution.

One commentator also suggested expanding this exception to apply to

the extent of the built-in gain or loss in the property distributed to

the contributing partner. This comment is not adopted in the final

regulations. The exception was intended to apply only in the limited

situation in which a partnership liquidates and the value of the

contributed property exceeds the contributing partner's capital

account. In that situation, the portion of the contributed property in

excess of the contributing partner's capital account would have to be

distributed to another partner, thereby triggering section

704(c)(1)(B). The exception allows a partner to avoid section

704(c)(1)(B) in this situation, so long as the built-in gain or loss in

the property distributed to the contributing partner is at least equal

to the gain or loss that would have been allocated to the contributing

partner under section 704(c)(1)(A) if the contributed property had been

sold immediately before the distribution.

Special Rules

The proposed regulations provide a special rule under section

704(c)(2) for situations in which the partnership distributes like-kind

property to a contributing partner within a specified period of the

distribution of the property contributed by that partner. Under this

rule, the gain or loss that otherwise would have been recognized on the

distribution of the contributed property is reduced by the amount of

the contributing partner's built-in gain or loss in the distributed

like-kind property. One commentator criticized this rule as

inconsistent with the statutory provision.

Section 704(c)(2) provides that ``[u]nder regulations prescribed by

the Secretary, * * * to the extent of the value of the [like-kind

property distributed to the contributing partner, the calculation of

the contributing partner's gain or loss attributable to the

distribution of the contributed property] shall be [determined] as if

the contributing partner had contributed to the partnership the [like-

kind] property.'' This provision is generally intended to treat the

contributing partner as if the partner had exchanged

[[Page 66729]]

the contributed property for like-kind property in a nontaxable

exchange outside of the partnership. This allows the contributing

partner to avoid recognition of gain or loss under section 704(c)(1)(B)

on the distribution of the contributed property to another partner

because the contributing partner is treated as having contributed the

like-kind property, not the property that is actually distributed to

the other partner.

If the contributing partner, however, had engaged in a like- kind

exchange outside of the partnership, the partner's built-in gain or

loss in the like-kind property received would have been the same as the

property that was surrendered. The rule in the proposed regulations

reflects this result by limiting the application of section 704(c)(2)

to the extent that the built-in gain or loss in the contributed

property is not preserved in the like-kind property distributed to the

contributing partner. The IRS and Treasury continue to believe that the

regulations properly implement Congress' objective with respect to this

provision. Therefore, the regulations are finalized without change.

One commentator also suggested a clarification of the interaction

of the like-kind exception and the disguised sale rules of

707(a)(2)(B). The proposed regulations provide that the like-kind

exception reduces any gain that would have otherwise been recognized

under section 704(c)(1)(B). The proposed regulations also provide that

section 704(c)(1)(B) applies only to a distribution to a partner within

the meaning of section 731. There is no suggestion in section 704(c)(2)

or the proposed regulations that the like-kind exception was intended

as an exception to the disguised sale provisions. The final regulations

confirm that the disguised sale provisions can apply to a distribution,

even if the distribution would otherwise have qualified for the section

704(c)(2) like-kind exception.

Anti-Abuse Rule

Commentators made several suggestions for clarifying or modifying

the anti-abuse rule in the proposed regulations. In particular, these

commentators requested clarification of the relationship between this

rule and the general partnership anti-abuse rule in Treas. Reg. section

1.701-2. The general anti-abuse regulation is a rule of general

applicability that provides general principles to be applied in

interpreting and applying all of the provisions of subchapter K. In

certain situations, however, more specific anti-abuse rules are needed

to carry out the purpose of a particular provision. The final

regulations therefore adopt the rule in the proposed regulations

without modification.

B. Section 737

Determination of Gain

The final regulations are clarified to provide that section 737

applies only to the extent that a transaction is a distribution under

section 731. In accordance with section 737(d)(2), the final

regulations also provide that section 737 does not apply to the extent

that section 751(b) applies to the distribution.

Net Precontribution Gain

The proposed regulations provide that a distributee partner's net

precontribution gain is determined without regard to the like-kind

exception of section 704(c)(2) in situations in which the contributed

property is not actually distributed to another partner. One

commentator suggested deleting this provision as superfluous. The final

regulations adopt the proposed regulations without change. This

provision clarifies that section 737 does not contain a like-kind

exception similar to the exception in section 704(c)(2). Section 737

applies even if the property received by the partner is of a like-kind

with the contributed property.

Character of Gain

One commentator suggested that the proposed regulations fail to

clarify whether there are two groups (ordinary and capital) for

purposes of determining the character of a partner's net

precontribution gain or whether there may be an additional section 1231

group or section 1245 and section 1250 groups. The final regulations

adopt the proposed regulations without change.

