Allocations of Depreciation Recapture Among Partners in a Partnership

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-209762-95]

RIN 1545-AT32

Allocations of Depreciation Recapture Among Partners in a

Partnership

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations relating to the

allocation of depreciation recapture among partners in a partnership.

The proposed regulations amend existing regulations to require that any

gain characterized as depreciation recapture must be allocated to each

partner in an amount equal to the lesser of the partner's share of

total gain from the sale of the property or the partner's share of

depreciation from the property. The proposed regulations affect

partnerships and their partners. This document also contains a notice

of public hearing on the proposed regulations.

DATES: Written comments must be received by March 6, 1997. Outlines of

oral comments and requests to speak at the public hearing scheduled for

March 27, 1997, at 10 a.m., must be received by March 6, 1997.

ADDRESSES: Send submissions to CC:DOM:CORP:R [REG-209762-95], room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered between the

hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R [REG-209762-95], Courier's

Desk, Internal Revenue Service, 1111 Constitution Avenue, NW.,

Washington, DC. Alternatively, taxpayers may submit comments

electronically via the Internet by selecting the ``Tax Regs'' option on

the IRS Home Page, or by submitting comments directly to the IRS

Internet site at http://www.irs.ustreas.gov/prod/tax__regs/

comments.html. The public hearing will be held in room 3313, Internal

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

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Daniel

J. Coburn or Deborah Harrington, (202) 622-3050 (not a toll-free

number); concerning submissions and the hearing, Evangelista Lee,

(202) 622-7190 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document proposes to change the current Income Tax Regulations

(26 CFR part 1) relating to the characterization and allocation of

depreciation recapture among partners in a partnership.

Section 1245 of the Internal Revenue Code requires taxpayers to

recharacterize as ordinary income some or all of the gain on the

disposition of certain types of business properties. The amount

recharacterized as ordinary income (recapture gain) is the lesser of:

(a) the gain realized on disposition, or (b) the total deductions

allowed or allowable for depreciation or amortization from the

property. Section 1.1245-1(e)(2) of the Income Tax Regulations

currently provides that each partner's share of recapture gain will

generally be determined in accordance with the provisions of section

704. The regulations also provide that, if the partnership agreement

provides for the allocation of total gain from the property but does

not provide for the allocation of recapture gain, recapture gain is

allocated in the same manner as total gain.

The current regulations create some uncertainty because it is

unclear how recapture gain is allocated under section 704. The

allocation of recapture gain cannot have substantial economic effect

because classifying a portion of the gain as recapture gain merely

changes the tax character of the gain. In addition, by allowing the

partnership to allocate recapture gain in the same manner as total

gain, the current regulations increase the possibility that a partner

may receive an allocation of recapture gain in excess of the partner's

share of depreciation from the property. For example, if a partner

acquires an interest in a partnership that has fully depreciated the

property and the property is subsequently sold at a gain, the partner

may be allocated a portion of the total gain and a portion of the

recapture gain, even though the partner did not receive any

depreciation deductions from the property. This mismatch between

depreciation allocations and recapture allocations should be minimized

because recapture gain is intended to offset the earlier depreciation

deductions taken from the property and should therefore be allocated to

the extent possible to the partner that received those depreciation

deductions. Finally, the current regulations do not provide guidance on

the allocation of recapture gain from contributed property subject to

section 704(c). In the legislative history of the 1984 amendment to

section 704(c), Congress suggested that Treasury and the Service issue

regulations governing the allocation of recapture gain inherent in

property contributed to a partnership. See H.R. Rep. No. 861, 98th

Cong., 2d Sess. 857 (1984); see also Staff of the Joint Comm. on

Taxation, 98th Cong., 2d Sess., General Explanation of the Revenue

Provisions of the Deficit Reduction Act of 1984 214 (Comm. Print 1984).

In the 1994 preamble to the section 704(c) final regulations, Treasury

and the Service indicated that this issue would be considered in a

separate regulations project. 59 FR 66,726 (1994).

