Allocations of Depreciation Recapture Among Partners in a Partnership

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8730]

RIN 1545-AT32

Allocations of Depreciation Recapture Among Partners in a

Partnership

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

SUMMARY: This document contains final regulations relating to the

allocation of depreciation recapture among partners in a partnership.

The final regulations amend existing regulations to require that gain

characterized as depreciation recapture be allocated, to the extent

possible, to the partners who took the depreciation or amortization

deductions. The final regulations affect partnerships (and their

partners) that sell or dispose of certain depreciable or amortizable

property.

DATES: These regulations are effective August 20, 1997. For dates of

applicability of these regulations, see Secs. 1.704-3(f) and 1.1245-

1(e)(2)(iv).

FOR FURTHER INFORMATION CONTACT: Daniel J. Coburn, (202) 622-3050 (not

a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document amends the 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 (depreciation

recapture) is the lesser of (1) the gain realized on the disposition,

or (2) the total deductions allowed or allowable for depreciation or

amortization from the property.

On December 12, 1996, the IRS published in the Federal Register (61

[[Page 44215]]

FR 65371) a notice of proposed rulemaking (REG-209762-95) to provide

guidance on partnership allocations of depreciation recapture. Although

a public hearing was scheduled for March 27, 1997, the IRS cancelled

the hearing because it received no requests to speak.

Explanation of Provisions

I. General Background

The regulations provide guidance on allocating depreciation

recapture among partners, including depreciation recapture attributable

to contributed property.

The regulations provide that a partner's share of depreciation

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

gain arising from the disposition of the property (gain limitation) or

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

property (as defined in paragraph (e)(2)(ii) of the regulations). 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 from the property previously

taken by the partner. Any depreciation recapture that is not allocated

to a partner due to the gain limitation is allocated among those

partners whose shares of total gain on the disposition of the property

exceed their shares of depreciation or amortization from the property.

This unallocated depreciation recapture is allocated among those

partners in proportion to their relative shares of the total gain on

the disposition of the property.

The regulations provide special rules for determining a partner's

share of depreciation or amortization from contributed property subject

to section 704(c). Under the regulations, a contributing partner's

share of depreciation or amortization includes depreciation or

amortization allowed or allowable prior to contribution. In addition,

the regulations provide that curative and remedial allocations

generally reduce the contributing partner's share of depreciation or

amortization and increase the noncontributing partners' shares of

depreciation or amortization.

II. Changes in Response to Comments

In response to comments, the regulations clarify the effect of

curative and remedial allocations on the partners' shares of

depreciation or amortization from contributed property. The examples

now demonstrate that curative and remedial allocations can reduce the

contributing partner's share of depreciation or amortization to zero,

but not below zero. Once the contributing partner's share of

depreciation or amortization has been reduced to zero, the curative or

remedial allocations do not affect the contributing partner's share of

depreciation or amortization. However, the curative or remedial

allocations continue to affect the noncontributing partners' shares of

depreciation or amortization.

The regulations have also been revised to make it clear that these

amendments to the section 1245 regulations only affect how the

depreciation recapture recognized by the partnership is allocated among

the partners; they do not affect the computation of depreciation

recapture at the partnership level. The regulations recognize that even

absent a gain limitation, remedial and curative allocations may cause

the total of the partners' shares of depreciation to exceed the amount

of depreciation recapture recognized at the partnership level. In such

a case, the partnership's depreciation recapture with respect to the

contributed property is to be allocated among the partners in

proportion to their relative shares of depreciation or amortization

with respect to that property. However, no partner's share of

depreciation recapture from the property can exceed that partner's

share of the total gain arising from the disposition of the property.

Example 2 of paragraph (e)(2)(iii) of the regulations has also been

revised to demonstrate more thoroughly how recapture is allocated when

a partner's share of depreciation recapture is capped by the partner's

share of gain from the disposition of the property. As illustrated in

the example, some partnerships may find it necessary to make multiple

reallocations of depreciation recapture from a property if allocations

under the general rule (allocations in proportion to the remaining

partners' shares of gain from the disposition of the property) cause a

remaining partner's share of depreciation to exceed the partner's share

of gain from the disposition of the property.

One commentator requested that the regulations allow but not

require that partnerships allocate depreciation recapture in proportion

to the partners' shares of the gain from the disposition of the

property. This change was not made because the IRS and Treasury

continue to believe that matching depreciation recapture allocations to

depreciation allocations most appropriately carries out the policies

underlying section 1245.

A number of terminology and stylistic changes have also been made

to these regulations. These changes were made for purposes of economy

and should not be interpreted as substantive changes.

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 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, the notice of proposed

rulemaking preceding these regulations was submitted to the Small

Business Administration for comment on its impact on small business.

Drafting Information: The principal author of these regulations is

Daniel J. Coburn, Office of Assistant Chief Counsel (Passthroughs and

Special Industries), IRS. However, other personnel from the IRS and

Treasury participated in their development.

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 continues to read,

in part, as follows:

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

Par. 2. Section 1.704-3 is amended by:

(1) Adding new paragraph (a)(11).

(2) Revising paragraph (f).