The proposed regulations provide that character for purposes of a

partner's net precontribution gain is determined as if the contributed

property were sold to an unrelated third party. As a result, all of the

provisions that are relevant in determining the character of gain or

loss on a sale are relevant in determining the character of the net

precontribution gain. For example, if the sale of property would have

resulted in part capital gain and part ordinary income, the character

of the net precontribution gain for that property is part ordinary and

part capital. The same approach applies in determining the allocation

of any adjustment to the partnership's basis in partnership property as

a result of gain recognized by the distributee partner. A basis

adjustment attributable to gain treated as capital gain under section

1231 would be allocated to the property that entered into the

calculation of the amount of section 1231 gain.

One commentator also suggested that the proposed regulations do not

clarify whether character is determined at the partnership or the

partner level. This determination may be important in situations such

as section 1231 where the character of the gain or loss may depend on

the partner's particular tax circumstances. The final regulations

clarify that the character of the gain or loss is determined at the

partnership level for this purpose.

Exceptions

One commentator suggested adding an exception for certain divisive

transactions in which the contributing partner continued to own an

indirect interest in the contributed property. The final regulations

add a new exception under which section 737 does not apply to a

transfer of contributed property by a transferor partnership to a

transferee partnership, followed by a distribution of an interest in

the transferee partnership (and no other property) to the contributing

partner in complete liquidation of the partner's interest.

This exception is added because the distributee partner has simply

converted an interest in the transferor partnership into an interest in

a transferee partnership that holds the same contributed section 704(c)

property. The limitations on this exception ensure that the partner's

basis in the transferee partnership attributable to the contributed

property is the same as the partner's basis in the transferor

partnership attributable to that property. This allows a partnership to

engage in a divisive split-up transaction, while preventing any

avoidance of section 737 that might occur as a result of the basis

allocation rules for non-liquidating distributions.

The proposed regulations provide that section 737 does not apply to

an incorporation of a partnership other than an incorporation involving

an actual distribution of partnership property to the partners. One

commentator suggested that this distinction between methods of

incorporation creates an unnecessary trap for the unwary and may have a

chilling effect on the conversion of partnerships into S corporations.

The final regulations adopt the proposed regulations without change.

The form of incorporation chosen by the partners is respected for

Federal tax purposes and, as a result, the distribution of property in

connection with the incorporation is treated as a distribution for

purposes of section 737.

[[Page 66730]]

One commentator suggested an additional exception for distributions

of an undivided interest in property similar to that described with

respect to the regulations under section 704(c)(1)(B). The final

regulations provide a comparable rule under section 737.

Anti-Abuse Rule

Commentators made several suggestions regarding the anti-abuse rule

in the proposed regulations. These suggestions are essentially the same

as the comments regarding the anti-abuse rule in the section

704(c)(1)(B) regulations, and thus the comments are discussed above.

Effective Date

These regulations are effective for distributions by a partnership

to a partner on or after January 9, 1995.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 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,

the notice of proposed rulemaking preceding these regulations was

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

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.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is 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 and loss--(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 the extent that a

distribution by a partnership is a distribution to a partner acting in

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

(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 would

not have been allocated to the contributing partner under section

704(c)(1)(A) and Sec. 1.704-3 on a sale of the contributed property to

an unrelated party immediately before the termination. 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.

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, 1997, 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

[[Page 66731]]

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 a current distribution. 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 a

current distribution. 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 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 liquidation of

the partnership if--

(i) The contributing partner receives an interest in the section

704(c) property contributed by that partner (and no other 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 under section

704(c)(1)(A) and Sec. 1.704-3 on a sale of the contributed property to

an unrelated party immediately before the distribution.

(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)(ii) 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) Complete transfer to another partnership. Section 704(c)(1)(B)

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 liquidation of the transferor partnership as

part of the same plan or arrangement. A subsequent distribution of

section 704(c) property by the transferee partnership to a partner of

the transferee partnership is subject to section 704(c)(1)(B) to the

same extent that a distribution by the transferor partnership would

have been subject to section 704(c)(1)(B). See Sec. 1.737-2(b) for a

similar rule in the context of section 737.

(5) Incorporation of a partnership. Section 704(c)(1)(B) 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

liquidated as part of the incorporation transaction. See Sec. 1.737-

2(c) for a similar rule in the context of section 737.

(6) Undivided interests. Section 704(c)(1)(B) and this section do

not apply to a distribution of an undivided interest in property to the

extent that the undivided interest does not exceed the undivided

interest, if any, contributed by the distributee partner in the same

property. See Sec. 1.737-2(d)(4) for the application of section 737 in

a similar context. The portion of the undivided interest in property

retained by the partnership after the distribution, if any, that is

treated as contributed by the distributee partner, is reduced to the

extent of the undivided interest distributed to the distributee

partner.

(7) 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. (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 built-in gain of $10,000 at the time of

contribution.

(ii) On December 31, 1998, the partnership 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

[[Page 66732]]

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 distribution 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. See Sec. 1.707-3 for provisions treating

the distribution of the like-kind property to the contributing partner

as a disguised sale in certain situations.