Explanation of Provisions

The proposed regulations provide guidance on allocating recapture

gain among partners, including recapture gain attributable to

contributed property. The proposed regulations provide that a partner's

share of recapture gain is equal to the lesser of (1) the partner's

share of total gain arising from the disposition of the property, or

(2) the partner's share of depreciation or amortization from the

property. This rule seeks to insure, to the extent possible, that a

partner recognizes recapture on the disposition of property in an

amount equal to the depreciation or amortization deductions previously

taken by the partner on the property. If recapture gain remains

unallocated under the general rule, the remaining unallocated gain is

allocated among those partners whose shares of total gain on the

disposition of the property exceed their shares of depreciation or

amortization with respect to the property. Recapture gain may be

unallocated under the general rule if, for example, the total gain

allocated to a partner on the sale of the property is less than the

amount of depreciation previously allocated to that partner.

The proposed regulations provide special rules for determining a

partner's share of depreciation or amortization from contributed

property subject to section 704(c). The proposed regulations provide

that a contributing partner's share of depreciation or amortization

includes depreciation or amortization allowed or allowable prior to

contribution. In addition, the proposed regulations provide that

curative and

[[Page 65372]]

remedial allocations generally reduce the contributing partner's share

of depreciation or amortization and increase the noncontributing

partners' shares of depreciation or amortization.

Treasury and the Service request comments on whether these special

rules can be incorporated into accounting systems that track section

704(c) allocations for partnerships with multiple section 704(c)

properties.

Proposed Effective Date

These amendments are proposed to apply to properties acquired by a

partnership on or after the date the regulations are published as final

regulations in the Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) does not apply to these regulations, and, because the

regulations do not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Internal Revenue Code, this

notice of proposed rulemaking will be submitted to the Chief Counsel

for Advocacy of the Small Business Administration for comment on its

impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

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

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

comments will be available for public inspection and copying.

A public hearing has been scheduled for March 27, 1997, at 10:00

a.m. in room 3313 of the Internal Revenue Building, 1111 Constitution

Avenue, NW., Washington, DC. Because of access restrictions, visitors

will not be admitted beyond the Internal Revenue Building lobby more

than 15 minutes before the hearing starts.

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

Persons that wish to present oral comments at the hearing must

submit written comments by March 6, 1997, and submit an outline of the

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

original and eight (8) copies) by March 6, 1997.

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

comments.

An agenda showing the scheduling of the speakers will be prepared

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

agenda will be available free of charge at the hearing.

Drafting Information: The principal authors of these regulations

are Daniel J. Coburn and Deborah Harrington, Office of Assistant

Chief Counsel (Passthroughs and Special Industries), IRS. However,

other personnel from the IRS and Treasury Department participated in

their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements. Proposed

Amendments to the Regulations

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

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read,

in part, as follows:

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

Par. 2. Section 1.704-3 is amended as follows:

1. Paragraphs (a)(9) and (a)(10) are redesignated as paragraphs

(a)(10) and (a)(11), respectively.

2. New paragraph (a)(9) is added.

The addition reads as follows:

Sec. 1.704-3 Contributed property.

(a) * * *

(9) Contributing and noncontributing partners' recapture shares.

For special rules applicable to the allocation of recapture gain with

respect to property contributed by a partner to a partnership, see

Secs. 1.1245-1(e)(2) and 1.1250-1(f).

* * * * *

Par. 3. Section 1.1245-1 is amended by revising paragraph (e)(2) to

read as follows:

Sec. 1.1245-1 General rule for treatment of gain from dispositions of

certain depreciable property.

* * * * *

(e) * * *

(2)(i) Unless paragraph (e)(3) of this section applies, a partner's

distributive share of gain recognized under section 1245(a)(1) by the

partnership is equal to the lesser of the partner's share of the total

gain from the disposition of the property or the partner's share of the

depreciation or amortization with respect to the property. Any gain

recognized under section 1245(a)(1) by the partnership that is not

allocated under the first sentence of this paragraph is allocated among

the partners whose shares of total gain exceed their shares of

depreciation or amortization with respect to the property and is

allocated to those partners in proportion to (but not in excess of)

their shares of the total gain (including gain recognized under section

1245(a)(1)) from the disposition of the property.

(ii) A partner's share of depreciation or amortization with respect

to property equals the total amount of allowed or allowable

depreciation or amortization previously allocated to that partner with

respect to the property. If a partner transfers a partnership interest,

a share of depreciation or amortization must be allocated to the

transferee partner as it would have been allocated to the transferor

partner. If the partner transfers a portion of the partnership

interest, a share of depreciation or amortization proportionate to the

interest transferred must be allocated to the transferee partner.

