[Federal Register Volume 59, Number 248 (Wednesday, December 28, 1994)]
[Unknown Section]
[Page ]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31435]


[Federal Register: December 28, 1994]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8585]
RIN 1545-AS00


Allocations Reflecting Built-in Gain or Loss on Property 
Contributed to a Partnership

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

SUMMARY: This document contains final regulations under section 704 of 
the Internal Revenue Code relating to the remedial allocation method 
with respect to property contributed by a partner to a partnership and 
to allocations with respect to securities and similar investments owned 
by a partnership. Changes to the applicable law were made by the Tax 
Reform Act of 1984 (the 1984 Act) and the Revenue Reconciliation Act of 
1989 (the 1989 Act). The final regulations affect partnerships and 
their partners and provide guidance needed to comply with the 
applicable tax law.

EFFECTIVE DATE: These regulations are effective December 21, 1993.

FOR FURTHER INFORMATION CONTACT: Deborah Harrington at (202) 622-3050 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Introduction

    This document adds Secs. 1.704-3(d), 1.704-3(e)(3) and 1.704-
3(e)(4) to the Income Tax Regulations (26 CFR part 1) under sections 
704(c)(1)(A) and 704(c)(3), removes existing Secs. 1.704-3(e)(2)(iv) 
and 1.704-3(e)(2)(v), revises existing Secs. 1.704-1(b)(1)(vi), 1.704-
1(b)(2)(iv)(d)(3), 1.704-1(c), 1.704-3(a)(1), 1.704-3(a)(3)(i), and 
1.704-3(e)(2)(iii), and removes Sec. 1.704-3T of the Temporary Income 
Tax Regulations.

Background

    On December 22, 1993, final regulations (TD 8500, 58 FR 67676) (the 
1993 regulations) under section 704 relating to allocations with 
respect to property contributed by a partner to a partnership were 
published in the Federal Register. The 1993 regulations implement 
section 704(c) as amended by the 1984 Act and the 1989 Act. The 
portions of the 1993 regulations relating to the remedial allocation 
method and allocations with respect to securities and similar 
investments owned by a partnership were reserved. The IRS and Treasury 
contemporaneously issued temporary regulations (TD 8501, 58 FR 67684) 
(the temporary regulations) addressing the issues reserved in the final 
regulations. A notice of proposed rulemaking (58 FR 67744) cross-
referencing the temporary regulations was published in the Federal 
Register on the same day. Comments responding to the notice were 
received, and a public hearing was held on April 4, 1994. After 
considering the comments and the statements made at the hearing, the 
IRS and Treasury adopt the proposed regulations as revised by this 
Treasury decision and withdraw the temporary regulations. The IRS and 
Treasury also amend the 1993 regulations as described by this Treasury 
decision.

Explanation of Provisions

Remedial Allocation Method

    The final regulations generally adopt the provisions of the 
proposed regulations with respect to the remedial allocation method of 
making allocations under section 704(c). Accordingly, under the final 
regulations, a partnership may eliminate ceiling rule distortions by 
making remedial allocations of income, gain, loss, or deduction to the 
noncontributing partners equal to the full amount of the limitation 
caused by the ceiling rule, and offsetting those allocations with 
remedial allocations of deduction, loss, gain, or income to the 
contributing partner. In response to comments, the final regulations 
emphasize that the remedial allocation method involves the creation of 
notional tax items by the partnership and is not dependent upon the 
actual tax items recognized by the partnership.
    One comment questioned the Secretary's authority to issue 
regulations allowing partnerships to create notional tax items in order 
to make allocations under section 704(c). In enacting section 704(c), 
Congress gave the Secretary broad authority to permit allocations that 
correct ceiling rule distortions. See H.R. Rep. No. 98-432 (Part 2), 
98th Cong., 2d Sess. 1209 (1984). Offering partnerships a voluntary 
method of correcting ceiling rule distortions by creating notional tax 
items is consistent with this congressional grant of authority.
    One comment suggested that the final regulations adopt the remedial 
allocation method as a safe harbor method for making section 704(c) 
allocations. Another comment suggested that the remedial allocation 
method be a baseline for measuring whether the section 704(c) method 
used by a partnership has the effect of substantially reducing the 
present value of the aggregate tax liabilities of the partners for 
purposes of the anti-abuse rule set forth in Sec. 1.704-3(a)(10).
    The IRS and Treasury continue to believe it is appropriate to 
require that all allocation methods, including the remedial allocation 
method, be subject to the anti-abuse rule. There may be circumstances 
under which contributions of property could be made and the remedial 
allocation method adopted with a view to shifting tax consequences 
impermissibly. It would be inconsistent with the general scope of these 
regulations to prescribe a method of allocation that is always 
reasonable regardless of the facts and circumstances. Furthermore, the 
IRS and Treasury believe that it would be inappropriate to adopt the 
remedial allocation method as a baseline for measuring whether the 
partners' aggregate tax liability has been reduced. Such a baseline 
would make the remedial allocation method preeminent, undercutting its 
elective nature.
    One comment suggested that the regulations require partnerships to 
elect the remedial allocation method in their partnership agreements. 
The comment did not specify any reason for imposing this requirement on 
partnerships.
    The section 704(c) regulations generally allow partnerships to 
choose a reasonable section 704(c) method. The regulations only require 
adoption of an allocation method in the partnership agreement for those 
section 704(c) methods that have a significant potential for abuse. See 
Secs. 1.704-3(c)(3)(ii) and 1.704-3(c)(3)(iii)(B) of the 1993 
regulations. The use of the remedial allocation method can generally be 