(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 a

current distribution. At the same time, Property X is distributed to

A in a current distribution. The distribution of Property X does not

result in the contribution of Property A being properly

characterized as a disguised sale to the partnership under

Sec. 1.707-3. 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 distribution 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 distribution 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 adjustments to partnership

property made pursuant to paragraph (e)(2) of this section are 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. 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 a

current distribution.

(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 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

[[Page 66733]]

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 desire to distribute

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

partnership. If Property A were distributed at that time, however, 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 borne by B as of December 31, 1998,

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

other partnership property are borne by 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 actual 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 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 paragraph (c) of

this section). Gain recognized under section 737 and this section is in

addition to any gain recognized under section 731.

[[Page 66734]]

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

section apply only to the extent that a distribution by a partnership

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

within the meaning of section 731, except that section 737 and this

section do not apply to the extent that section 751(b) applies to the

distribution.

(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

distribution, 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 would

have been recognized by the distributee partner under section

704(c)(1)(B) and Sec. 1.704-4 if all property that had been contributed

to the partnership by the distributee partner within five years of the

distribution and is held by the partnership immediately before the

distribution had been distributed by the partnership to another partner

other than a partner who owns, directly or indirectly, more than 50

percent of the capital or profits interest in the partnership. 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 distribution 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 distribution 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)(3) 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. Character

is determined at the partnership level for this purpose, and 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

[[Page 66735]]

is allocated $1,000 of book depreciation per 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 contributes $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 a current distribution.

(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 located in the United States each

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

$6,000. B contributes Property B, nondepreciable real property

located outside the United States, 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 a current

distribution.

(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 lesser of 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 caused by 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) Transfers to another partnership--(1) Complete transfer.

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 liquidation of the transferor

partnership as part of the same plan or arrangement. See Sec. 1.704-

4(c)(4) for a similar rule in the context of section 704(c)(1)(B).

(2) Certain divisive transactions. Section 737 and this section do

not apply to a transfer by a partnership (transferor partnership) of

all of the section 704(c) property contributed by a partner to a second

partnership (transferee partnership) in an exchange described in

section 721, followed by a distribution as part of the same plan or

arrangement of an interest in the transferee partnership (and no other

property) in complete liquidation of the interest of the partner that

originally contributed the section 704(c) property to the transferor

partnership.

(3) Subsequent distributions. A subsequent distribution of property

by the transferee partnership to a partner of the transferee

partnership that was formerly a partner 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

[[Page 66736]]

partnership property to the partners followed by a contribution of that

property to a corporation), provided that the partnership is liquidated

as part of the incorporation transaction. See Sec. 1.704-4(c)(5) for a

similar rule in the context of section 704(c)(1)(B).

(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 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).

(4) Undivided interests. The distribution of an undivided interest

in property is treated as the distribution of previously contributed

property to the extent that the undivided interest does not exceed the

undivided interest, if any, contributed by the distributee partner in

the same property. See Sec. 1.704-4(c)(6) for the application of

section 704(c)(1)(B) in a similar context. The portion of the undivided

interest in property retained by the partnership after the

distribution, if any, that is treated as contributed by the distributee

partner, is reduced to the extent of the undivided interest distributed

to the distributee partner.

(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).

Example 3. Distribution of undivided interest in property. (i)

On January 1, 1995, A and B form partnership AB as equal partners. A

contributes $500 cash and an undivided one-half interest in Property

X. B contributes $500 cash and an undivided one-half interest in

Property X.

(ii) On December 31, 1998, an undivided one-half interest in

Property X is distributed to A in a current distribution. The

distribution of the undivided one-half interest in Property X is

treated as a distribution of previously contributed property because

A contributed an undivided one-half interest in Property X. As a

result, A does not recognize any gain under section 737 on the

distribution.

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

[[Page 66737]]

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 distribution 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

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 adjustments to partnership

property made pursuant to paragraph (c)(1) of this section are 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 distribution

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.

(e) 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 a

current distribution and Property A1 is distributed to B in a

current distribution. 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.-

[[Page 66738]]

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 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 transfers to the

partnership Property A2, nondepreciable real property with a fair

market value and adjusted tax basis of $9,000. A treats the transfer

as a contribution to the partnership pursuant to section 721 and

increases the adjusted tax basis of A's partnership interest from

$1,000 to $10,000. On January 1, 1999, 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 a current distribution. If the contribution of Property A2 is

treated as a contribution to the partnership 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 A has treated the transfer of Property A2 as a

contribution to the partnership that increased the adjusted tax

basis of A's interest in the partnership, it would be inconsistent

with the purpose of section 737 to recognize the transfer as a

contribution to the partnership. 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 a

contribution or transaction in substance and is not engaged in with

a principal purpose of avoiding recognition of gain under section

737. Because the transfer of Property A2 to the partnership was not

a contribution in substance and was 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 a current distribution. 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

[[Page 66739]]

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 that was undertaken for a

substantial business purpose 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.

Dated: December 13, 1995.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved:

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95-30870 Filed 12-22-95; 8:45 am]

BILLING CODE 4830-01-U