The addition and revision read as follows:

Sec. 1.704-3 Contributed property.

(a) * * *

(11) Contributing and noncontributing partners' recapture shares.

For special rules applicable to the allocation of depreciation

recapture with respect to property contributed by a partner to a

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

* * * * *

(f) Effective date. With the exception of paragraph (a)(11) of this

section, this section applies to properties contributed

[[Page 44216]]

to a partnership and to restatements pursuant to Sec. 1.704-

1(b)(2)(iv)(f) on or after December 21, 1993. Paragraph (a)(11) of this

section applies to properties contributed by a partner to a partnership

on or after August 20, 1997. However, partnerships may rely on

paragraph (a)(11) of this section for properties contributed before

August 20, 1997 and disposed of on or after August 20, 1997.

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 total gain

from the disposition of the property (gain limitation) or the partner's

share of depreciation or amortization with respect to the property (as

determined under paragraph (e)(2)(ii) of this section). Any gain

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

allocated under the first sentence of this paragraph (e)(2)(i) (excess

depreciation recapture) is allocated among the partners whose shares of

total gain from the disposition of the property exceed their shares of

depreciation or amortization with respect to the property. Excess

depreciation recapture is allocated among those partners in proportion

to their relative shares of the total gain (including gain recognized

under section 1245(a)(1)) from the disposition of the property that is

allocated to the partners who are not subject to the gain limitation.

See Example 2 of paragraph (e)(2)(iii) of this section.

(ii)(A) Subject to the adjustments described in paragraphs

(e)(2)(ii)(B) and (e)(2)(ii)(C) of this section, 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.

(B) 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.

(C)(1) 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 before the property is contributed.

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

to property contributed by a partner is adjusted to account for any

curative allocations. (See Sec. 1.704-3(c) for a description of the

traditional method with curative allocations.) 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 that property and by the amount of any curative

allocation of deduction or loss (other than capital loss) to the

noncontributing partners with respect to that 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 that property and by the amount of

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

to the noncontributing partner with respect to that 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. See Example 3(iii) of paragraph (e)(2)(iii) of this

section.

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

to property contributed by a partner is 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 income to the contributing partner with respect to that

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 that property. See

Example 3(iv) of paragraph (e)(2)(iii) of this section.

(4) If, under paragraphs (e)(2)(ii)(C)(2) and (e)(2)(ii)(C)(3) of

this section, the partners' shares of depreciation or amortization with

respect to a contributed property exceed the adjustments reflected in

the adjusted basis of the property under Sec. 1.1245-2(a) at the

partnership level, then the partnership's gain recognized under section

1245(a)(1) with respect to that property is allocated among the

partners in proportion to their relative shares of depreciation or

amortization (subject to any gain limitation that might apply).

(5) This paragraph (e)(2)(ii)(C) also applies in determining 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).

(iii) 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). (To simplify this example, AB's depreciation

deductions are determined without regard to any first-year

depreciation conventions.)

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

depreciation from the partnership equipment. 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 section 1245(a)(1) gain. Under paragraph

(e)(2)(i) of this section, each partner's share of the section

1245(a)(1) gain is equal to 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(a)(1) gain is $900 (the lesser of A's

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

($900)). B's share of the section 1245(a)(1) gain is $100 (the

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

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

allocated to A is treated as ordinary income and $100 of

[[Page 44217]]

the $200 of total gain allocated to B is treated as ordinary income.

Example 2. Recapture allocation subject to gain limitation. (i)

Facts. A, B, and C form general partnership ABC. The partnership

agreement provides that depreciation deductions will be allocated

equally among the partners, but that gain from the sale of

depreciable property will be allocated 75 percent to A and 25

percent to B. ABC purchases depreciable personal property for $300

and subsequently allocates $100 of depreciation deductions each to

A, B, and C, reducing the adjusted tax basis of the property to $0.

ABC then sells the property for $440. ABC allocates $330 of the gain

to A (75 percent of $440) and allocates $110 of the gain to B (25

percent of $440). No gain is allocated to C.

(ii) Application of gain limitation. Each partner's share of

depreciation with respect to the property is $100. C's share of the

total gain from the disposition of the property, however, is $0. As

a result, under the gain limitation provision in paragraph (e)(2)(i)

of this section, C's share of section 1245(a)(1) gain is limited to

$0.

(iii) Excess depreciation recapture. Under paragraph (e)(2)(i)

of this section, the $100 of section 1245(a)(1) gain that cannot be

allocated to C under the gain limitation provision (excess

depreciation recapture) is allocated to A and B (the partners not

subject to the gain limitation at the time of the allocation) in

proportion to their relative shares of total gain from the

disposition of the property. A's relative share of the total gain

allocated to A and B is 75 percent ($330 of $440 total gain). B's

relative share of the total gain allocated to A and B is 25 percent

($110 of $440 total gain). However, under the gain limitation

provision of paragraph (e)(2)(i) of this section, B cannot be

allocated 25 percent of the excess depreciation recapture ($25)

because that would result in a total allocation of $125 of

depreciation recapture to B (a $100 allocation equal to B's share of

depreciation plus a $25 allocation of excess depreciation

recapture), which is in excess of B's share of the total gain from

the disposition of the property ($110). Therefore, only $10 of

excess depreciation recapture is allocated to B and the remaining

$90 of excess depreciation recapture is allocated to A. A is not

subject to the gain limitation because A's share of the total gain

($330) still exceeds A's share of section 1245(a)(1) gain ($190).