determined from the partnership's books and records. Therefore, the 
final regulations do not require that the method be adopted in the 
partnership agreement.
    The temporary and proposed regulations require that a partnership 
using the remedial allocation method recover the portion of its book 
basis in the property equal to its tax basis in the property at the 
time of contribution in the same manner as the tax basis is recovered. 
The remainder of the partnership's book basis in the property (the 
amount by which book basis exceeds adjusted tax basis) is recovered 
using any applicable recovery period and depreciation (or other cost 
recovery) method available to the partnership for newly purchased 
property placed in service at the time of contribution. The final 
regulations clarify that the recovery period and depreciation (or other 
cost recovery) method adopted by the partnership for this purpose must 
be one that is available for newly purchased property of the type 
contributed, including any applicable first-year conventions.
    Under the temporary and proposed regulations, remedial allocations 
are reasonable only if they have the same effect on each partner's tax 
liability as the item limited by the ceiling rule. Some comments 
requested clarification of this provision.
    In response to these comments, the final regulations provide that 
the tax attributes of remedial allocations of income, gain, loss, or 
deduction to noncontributing partners must be the same as the tax 
attributes of the items limited by the ceiling rule. The tax attributes 
of offsetting remedial allocations of income, gain, loss, or deduction 
to the contributing partner are determined by reference to the items 
limited by the ceiling rule. Thus, for example, if the ceiling rule 
limited item is loss from the sale of contributed property, the 
offsetting remedial allocation to the contributing partner must be gain 
from the sale of that property. If the ceiling rule limited item is 
depreciation or other cost recovery from the contributed property, the 
offsetting remedial allocation to the contributing partner must be 
income of the type produced (directly or indirectly) by that property.
    Any partner level attributes are determined at the partner level. 
The tax attributes of a remedial allocation at the partner level are 
determined by treating the remedial allocation as if it were related to 
the same activity, investment, or business as the item limited by the 
ceiling rule. For instance, a remedial allocation of depreciation to a 
noncontributing partner will not be subject to section 469 (passive 
activity loss) limitations if the noncontributing partner materially 
participates in the activity in which the contributed property is used. 
However, the offsetting remedial allocation of income to the 
contributing partner will be treated as income from a passive activity 
if the contributing partner does not materially participate in the 
activity in which the contributed property is used. See section 469.
    Several comments requested that the regulations clarify the effect 
of remedial allocations on other tax computations, such as the 
partnership's basis in the section 704(c) property to which the 
allocation relates and the basis of the partner's partnership interest. 
The final regulations clarify that remedial allocations have the same 
effect on a partner's tax liability as other tax items actually 
recognized by the partnership and have the same effect on the adjusted 
tax basis of the partner's partnership interest.
    The final regulations also clarify that, because remedial 
allocations to noncontributing partners and offsetting remedial 
allocations to the contributing partner net to zero at the partnership 
level, remedial allocations do not affect the partnership's computation 
of its taxable income under section 703. Remedial allocations also do 
not affect the partnership's adjusted tax basis in partnership property 
(and, consequently, do not affect the aggregate amount of depreciation 
recapture income recognized by the partnership on the sale of the 
property).
    Some comments requested that the final regulations address the 
allocation of gain from section 704(c) property that is treated as 
ordinary income under sections 1245 or 1250 (depreciation recapture). 
One comment suggested that the regulations require partnerships to 
allocate depreciation recapture from section 704(c) property based on 
the partners' relative shares of depreciation or amortization from the 
property, rather than on their shares of gain or loss from the 
property. See Secs. 1.1245-1(e)(2) and 1.1250-1(f).
    The IRS and Treasury do not believe this issue is appropriately 
addressed in regulations issued under section 704(c); however, this 
issue is under review and consideration is being given to amending the 
regulations under sections 1245 and 1250 to incorporate the rule 
suggested by these comments. Additional comments on the proper 
allocation of depreciation recapture income by a partnership, both 
inside and outside of the section 704(c) context, are welcomed.
    The temporary and proposed regulations provide that the IRS will 
not require a partnership to use the remedial allocation method 
described in Sec. 1.704-3T(d). In response to a comment, the final 
regulations clarify that the IRS may not force a partnership to use any 
other method involving the creation of notional tax items.
    Several comments requested that the final regulations clarify the 
interaction between the remedial allocation method and other Code 
provisions, notably sections 743, 752, and 754. The IRS and Treasury 
have determined that these issues would be better addressed in other 
guidance. To give the IRS and Treasury flexibility in addressing these 
issues in the future, the final regulations provide that the 
Commissioner may, by published guidance, prescribe adjustments to the 
remedial allocation method as necessary or appropriate. This guidance 
may, for example, prescribe adjustments to the remedial allocation 
method to prevent the duplication or omission of items of income or 
deduction or to reflect more clearly the partners' income or the income 
of a transferee of a partner.