(iii)(A) A partner's share of depreciation or amortization with

respect to property contributed by the partner includes the amount of

depreciation or amortization allowed or allowable to the partner for

the period prior to the property's contribution.

(B) The partners' shares of depreciation or amortization with

respect to property contributed by a partner must be adjusted to

account for any curative allocations. (See Sec. 1.704-3(c) for a

description of the curative allocation method). The contributing

partner's share of depreciation or amortization with respect to the

contributed property is decreased (but not below zero) by the amount of

any curative allocation of ordinary income to the contributing partner

with respect to the contributed property and by the amount of any

curative allocation of deduction or loss (other than capital loss)

allocated to the noncontributing partners with respect to the

contributed property. A noncontributing partner's share of depreciation

or amortization with respect to the contributed property is increased

by the noncontributing partner's share of any curative allocation of

ordinary income to the contributing partner with respect to the

contributed property and by the amount of any curative allocation of

deduction or loss (other than capital loss) allocated to the

noncontributing partner with respect to the contributed property. The

partners' shares of depreciation or amortization with respect to

property from which curative allocations of depreciation or

amortization are taken is determined without regard to those curative

allocations.

[[Page 65373]]

(C) The partners' shares of depreciation or amortization with

respect to property contributed by a partner must be adjusted to

account for any remedial allocations. (See Sec. 1.704-3(d) for a

description of the remedial allocation method.) The contributing

partner's share of depreciation or amortization with respect to the

contributed property is decreased (but not below zero) by the amount of

any remedial allocation of ordinary income to the contributing partner

with respect to the contributed property. A noncontributing partner's

share of depreciation or amortization with respect to the contributed

property is increased by the amount of any remedial allocation of

depreciation or amortization to the noncontributing partner with

respect to the contributed property.

(D) The principles of this paragraph (e)(2)(iii) apply in

determining the effect of remedial or curative allocations on a

partner's share of depreciation or amortization with respect to

property for which differences between book value and adjusted tax

basis are created when a partnership revalues partnership property

pursuant to Sec. 1.704-1(b)(2)(iv)(f).

(iv) Examples. The application of this paragraph (e)(2) may be

illustrated by the following examples:

Example 1. Recapture allocations. (i) Facts. A and B each

contribute $5,000 cash to form AB, a general partnership. The

partnership agreement provides that depreciation deductions will be

allocated 90 percent to A and 10 percent to B, and, on the sale of

depreciable property, A will first be allocated gain to the extent

necessary to equalize A's and B's capital accounts. Any remaining

gain will be allocated 50 percent to A and 50 percent to B. In its

first year of operations, AB purchases depreciable equipment for

$5,000. AB depreciates the equipment over its 5-year recovery period

and elects to use the straight-line method. In its first year of

operations, AB's operating income equals its expenses (other than

depreciation).

(ii) Year 1. In its first year of operations, AB has $1,000 of

depreciation from the partnership equipment. (To simplify this

example, the partnership's depreciation deductions are determined

without regard to any first-year depreciation conventions.) In

accordance with the partnership agreement, AB allocates 90 percent

($900) of the depreciation to A and 10 percent ($100) of the

depreciation to B. At the end of the year, AB sells the equipment

for $5,200, recognizing $1,200 of gain ($5,200 amount realized less

$4,000 adjusted tax basis). In accordance with the partnership

agreement, the first $800 of gain is allocated to A to equalize the

partners' capital accounts, and the remaining $400 of gain is

allocated $200 to A and $200 to B.

(iii) Recapture allocations. $1,000 of the gain from the sale of

the equipment is treated as gain recognized under section

1245(a)(1). Under paragraph (e)(2)(i) of this section, each

partner's share of this section 1245 gain is the lesser of the

partner's share of total gain recognized on the sale of the

equipment or the partner's share of total depreciation with respect

to the equipment. Thus, A's share of the section 1245 gain is $900

(the lesser of A's share of total gain ($1,000) and A's share of

depreciation ($900)) and B's share of the section 1245 gain is $100

(the lesser of B's share of total gain ($200) and B's share of

depreciation ($100)). Accordingly, $900 of the $1,000 of total gain

allocated to A will be treated as ordinary income and $100 of the

$200 of total gain allocated to B will be treated as ordinary

income.