Accordingly, all $110 of the total gain allocated to B is treated as

ordinary income ($100 share of depreciation allocated to B plus $10

of excess depreciation recapture) and $190 of the total gain

allocated to A is treated as ordinary income ($100 share of

depreciation allocated to A plus $90 of excess depreciation

recapture).

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. Prior to the contribution, C claimed $200 of

depreciation from C1. At the time of the contribution, C1 is

depreciable under the straight-line method and has four years

remaining on its 5-year recovery period. D contributes $2,800 cash,

which CD uses to purchase depreciable personal property D1, 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. C1 generates $700 of book depreciation

(\1/4\ of $2,800 book value) and $200 of tax depreciation (\1/4\ of

$800 adjusted tax basis) each year. C and D will each be allocated

$350 of book depreciation from C1 in year 1. Under the traditional

method of making section 704(c) allocations, D will be allocated the

entire $200 of tax depreciation from C1 in year 1. D1 generates $400

of book and tax depreciation each year (\1/7\ of $2,800 book value

and adjusted tax basis). C and D will each be allocated $200 of book

and tax depreciation from D1 in year 1. 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. At the end of

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

$200 (the depreciation taken by C prior to contribution) and D's

share of depreciation with respect to C1 will be $800 (four years of

$200 depreciation per year). At the end of four years, C and D will

each have an $800 share of depreciation with respect to D1 (four

years of $200 depreciation per year).

(iii) Effect of curative allocations. (A) Year 1. If the

partnership elects to make curative allocations under Sec. 1.704-

3(c) using depreciation from D1, the results will be the same as

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

depreciation from D1 that would be 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)). 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)). C and D will each have a $200 share of

depreciation with respect to D1.

(B) Year 4. At the end of four years, C's share of depreciation

with respect to C1 will be reduced to $0 (the total depreciation

taken by C prior to contribution ($200) decreased, but not below

zero, by the amount of the curative allocations to D ($600)), and

D's share of depreciation with respect to C1 will be $1,400 (the

total depreciation allocated to D under the traditional method

($800) increased by the amount of the curative allocations to D

($600)). However, CD's section 1245(a)(1) gain with respect to C1

will not be more than $1,000 (CD's tax depreciation ($800) plus C's

tax depreciation prior to contribution ($200)). Under paragraph

(e)(2)(ii)(C)(4) of this section, because the partners' shares of

depreciation with respect to C1 exceed the adjustments reflected in

the property's adjusted basis, CD's section 1245(a)(1) gain will be

allocated in proportion to the partners' relative shares of

depreciation with respect to C1. Because C's share of depreciation

with respect to C1 is $0, and D's share of depreciation with respect

to C1 is $1,400, all of CD's $1,000 of section 1245(a)(1) gain will

be allocated to D. At the end of four years, C and D will each have

an $800 share of depreciation with respect to D1 (four years of $200

depreciation per year).

(iv) Effect of remedial allocations. (A) Year 1. If the

partnership elects to make remedial allocations under Sec. 1.704-

3(d), there will be $600 of 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, D will be allocated all $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)). C and D will each have a $200 share of depreciation with

respect to D1.

(B) Year 5. At the end of five years, C's share of depreciation

with respect to C1 will be $0 (the total depreciation taken by C

prior to contribution ($200) decreased, but not below zero, by the

total amount of the remedial allocations of income to C ($600)). D's

share of depreciation with respect to C1 will be $1,400 (the total

depreciation allocated to D under the traditional method ($800)

increased by the total amount of the remedial allocations of

depreciation to D ($600)). However, CD's section 1245(a)(1) gain

with respect to C1 will not be more than $1,000 (CD's tax

depreciation ($800) plus C's tax depreciation prior to contribution

($200)). Under paragraph (e)(2)(ii)(C)(4) of this section, because

the partners' shares of depreciation with respect to C1 exceed the

adjustments reflected in the property's adjusted basis, CD's section

1245(a)(1) gain will be allocated in proportion to the partners'

relative shares of depreciation with respect to C1. Because C's

share of depreciation with respect to C1 is $0, and D's share of

depreciation with respect to C1 is $1,400, all of CD's $1,000 of

section 1245(a)(1) gain will be allocated to D. At the end of five

years, C and D will each have a $1,000 share of depreciation with

respect to D1 (five years of $200 depreciation per year).

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

properties acquired by a partnership on or after August 20,

[[Page 44218]]

1997. However, partnerships may rely on this paragraph (e)(2) for

properties acquired before August 20, 1997 and disposed of on or after

August 20, 1997.

* * * * *

Michael P. Dolan,

Acting Commissioner of Internal Revenue.

Approved: July 8, 1997.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 97-22019 Filed 8-19-97; 8:45 am]

BILLING CODE 4830-01-U