Securities Aggregation

    The frequency of capital account restatements under Sec. 1.704-
1(b)(2)(iv)(f) and the number of partnership assets may make it 
impractical for certain securities partnerships to make reverse section 
704(c) allocations on an asset-by-asset basis. Therefore, the temporary 
and proposed regulations permit certain securities partnerships to 
aggregate gains and losses from securities or similar instruments when 
making reverse section 704(c) allocations. The temporary and proposed 
regulations define a securities partnership as one that: (1) is 
diversified as defined in section 851(b)(4), (2) has at least 90 
percent of its non-cash assets in stock, securities, commodities, 
options, warrants, futures, or similar investments that are readily 
tradeable on an established securities market, (3) either is registered 
as a management company with the Securities and Exchange Commission 
under the Investment Company Act of 1940, as amended (15 U.S.C. 80a) 
(the 1940 Act), or does not have 50 percent or more of its capital 
interests held at any time during the current partnership year by five 
or fewer unrelated persons, and (4) makes all of its allocations in 
proportion to the partners' relative book capital accounts (except for 
reasonable special allocations to a partner that provides management 
services).
    The IRS and Treasury requested and received comments suggesting 
other definitions of securities partnerships. After considering these 
comments, the IRS and Treasury have determined that a more flexible 
definition of securities partnership should be adopted. Accordingly, 
under the final regulations, a securities partnership is a partnership 
that is either a management company or an investment partnership, and 
that makes all of its book allocations in proportion to the partners' 
relative book capital accounts (except for reasonable special 
allocations to a partner providing management services or investment 
advisory services). The final regulations define a management company 
as a partnership that is registered as a management company under the 
1940 Act. The final regulations define an investment partnership as a 
partnership that, on the date of each capital account restatement, 
holds qualified financial assets constituting at least 90 percent of 
the fair market value of its non-cash assets and that reasonably 
expects, as of the end of the first taxable year in which the 
partnership adopts an aggregate approach for reverse section 704(c) 
allocations, to make revaluations of its qualified financial assets at 
least annually.
    Some comments suggested that the regulations allow a securities 
partnership to aggregate gains and losses from all of its assets. The 
IRS and Treasury believe that it is not generally appropriate to allow 
a partnership to aggregate gains and losses from financial assets with 
gains and losses from other types of assets. The IRS and Treasury also 
believe that aggregation should generally be limited to financial 
assets that are easily valued.
    Nevertheless, the IRS and Treasury recognize that some financial 
assets that are not readily tradeable on an established securities 
market may be easily valued. These financial assets are included in 
Sec. 1.1092(d)-1 (defining actively traded property for purposes of the 
straddle rules). Accordingly, the final regulations permit securities 
partnerships to aggregate gains and losses from qualified financial 
assets, defined as any personal property (including stock) that is 
actively traded as defined in Sec. 1.1092(d)-1, even if it is not 
readily tradeable on an established securities market.
    There is less reason to limit aggregation to easily valued assets 
when the partnership is registered as a management company under the 
1940 Act, because a management company's valuation of its assets is 
closely regulated by the Securities and Exchange Commission. 
Accordingly, the final regulations allow partnerships registered as 
management companies to aggregate gains and losses from stock, 
evidences of indebtedness, notional principal contracts, derivative 
financial instruments, options, forward or futures contracts, short 
positions, and similar financial instruments, whether or not actively 
traded.
    In response to comments, the final regulations also clarify the 
treatment of tiered partnerships. Under the final regulations, a 
partnership interest is not a qualified financial asset. However, if a 
partnership (upper-tier partnership) holds an interest in a securities 
partnership (lower-tier partnership), the upper-tier partnership must 
treat its proportionate share of the lower-tier partnership's assets as 
assets of the upper-tier partnership in determining whether the upper-
tier partnership qualifies as an investment partnership. The final 
regulations also provide that, if the upper-tier partnership adopts an 
aggregate approach under the special rule for securities partnerships, 
the upper-tier partnership must aggregate the gains and losses from its 
directly held qualified financial assets with its distributive share of 
the gains and losses from the qualified financial assets of the lower-
tier partnership.
    The temporary and proposed regulations require that a securities 
partnership aggregate its gains separately from its losses. In response 
to comments, this requirement has been eliminated in the final 
regulations. Under the final regulations, partnerships may net book 
gains with book losses and may also net tax gains with tax losses when 
making reverse section 704(c) allocations so long as the partnership's 
aggregate approach is reasonable and does not violate the anti-abuse 
rule set forth in Sec. 1.704-3(a)(10). This rule accords more with the 
overall flexibility of the section 704(c) regulations than does an 
outright prohibition of netting.
    Two examples of aggregate approaches have been added to the 
regulations for purposes of illustrating the operation of the 
aggregation rules. Other aggregate approaches were suggested. Although 
those approaches may be reasonable in appropriate situations, they are 
not specifically described in the final regulations because they appear 
to be less common than those aggregate approaches that are described in 
the regulations.
    Under the final regulations, the character and other tax attributes 
of gain or loss allocated to the partners must: (1) preserve the tax 
attributes of each item of gain or loss realized by the partnership; 
(2) be determined under an approach that is consistently applied; and 
(3) not be determined with a view to reducing substantially the present 
value of the partners' aggregate tax liability.
    In response to a comment, the IRS and Treasury have added in the 
final regulations a transitional rule that allows securities 
partnerships to use any reasonable approach to coordinate revaluations 
occurring on or after the effective date of these regulations with 
revaluations occurring before the effective date of these regulations. 
This provision allows securities partnerships to net book gains and 
book losses from revaluations occurring before the effective date of 
these regulations with book gains and book losses from revaluations 
occurring on or after the effective date of these regulations in making 
allocations under these regulations.
    The IRS and Treasury recognize that a partnership may, at some 
point, no longer qualify as a securities partnership. The final 
regulations make it clear that a securities partnership that adopts an 
aggregate approach and subsequently fails to qualify as a securities 
partnership is not required to disaggregate the book gain or book loss 
from qualified asset revaluations before the date of disqualification 
when making reverse section 704(c) allocations on or after the date of 
disqualification. Additional guidance relating to this issue may be 
issued in the future. The final regulations authorize the Commissioner 
to permit, by published guidance or by letter ruling, aggregation of 
gain and loss from qualified financial assets by partnerships not 
qualifying as securities partnerships. The IRS and Treasury welcome 
comments on whether and under what circumstances waivers of the 
qualification requirements should be granted.

Aggregation of Section 704(c) and Reverse Section 704(c) 
Allocations

    Several comments requested that the final regulations allow 
partnerships that restate capital accounts pursuant to Sec. 1.704-
1(b)(2)(iv)(f) to aggregate their built-in gains and losses from 
contributed property with their built-in gains and losses from capital 
account restatements. Because this type of aggregation could lead to 
substantial distortions in the character and timing of the income or 
loss recognized by contributing partners, the final regulations do not 
specifically authorize this type of aggregation. The IRS and Treasury 
recognize, however, that there may be instances in which the likelihood 
of character and timing distortions is minimal and the burden of making 
section 704(c) allocations separate from reverse section 704(c) 
allocations is great. Accordingly, the final regulations authorize the 
Commissioner to permit, by letter ruling or in published guidance, 
aggregation of section 704(c) gains and losses with reverse section 
704(c) gains and losses.
    In response to another comment, the final regulations also 
authorize the Commissioner to permit, by letter ruling or in published 
guidance, aggregation of section 704(c) gains and losses from 
properties other than those specifically authorized in the regulations 
or from properties contributed by more than one partner.

Effective date

    The provisions added by this Treasury decision apply to property 
contributed to a partnership and to restatements pursuant to 
Sec. 1.704-1(b)(2)(iv)(f) on or after December 21, 1993. However, 
taxpayers may rely on the provisions of Sec. 1.704-3T when making 
allocations with respect to properties contributed to a partnership and 
to restatements pursuant to Sec. 1.704-1(b)(2)(iv)(f) on or after 
December 21, 1993 and before December 28, 1994.
    General tax principles continue to apply to all transactions 
involving section 704(c) entered into before and after the effective 
date of the regulations under section 704(c). The IRS and Treasury are 
aware of certain transactions entered into after the proposed section 
704(c) regulations were issued under Sec. 1.704-3, but before the 
regulations were finalized, that were similar to the anti-abuse 
examples contained in the proposed regulations and that would violate 
the anti-abuse rule contained in the final section 704(c) regulations 
under Sec. 1.704-3(a)(10) but for the effective date of those 
regulations. The IRS and Treasury believe that the validity of these 
transactions is subject to challenge under general tax principles and 
will apply these principles in reviewing such transactions.

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) 
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 Small Business Administration for comment on its 
impact on small business.