Example 2. Recapture allocation limited by gain share. Assume

the same facts as in Example 1, except that the partnership

agreement provides that gains and losses from the sale of

depreciable property will be allocated equally between the partners.

On the sale of the equipment, the partnership's total gain of $1,200

is allocated $600 to A and $600 to B. Under paragraph (e)(2)(i) of

this section, A's share of the section 1245 gain is limited to $600

(the amount of total gain allocated to A) even though A's share of

the total depreciation from the equipment was $900. The remaining

$400 of section 1245 gain must be allocated to B. Accordingly, all

$600 of total gain allocated to A is treated as ordinary income and

$400 of the $600 of total gain allocated to B is treated as ordinary

income.

Example 3. Determination of partners' shares of depreciation

with respect to contributed property. (i) Facts. C and D form

partnership CD as equal partners. C contributes depreciable personal

property C1 with an adjusted tax basis of $800 and a fair market

value of $2,800. D contributes $2,800 cash. Prior to contributing

C1, C claimed $200 of depreciation from C1. At the time of

contribution, C1 has four years remaining on its 5-year recovery

period and is depreciable under the straight-line method. At the

time CD is formed, it purchases depreciable personal property D1 for

$2,800, which is depreciable over seven years under the straight-

line method. (To simplify the example, all depreciation is

determined without regard to any first-year depreciation

conventions).

(ii) Traditional method. C and D will each be allocated $350 of

the total of $700 of book depreciation from C1 in year 1. Under the

traditional method of making section 704(c) allocations, C will not

be allocated any tax depreciation from C1 and D will be allocated

the entire $200 of tax depreciation from C1. C and D will each be

allocated $200 of book and tax depreciation from D1. As a result,

after the first year of partnership operations, C's share of

depreciation with respect to C1 is $200 (the depreciation taken by C

prior to contribution) and D's share of depreciation with respect to

C1 is $200 (the amount of tax depreciation allocated to D). C and D

each have a $200 share of depreciation with respect to D1.

(iii) Effect of curative allocations. If the partnership elects

to make curative allocations under Sec. 1.704-3(c) using

depreciation from D1, the results in year 1 will be the same as

under the traditional method, except that $150 of the $200 of tax

depreciation from D1 that would have been allocated to C under the

traditional method will be allocated to D as additional depreciation

with respect to C1. As a result, after the first year of partnership

operations, C's share of depreciation with respect to C1 will be

reduced to $50 (the total depreciation taken by C prior to

contribution ($200) decreased by the amount of the curative

allocation to D ($150)). C's share of depreciation with respect to

D1 will still be $200 and D's share of depreciation with respect to

C1 will be $350 (the depreciation allocated to D under the

traditional method ($200) increased by the amount of the curative

allocation to D ($150)). D's share of depreciation with respect to

D1 will still be $200.

(iv) Effect of remedial allocations. If the partnership elects

the remedial allocation method for making section 704(c) allocations

under Sec. 1.704-3(d), there will be $600 of total book depreciation

from C1 in year 1. (Under the remedial allocation method, the amount

by which C1's book basis ($2,800) exceeds its tax basis ($800) is

depreciated over a 5-year life, rather than a 4-year life). C and D

will each be allocated one-half ($300) of the total book

depreciation. As under the traditional method, C will be allocated

$0 of tax depreciation from C1 and D will be allocated $200 of tax

depreciation from C1. Because the ceiling rule would cause a

disparity of $100 between D's book and tax allocations of

depreciation, D will also receive a $100 remedial allocation of

depreciation with respect to C1, and C will receive a $100 remedial

allocation of income with respect to C1. As a result, after the

first year of partnership operations, D's share of depreciation with

respect to C1 is $300 (the depreciation allocated to D under the

traditional method ($200) increased by the amount of the remedial

allocation ($100)). C's share of depreciation with respect to C1 is

$100 (the total depreciation taken by C prior to contribution ($200)

decreased by the amount of the remedial allocation of income

($100)). As under the traditional method, C and D each have a $200

share of depreciation with respect to D1.

(v) Effective date. This paragraph (e)(2) is effective for

properties acquired by the partnership on or after [the date the

regulations are published as final regulations in the Federal

Register].

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 96-31364 Filed 12-11-96; 8:45 am]

BILLING CODE 4830-01-U