Drafting Information

    The principal author of these final regulations is Deborah 
Harrington of the Office of the Assistant Chief Counsel (Passthroughs 
and Special Industries). 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 as 
follows:

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

    Section 1.704-3 also issued under 26 U.S.C. 704(c). * * *


Sec. 1.704  [Amended]

    Par. 2. Section 1.704-1 is amended as follows:
    1. Paragraph (b)(1)(vi) is amended by removing the reference 
``Sec. 1.704-3T(d)(2)'' and adding ``Sec. 1.704-3(d)(2)'' in its place.
    2. Paragraph (b)(2)(iv)(d)(3) is amended by removing the reference 
``Sec. 1.704-3T(d)(2)'' and adding ``Sec. 1.704-3(d)(2)'' in its place.
    3. Paragraph (c) is amended by removing the reference ``See 
Secs. 1.704-3 and 1.704-3T'' and adding ``See Sec. 1.704-3'' in its 
place.
* * * * *
    Par. 3. Section 1.704-3 is amended as follows:
    1. Paragraph (a)(1) is amended by removing the reference 
``Sec. 1.704-3T(d)'' and adding ``Sec. 1.704-3(d)'' in its place.
    2. Paragraph (a)(3)(i) is amended by removing the reference 
``Sec. 1.704-3T(d)(2)'' and adding ``Sec. 1.704-3(d)(2)'' in its place.
    3. Paragraph (d) is revised.
    4. Paragraph (e)(2)(iii) is revised.
    5. Paragraphs (e)(2)(iv) and (e)(2)(v) are removed.
    6. Paragraph (e)(3) is revised and paragraph (e)(4) is added.
    7. The additions and revisions read as follows:


Sec. 1.704-3  Contributed property.

* * * * *
    (d) Remedial allocation method--(1) In general. A partnership may 
adopt the remedial allocation method described in this paragraph to 
eliminate distortions caused by the ceiling rule. A partnership 
adopting the remedial allocation method eliminates those distortions by 
creating remedial items and allocating those items to its partners. 
Under the remedial allocation method, the partnership first determines 
the amount of book items under paragraph (d)(2) of this section and the 
partners' distributive shares of these items under section 704(b). The 
partnership then allocates the corresponding tax items recognized by 
the partnership, if any, using the traditional method described in 
paragraph (b)(1) of this section. If the ceiling rule (as defined in 
paragraph (b)(1) of this section) causes the book allocation of an item 
to a noncontributing partner to differ from the tax allocation of the 
same item to the noncontributing partner, the partnership creates a 
remedial item of income, gain, loss, or deduction equal to the full 
amount of the difference and allocates it to the noncontributing 
partner. The partnership simultaneously creates an offsetting remedial 
item in an identical amount and allocates it to the contributing 
partner.
    (2) Determining the amount of book items. Under the remedial 
allocation method, a partnership determines the amount of book items 
attributable to contributed property in the following manner rather 
than under the rules of Sec. 1.704-1(b)(2)(iv)(g)(3). The portion of 
the partnership's book basis in the property equal to the adjusted tax 
basis in the property at the time of contribution is recovered in the 
same manner as the adjusted tax basis in the property is recovered 
(generally, over the property's remaining recovery period under section 
168(i)(7) or other applicable Internal Revenue Code section). The 
remainder of the partnership's book basis in the property (the amount 
by which book basis exceeds adjusted tax basis) is recovered using any 
recovery period and depreciation (or other cost recovery) method 
(including first-year conventions) available to the partnership for 
newly purchased property (of the same type as the contributed property) 
that is placed in service at the time of contribution.
    (3) Type. Remedial allocations of income, gain, loss, or deduction 
to the noncontributing partner have the same tax attributes as the tax 
item limited by the ceiling rule. The tax attributes of offsetting 
remedial allocations of income, gain, loss, or deduction to the 
contributing partner are determined by reference to the item limited by 
the ceiling rule. Thus, for example, if the ceiling rule limited item 
is loss from the sale of contributed property, the offsetting remedial 
allocation to the contributing partner must be gain from the sale of 
that property. Conversely, if the ceiling rule limited item is gain 
from the sale of contributed property, the offsetting remedial 
allocation to the contributing partner must be loss from the sale of 
that property. If the ceiling rule limited item is depreciation or 
other cost recovery from the contributed property, the offsetting 
remedial allocation to the contributing partner must be income of the 
type produced (directly or indirectly) by that property. Any partner 
level tax attributes are determined at the partner level. For example, 
if the ceiling rule limited item is depreciation from property used in 
a rental activity, the remedial allocation to the noncontributing 
partner is depreciation from property used in a rental activity and the 
offsetting remedial allocation to the contributing partner is ordinary 
income from that rental activity. Each partner then applies section 469 
to the allocations as appropriate.
    (4) Effect of remedial items--(i) Effect on partnership. Remedial 
items do not affect the partnership's computation of its taxable income 
under section 703 and do not affect the partnership's adjusted tax 
basis in partnership property.
    (ii) Effect on partners. Remedial items are notional tax items 
created by the partnership solely for tax purposes and do not affect 
the partners' book capital accounts. Remedial items have the same 
effect as actual tax items on a partner's tax liability and on the 
partner's adjusted tax basis in the partnership interest.
    (5) Limitations on use of methods involving remedial allocations--
(i) Limitation on taxpayers. In the absence of published guidance, the 
remedial allocation method described in this paragraph (d) is the only 
reasonable section 704(c) method permitting the creation of notional 
tax items.
    (ii) Limitation on Internal Revenue Service. In exercising its 
authority under paragraph (a)(10) of this section to make adjustments 
if a partnership's allocation method is not reasonable, the Internal 
Revenue Service will not require a partnership to use the remedial 
allocation method described in this paragraph (d) or any other method 
involving the creation of notional tax items.
    (6) Adjustments to application of method. The Commissioner may, by 
published guidance, prescribe adjustments to the remedial allocation 
method under this paragraph (d) as necessary or appropriate. This 
guidance may, for example, prescribe adjustments to the remedial 
allocation method to prevent the duplication or omission of items of 
income or deduction or to reflect more clearly the partners' income or 
the income of a transferee of a partner.

    (7) Examples. The following examples illustrate the principles of 
this paragraph (d).
    Example 1. Remedial allocation method--(i) Facts. On January 1, 
L and M form partnership LM and agree that each will be allocated a 
50 percent share of all partnership items. The partnership agreement 
provides that LM will make allocations under section 704(c) using 
the remedial allocation method under this paragraph (d) and that the 
straight-line method will be used to recover excess book basis. L 
contributes depreciable property with an adjusted tax basis of 
$4,000 and a fair market value of $10,000. The property is 
depreciated using the straight-line method with a 10-year recovery 
period and has 4 years remaining on its recovery period. M 
contributes $10,000, which the partnership uses to purchase land. 
Except for the depreciation deductions, LM's expenses equal its 
income in each year of the 10 years commencing with the year the 
partnership is formed.
    (ii) Years 1 through 4. Under the remedial allocation method of 
this paragraph (d), LM has book depreciation for each of its first 4 
years of $1,600 [$1,000 ($4,000 adjusted tax basis divided by the 4-
year remaining recovery period) plus $600 ($6,000 excess of book 
value over tax basis, divided by the new 10-year recovery period)]. 
(For the purpose of simplifying the example, the partnership's book 
depreciation is determined without regard to any first-year 
depreciation conventions.) Under the partnership agreement, L and M 
are each allocated 50 percent ($800) of the book depreciation. M is 
allocated $800 of tax depreciation and L is allocated the remaining 
$200 of tax depreciation ($1,000-$800). See paragraph (d)(1) of this 
section. No remedial allocations are made because the ceiling rule 
does not result in a book allocation of depreciation to M different 
from the tax allocation. The allocations result in capital accounts 
at the end of LM's first 4 years as follows:

------------------------------------------------------------------------
                                        L                     M         
                             -------------------------------------------
                                 Book       Tax        Book       Tax   
------------------------------------------------------------------------
Initial contribution........    $10,000     $4,000    $10,000    $10,000
Depreciation................    <3,200>      <800>    <3,200>    <3,200>
                             -------------------------------------------
                                 $6,800     $3,200     $6,800     $6,800
------------------------------------------------------------------------

    (iii) Subsequent Years. (A) For each of years 5 through 10, LM 
has $600 of book depreciation ($6,000 excess of initial book value 
over adjusted tax basis divided by the 10-year recovery period that 
commended in year 1), but no tax depreciation. Under the partnership 
agreement, the $600 of book depreciation is allocated equally to L 
and M. Because of the application of the ceiling rule in year 5, M 
would be allotted $300 of book depreciation, but no tax 
depreciation. Thus, at the end of LM's fifth year L's and M's book 
and tax capital accounts would be as follows:

----------------------------------------------------------------------------------------------------------------
                                            L                                           M                       
                         ---------------------------------------------------------------------------------------
                              Book               Tax                      Book                     Tax          
----------------------------------------------------------------------------------------------------------------
End of year 4...........       $6,800                   $3,200                   $6,800                   $6,800
Depreciation............        <300>  .......................                    <300>  .......................
                         ---------------------------------------------------------------------------------------
                               $6,500                   $3,200                   $6,500                   $6,800
----------------------------------------------------------------------------------------------------------------

    (B) Because the ceiling rule would cause an annual disparity of 
$300 between M's allocations of book and tax depreciation, LM must 
make remedial allocations of $300 of tax depreciation deductions to 
M under the remedial allocation method for each of years 5 through 
10. LM must also make an offsetting remedial allocation to L of $300 
of taxable income, which must be of the same type as income produced 
by the property. At the end of year 5, LM's capital accounts are as 
follows:

------------------------------------------------------------------------
                                        L                     M         
                             -------------------------------------------
                                 Book       Tax        Book       Tax   
------------------------------------------------------------------------
End of year 4...............     $6,800     $3,200     $6,800     $6,800
Depreciation................      <300>  .........      <300>  .........
Remedial allocations........  .........        300  .........      <300>
                             -------------------------------------------
                                 $6,500     $3,500     $6,500     $6,500
------------------------------------------------------------------------

    (C) At the end of year 10, LM's capital accounts are as follows:

------------------------------------------------------------------------
                                        L                     M         
                             -------------------------------------------
                                 Book       Tax        Book       Tax   
------------------------------------------------------------------------
End of year 5...............     $6,500     $3,500     $6,500     $6,500
Depreciation................    <1,500>  .........    <1,500>  .........
Remedial allocations........  .........    <1,500>  .........    <1,500>
                             -------------------------------------------
                                 $5,000     $5,000     $5,000     $5,000
------------------------------------------------------------------------

    Example 2. Remedial allocations on sale--(i) Facts. N and P form 
partnership NP and agree that each will be allocated a 50 percent 
share of all partnership items. The partnership agreement provides 
that NP will make allocations under section 704(c) using the 
remedial allocation method under this paragraph (d). N contributes 
Blackacre (land) with an adjusted tax basis of $4,000 and a fair 
market value of $10,000. Because N has a built-in gain of $6,000, 
Blackacre is section 704(c) property. P contributes Whiteacre (land) 
with an adjusted tax basis and fair market value of $10,000. At the 
end of NP's first year, NP sells Blackacre to Q for $9,000 and 
recognizes a capital gain of $5,000 ($9,000 amount realized less 
$4,000 adjusted tax basis) and a book loss of $1,000 ($9,000 amount 
realized less $10,000 book basis). NP has no other items of income, 
gain, loss, or deduction. If the ceiling rule were applied, N would 
be allocated the entire $5,000 of tax gain and N and P would each be 
allocated $500 of book loss. Thus, at the end of NP's first year N's 
and P's book and tax capital accounts would be as follows:

------------------------------------------------------------------------
                                        N                     P         
                             -------------------------------------------
                                 Book       Tax        Book       Tax   
------------------------------------------------------------------------
Initial contribution........    $10,000     $4,000    $10,000    $10,000
Sale of Blackacre...........      <500>      5,000      <500>  .........
                             -------------------------------------------
                                 $9,500     $9,000     $9,500    $10,000
------------------------------------------------------------------------

    (ii) Remedial allocation. Because the ceiling rule would cause a 
disparity of $500 between P's allocation of book and tax loss, NP 
must make a remedial allocation of $500 of capital loss to P and an 
offsetting remedial allocation to N of an additional $500 of capital 
gain. These allocations result in capital accounts at the end of 
NP's first year as follows:

------------------------------------------------------------------------
                                        N                     P         
                             -------------------------------------------
                                 Book       Tax        Book       Tax   
------------------------------------------------------------------------
Initial contribution........    $10,000     $4,000    $10,000    $10,000
Sale of Blackacre...........      <500>      5,000      <500>  .........
Remedial allocations........  .........        500  .........      <500>
                             -------------------------------------------
                                 $9,500     $9,500     $9,500     $9,500
------------------------------------------------------------------------

    Example 3. Remedial allocation where built-in gain property sold 
for book and tax loss--(i) Facts. The facts are the same as in 
Example 2, except that at the end of NP's first year, NP sells 
Blackacre to Q for $3,000 and recognizes a capital loss of $1,000 
($3,000 amount realized less $4,000 adjusted tax basis) and a book 
loss of $7,000 ($3,000 amount realized less $10,000 book basis). If 
the ceiling rule were applied, P would be allocated the entire 
$1,000 of tax loss and N and P would each be allocated $3,500 of 
book loss. Thus, at the end of NP's first year, N's and P's book and 
tax capital accounts would be as follows:

------------------------------------------------------------------------
                                        N                     P         
                             -------------------------------------------
                                 Book       Tax        Book       Tax   
------------------------------------------------------------------------
Initial contribution........    $10,000     $4,000    $10,000    $10,000
Sale of Blackacre...........    <3,500>          0    <3,500>    <1,000>
                             -------------------------------------------
                                 $6,500     $4,000     $6,500     $9,000
------------------------------------------------------------------------

    (ii) Remedial allocation. Because the ceiling rule would cause a 
disparity of $2,500 between P's allocation of book and tax loss on 
the sale of Blackacre, NP must make a remedial allocation of $2,500 
of capital loss to P and an offsetting remedial allocation to N of 
$2,500 of capital gain. These allocations result in capital accounts 
at the end of NP's first year as follows:

------------------------------------------------------------------------
                                        N                     P         
                             -------------------------------------------
                                 Book       Tax        Book       Tax   
------------------------------------------------------------------------
Initial contribution........    $10,000     $4,000    $10,000    $10,000
Sale of Blackacre...........    <3,500>          0    <3,500>    <1,000>
Remedial Allocations........  .........      2,500  .........    <2,500>
                             -------------------------------------------
                                 $6,500     $6,500     $6,500     $6,500
------------------------------------------------------------------------

    (iii) Subsequent Years. (A) For each of years 5 through 10, LM has 
$600 of book depreciation ($6,000 excess of initial book value over 
adjusted tax basis divided by the 10-year recovery period that 
commenced in year 1), but no tax depreciation. Under the partnership 
agreement, the $600 of book depreciation is allocated equally to L and 
M. Because of the application of the ceiling rule in year 5, M would be 
allocated $300 of book depreciation, but no tax depreciation. Thus, at 
the end of LM's fifth year L's and M's book and tax capital accounts 
would be as follows:
    (e) * * *
    (2) * * *
    (iii) Inventory. For partnerships that do not use a specific 
identification method of accounting, each item of inventory, other than 
qualified financial assets (as defined in paragraph (e)(3)(ii) of this 
section).
    (3) Special aggregation rule for securities partnerships--(i) 
General rule. For purposes of making reverse section 704(c) 
allocations, a securities partnership may aggregate gains and losses 
from qualified financial assets using any reasonable approach that is 
consistent with the purpose of section 704(c). Notwithstanding 
paragraphs (a)(2) and (a)(6)(i) of this section, once a partnership 
adopts an aggregate approach, that partnership must apply the same 
aggregate approach to all of its qualified financial assets for all 
taxable years in which the partnership qualifies as a securities 
partnership. Paragraphs (e)(3)(iv) and (e)(3)(v) of this section 
describe approaches for aggregating reverse section 704(c) gains and 
losses that are generally reasonable. Other approaches may be 
reasonable in appropriate circumstances. See, however, paragraph 
(a)(10) of this section, which describes the circumstances under which 
section 704(c) methods, including the aggregate approaches described in 
this paragraph (e)(3), are not reasonable. A partnership using an 
aggregate approach must separately account for any built-in gain or 
loss from contributed property.
    (ii) Qualified financial assets--(A) In general. A qualified 
financial asset is any personal property (including stock) that is 
actively traded. Actively traded means actively traded as defined in 
Sec. 1.1092(d)-1 (defining actively traded property for purposes of the 
straddle rules).
    (B) Management companies. For a management company, qualified 
financial assets also include the following, even if not actively 
traded: shares of stock in a corporation; notes, bonds, debentures, or 
other evidences of indebtedness; interest rate, currency, or equity 
notional principal contracts; evidences of an interest in, or 
derivative financial instruments in, any security, currency, or 
commodity, including any option, forward or futures contract, or short 
position; or any similar financial instrument.
    (C) Partnership interests. An interest in a partnership is not a 
qualified financial asset for purposes of this paragraph (e)(3)(ii). 
However, for purposes of this paragraph (e)(3), a partnership (upper-
tier partnership) that holds an interest in a securities partnership 
(lower-tier partnership) must take into account the lower-tier 
partnership's assets and qualified financial assets as follows:
    (1) In determining whether the upper-tier partnership qualifies as 
an investment partnership, the upper-tier partnership must treat its 
proportionate share of the lower-tier securities partnership's assets 
as assets of the upper-tier partnership; and
    (2) If the upper-tier partnership adopts an aggregate approach 
under this paragraph (e)(3), the upper-tier partnership must aggregate 
the gains and losses from its directly held qualified financial assets 
with its distributive share of the gains and losses from the qualified 
financial assets of the lower-tier securities partnership.
    (iii) Securities partnership--(A) In general. A partnership is a 
securities partnership if the partnership is either a management 
company or an investment partnership, and the partnership makes all of 
its book allocations in proportion to the partners' relative book 
capital accounts (except for reasonable special allocations to a 
partner that provides management services or investment advisory 
services to the partnership).
    (B) Definitions--(1) Management company. A partnership is a 
management company if it is registered with the Securities and Exchange 
Commission as a management company under the Investment Company Act of 
1940, as amended (15 U.S.C. 80a).
    (2) Investment partnership. A partnership is an investment 
partnership if:
    (i) On the date of each capital account restatement, the 
partnership holds qualified financial assets that constitute at least 
90 percent of the fair market value of the partnership's non-cash 
assets; and
    (ii) The partnership reasonably expects, as of the end of the first 
taxable year in which the partnership adopts an aggregate approach 
under this paragraph (e)(3), to make revaluations at least annually.
    (iv) Partial netting approach. This paragraph (e)(3)(iv) describes 
the partial netting approach of making reverse section 704(c) 
allocations. See Example 1 of paragraph (e)(3)(ix) of this section for 
an illustration of the partial netting approach. To use the partial 
netting approach, the partnership must establish appropriate accounts 
for each partner for the purpose of taking into account each partner's 
share of the book gains and losses and determining each partner's share 
of the tax gains and losses. Under the partial netting approach, on the 
date of each capital account restatement, the partnership:
    (A) Nets its book gains and book losses from qualified financial 
assets since the last capital account restatement and allocates the net 
amount to its partners;
    (B) Separately aggregates all tax gains and all tax losses from 
qualified financial assets since the last capital account restatement; 
and
    (C) Separately allocates the aggregate tax gain and aggregate tax 
loss to the partners in a manner that reduces the disparity between the 
book capital account balances and the tax capital account balances 
(book-tax disparities) of the individual partners.
    (v) Full netting approach. This paragraph (e)(3)(v) describes the 
full netting approach of making reverse section 704(c) allocations on 
an aggregate basis. See Example 2 of paragraph (e)(3)(ix) of this 
section for an illustration of the full netting approach. To use the 
full netting approach, the partnership must establish appropriate 
accounts for each partner for the purpose of taking into account each 
partner's share of the book gains and losses and determining each 
partner's share of the tax gains and losses. Under the full netting 
approach, on the date of each capital account restatement, the 
partnership:
    (A) Nets its book gains and book losses from qualified financial 
assets since the last capital account restatement and allocates the net 
amount to its partners;
    (B) Nets tax gains and tax losses from qualified financial assets 
since the last capital account restatement; and
    (C) Allocates the net tax gain (or net tax loss) to the partners in 
a manner that reduces the book-tax disparities of the individual 
partners.
    (vi) Type of tax gain or loss. The character and other tax 
attributes of gain or loss allocated to the partners under this 
paragraph (e)(3) must:
    (A) Preserve the tax attributes of each item of gain or loss 
realized by the partnership;
    (B) Be determined under an approach that is consistently applied; 
and
    (C) Not be determined with a view to reducing substantially the 
present value of the partners' aggregate tax liability.
    (vii) Disqualified securities partnerships. A securities 
partnership that adopts an aggregate approach under this paragraph 
(e)(3) and subsequently fails to qualify as a securities partnership 
must make reverse section 704(c) allocations on an asset-by-asset basis 
after the date of disqualification. The partnership, however, is not 
required to disaggregate the book gain or book loss from qualified 
asset revaluations before the date of disqualification when making 
reverse section 704(c) allocations on or after the date of 
disqualification.
    (viii) Transitional rule for qualified financial assets revalued 
after effective date. A securities partnership revaluing its qualified 
financial assets pursuant to Sec. 1.704-1(b)(2)(iv)(f) on or after the 
effective date of this section may use any reasonable approach to 
coordinate with revaluations that occurred prior to the effective date 
of this section.
    (ix) Examples. The following examples illustrate the principles of 
this paragraph (e)(3).

    Example 1. Operation of the partial netting approach--(i) Facts. 
Two regulated investment companies, X and Y, each contribute 
$150,000 in cash to form PRS, a partnership that registers as a 
management company. The partnership agreement provides that book 
items will be allocated in accordance with the partners' relative 
book capital accounts, that book capital accounts will be adjusted 
to reflect daily revaluations of property pursuant to Sec. 1.704-
1(b)(2)(iv)(f)(5)(iii), and that reverse section 704(c) allocations 
will be made using the partial netting approach described in 
paragraph (e)(3)(iv) of this section. X and Y each have an initial 
book capital account of $150,000. In addition, the partnership 
establishes for each of X and Y a revaluation account with a 
beginning balance of $0. On Day 1, PRS buys Stock 1, Stock 2, and 
Stock 3 for $100,000 each. On Day 2, Stock 1 increases in value from 
$100,000 to $102,000, Stock 2 increases in value from $100,000 to 
$105,000, and Stock 3 declines in value from $100,000 to $98,000. At 
the end of Day 2, Z, a regulated investment company, joins PRS by 
contributing $152,500 in cash for a one-third interest in the 
partnership [$152,500 divided by $300,000 (initial values of stock) 
+ $5,000 (net gain at end of Day 2)+ $152,500]. PRS uses this cash 
to purchase Stock 4. PRS establishes a revaluation account for Z 
with a $0 beginning balance. As of the close of Day 3, Stock 1 
increases in value from $102,000 to $105,000, and Stocks 2, 3, and 4 
decrease in value from $105,000 to $102,000, from $98,000 to 
$96,000, and from $152,500 to $151,500, respectively. At the end of 
Day 3, PRS sells Stocks 2 and 3.
    (ii) Book allocations--Day 2. At the end of Day 2, PRS revalues 
the partnership's qualified financial assets and increases X's and 
Y's book capital accounts by each partner's 50 percent share of the 
$5,000 ($2,000 + $5,000 - $2,000) net increase in the value of the 
partnership's assets during Day 2. PRS increases X's and Y's 
respective revaluation account balances by $2,500 each to reflect 
the amount by which each partner's book capital account increased on 
Day 2. Z's capital account is not affected because Z did not join 
PRS until the end of Day 2. At the beginning of Day 3, the 
partnership's accounts are as follows:

------------------------------------------------------------------------
                              Stock 1    Stock 2    Stock 3     Stock 4 
------------------------------------------------------------------------
Opening Balance............   $100,000   $100,000   $100,000  ..........
Day 2 Adjustment...........      2,000      5,000    (2,000)  ..........
                            --------------------------------------------
Total......................   $102,000   $105,000    $98,000   $152,500 
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                       X                
                                      ----------------------------------
                                                             Revaluation
                                          Book       Tax       account  
------------------------------------------------------------------------
Opening Balance......................   $150,000   $150,000           0 
Day 2 Adjustment.....................      2,500          0      $2,500 
                                      ----------------------------------
Closing Balance......................   $152,500   $150,000      $2,500 
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                       Y                
                                      ----------------------------------
                                                             Revaluation
                                          Book       Tax       account  
------------------------------------------------------------------------
Opening Balance......................   $150,000   $150,000           0 
Day 2 Adjustment.....................      2,500          0      $2,500 
                                      ----------------------------------
Closing balance......................   $152,500   $150,000      $2,500 
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                       Z                
                                      ----------------------------------
                                                             Revaluation
                                          Book       Tax       account  
------------------------------------------------------------------------
Opening Balance......................  .........  .........  ...........
Day 2 Adjustment.....................  .........  .........  ...........
Closing Balance......................   $152,500   $152,500          $0 
------------------------------------------------------------------------

    (iii) Book and tax allocations--Day 3. At the end of Day 3, PRS 
decresases the book capital accounts of X, Y, and Z by $1,000 to 
reflect each partner's share of the $3,000 ($3,000--$3,000--$2,000--
$1,000) net decrease in the value of the partnership's qualified 
financial assets. PRS also reduces each partner's revaluation 
account balance by $1,000. Accordingly, X's and Y's revaluation 
account balances are reduced to $1,500 each and Z's revaulation 
account balance is ($1,000). PRS then separately allocates the tax 
gain from the sale of Stock 2 and the loss from the sale of Stock 3. 
The $2,000 of tax gain recognized on the sale of Stock 2 ($102,000--
$100,000) is allocated among the partners with positive revaluation 
account balances in accordance with the relative balances of those 
revaluation accounts. X's and Y's revaluation accounts have equal 
positive balances; thus, PRS allocates $1,000 of the gain from the 
sale of Stock 2 to X and $1,000 of that gain to Y. PRS allocates 
none of the gain from the sale to Z because Z's revaluation account 
balance is negative. The $4,000 of tax loss recognized from the sale 
of Stock 3 ($96,000--$100,000) is allocated first to the partners 
with negative revaluation account balances to the extent of those 
balances. Because Z is the only partner with a negative revaluation 
account balance, the tax loss is allocated first to Z to the extent 
of Z's ($1,000) balance. The remaining $3,000 of tax loss is 
allocated among the partners in accordance with their distributive 
shares of the loss. Accordingly, PRS allocates $1,000 of tax loss 
from the sale of Stock 3 to each of X and Y. PRS also allocates an 
additional $1,000 of the tax loss to Z, so that Z's total share of 
the tax loss from the sale of Stock 3 is $2,000. PRS then reduces 
each partner's revaluation account balance by the amount of any tax 
gain allocated to that partner and increases each partner's 
revaluation account balance by the amount of any tax loss allocated 
to that partner. At the beginning of Day 4, the partnership's 
accounts are as follows:

------------------------------------------------------------------------
                           Stock 1     Stock 2     Stock 3     Stock 4  
------------------------------------------------------------------------
Opening Balance.........   $100,000    $100,000    $100,000    $152,500 
Day 2 Adjustment........      2,000       5,000     (2,000)  ...........
Day 3 Adjustment........     $3,000     (3,000)     (2,000)      (1,000)
                         -----------------------------------------------
Total...................   $105,000    $102,000     $96,000    $151,500 
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                  X and Y               
                                  --------------------------------------
                                                             Revaluation
                                       Book         Tax        account  
------------------------------------------------------------------------
Opening Balance..................    $150,000     $150,000           0  
Day 2 Adjustment.................       2,500            0      $2,500  
Day 3 Adjustment.................      (1,000)           0     ($1,000) 
                                  --------------------------------------
Total............................    $151,500     $150,000      $1,500  
Gain from Stock 2................           0       $1,000      (1,000) 
Loss from Stock 3................           0      ($1,000)      1,000  
                                  --------------------------------------
Closing Balance..................    $151,500     $150,000      $1,500  
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                      Z                 
                                    ------------------------------------
                                                             Revaluation
                                        Book         Tax       account  
------------------------------------------------------------------------
Opening Balance....................   $151,500    $152,500            0 
Day 3 Adjustment...................     (1,000)          0      ($1,000)
                                    ------------------------------------
Total..............................   $151,500    $152,500      ($1,000)
Gain from Stock 2..................          0           0            0 
Loss from Stock 3..................          0      (2,000)       2,000 
                                    ------------------------------------
Closing Balance....................   $151,500    $150,500       $1,000 
------------------------------------------------------------------------

    Example 2. Operation of the full netting approach--(i) Facts. 
The facts are the same as in Example 1, except that the partnership 
agreement provides that PRS will make reverse section 704(c) 
allocations using the full netting approach described in paragraph 
(e)(3)(v) of this section.
    (ii) Book allocations--Days 2 and 3. PRS allocates its book 
gains and losses in the manner described in paragraphs (ii) and 
(iii) of Example 1 (the partial netting approach). Thus, at the end 
of Day 2, PRS increases the book capital accounts of X and Y by 
$2,500 to reflect the appreciation in the parntership's assets from 
the close of Day 1 to the close of Day 2 and records that increase 
in the revaluation account created for each partner. At the end of 
Day 3, PRS decreases the book capital accounts of X, Y, and Z by 
$1,000 to reflect each partner's share of the decline in value of 
the partnership's assets from Day 2 to Day 3 and reduces each 
partner's revaluation account by a corresponding amount.
    (iii) Tax allocations--Day 3. After making the book adjustments 
described in the previous paragraph, PRS allocates its net tax gain 
(or net tax loss) from its sales of qualified financial assets 
during Day 3. To do so, PRS first determines its net tax gain (or 
net tax loss) recognized from its sales of qualified financial 
assets for the day. There is a $2,000 net tax loss ($2,000 gain from 
the sale of Stock 2 less $4,000 loss from the sale of Stock 3) on 
the sale of PRS's qualified financial assets. Because Z is the only 
partner with a negative revaluation account balance, the 
partnership's net tax loss is allocated first to Z to the extent of 
Z's ($1,000) revaluation account balance. The remaining net tax loss 
is allocated among the partners in accoradnce with their 
distributive shares of loss. Thus, PRS allocates $333.33 of the 
$2,000 net tax loss to each of X and Y. PRS also allocates an 
additional $333.33 of the net tax loss to Z, so that the total net 
tax loss allocation to Z is $1,333.33. PRS then increases each 
partner's revaluation account balance by the amount of net tax loss 
allocated to that partner. At the beginning of Day 4, the 
partnership's accounts are as follows:

------------------------------------------------------------------------
                            Stock 1     Stock 2     Stock 3     Stock 4 
------------------------------------------------------------------------
Opening Balance..........   $100,000   $100,000    $100,000    $152,500 
Day 2 Adjustment.........      2,000      5,000      (2,000)  ..........
Day 3 Adjustment.........      3,000     (3,000)     (2,000)    ($1,000)
                          ----------------------------------------------
Total....................   $105,000   $102,000     $96,000    $151,500 
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                  Z and Y               
                                  --------------------------------------
                                                             Revaluation
                                       Book         Tax        account  
------------------------------------------------------------------------
Opening Balance..................    $150,000     $150,500           0  
Day 2 Adjustment.................      $2,500            0      $2,500  
Day 3 Adjustment.................      (1,000)           0      (1,000) 
                                  --------------------------------------
Total............................    $151,500     $150,000      $1,500  
Net Tax Loss-Stocks 2 & 3........           0         (333)        333  
                                  --------------------------------------
Closing Balance..................    $151,500     $149,667      $1,833  
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                      Z                 
                                    ------------------------------------
                                                             Revaluation
                                        Book         Tax       account  
------------------------------------------------------------------------
Opening Balance....................   $152,500    $152,500            0 
Day 3 Adjustment...................     (1,000)          0      ($1,000)
                                    ------------------------------------
    Total..........................   $151,500    $152,500      ($1,000)
Net Tax Loss-Stocks 2 & 3..........          0      (1,333)       1,333 
                                    ------------------------------------
Closing Balance....................   $151,500    $151,167         $333 
------------------------------------------------------------------------

    (4) Aggregation as permitted by the Commissioner. The Commissioner 
may, by published guidance or by letter ruling, permit:
    (i) Aggregation of properties other than those described in 
paragraphs (e)(2) and (e)(3) of this section;
    (ii) Partnerships and partners not described in paragraph (e)(3) of 
this section to aggregate gain and loss from qualified financial 
assets; and
    (iii) Aggregation of qualified financial assets for purposes of 
making section 704(c) allocations in the same manner as that described 
in paragraph (e)(3) of this section.
* * * * *


Sec. 1.704-3T  [Removed]

    Par. 4. Section 1.704-3T is removed.

    Dated: December 13, 1994.
Margaret Milner Richardson,
Commissioner of Internal Revenue.

    Approved:
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-31435 Filed 12-27-94; 8:45 am]
BILLING CODE 4830-01-P