[Federal Register Volume 60, Number 247 (Tuesday, December 26, 1995)]
[Rules and Regulations]
[Pages 66727-66739]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30870]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[T.D. 8642]
RIN 1545-AR48; 1545-AR93


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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
recognition of gain or loss on certain distributions of contributed 
property by a partnership under section 704(c)(1)(B) of the Internal 
Revenue Code of 1986 (Code). This document also contains final 
regulations relating to the recognition of gain on certain 
distributions to a contributing partner under section 737. The final 
regulations affect partnerships and their partners and are necessary to 
provide guidance for complying with the applicable tax law.

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

FOR FURTHER INFORMATION CONTACT: Stephen J. Coleman, (202) 622- 3060 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    The Revenue Reconciliation Act of 1989 added section 704(c)(1)(B) 
and section 704(c)(2) to the Internal Revenue Code. Section 
704(c)(1)(B) provides that, in the case of a distribution of 
contributed property to another partner within five years of its 
contribution, the contributing partner must recognize gain or loss in 
an amount equal to the gain or loss the partner would have been 
allocated under section 704(c)(1)(A) on a sale of the property by the 
partnership at its fair market value at the time of the distribution. 
Section 704(c)(2) provides an exception for distributions of certain 
like-kind property.
    The Energy Policy Act of 1992 added section 737 to the Code. 
Section 737 requires a partner who contributes appreciated property to 
recognize gain on a subsequent distribution of other property to the 
contributing partner to the extent of the lesser of (i) the net 
precontribution gain on property contributed by the partner, or (ii) 
the excess of the value of the distributed property over the adjusted 
basis of the partner's interest in the partnership.
    On January 9, 1995, a notice of proposed rulemaking (PS-76-92; PS-
51-93) under section 704(c)(1)(B) and section 737 was published in the 
Federal Register (60 FR 2352). Written comments responding to this 
notice were received. No public hearing was held because no hearing was 
requested. After consideration of all comments received, the proposed 
regulations under section 704(c)(1)(B) and section 737 are adopted as 
revised by this Treasury decision.

Summary of Significant Comments and Revisions

    The significant comments on the proposed regulations and the 
revisions made in the final regulations are discussed below.

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

Determination of Gain and Loss
    The proposed regulations provide that section 704(c)(1)(B) applies 
only to a distribution that is properly characterized as a distribution 
to a partner acting in the capacity of a partner within the meaning of 
section 731 and section 737, and not to a transaction or distribution 
that is subject to provisions other than section 731(a) or section 737. 
Comments requested that the provision be clarified. The final 
regulations clarify that section 704(c)(1)(B) applies only to the 
extent that a transaction is a distribution under section 731. 
References to transactions and distributions not subject to section 
704(c)(1)(B) have been deleted.
    One commentator suggested certain clarifying revisions to the 
proposed regulations' definition of fair market value. The definition 
in the proposed regulations, however, is identical to the definition of 
fair market value in the 704(b) regulations, and distributed property 
should have the same fair market value for purposes of determining gain 
and loss under section 704(c)(1)(B) and determining capital account 
adjustments under section 704(b). The final regulations therefore adopt 
the definition in the proposed regulations without change.
    The proposed regulations provide that the amount of gain or loss 
resulting from a distribution of partnership property is determined as 
if the distributed property had been sold by the partnership to the 
distributee partner. As a result, if built-in loss property is 
distributed to a partner that holds more than a 50 percent interest in 
partnership capital or profits, the built-in loss that otherwise would 
be recognized is disallowed under section 707(b)(1)(A). One commentator 
suggested that section 704(c)(1)(B) was intended to address disguised 
sales between partners and that, therefore, a loss should be disallowed 
on a distribution only if it would be disallowed on a direct sale 
between the partners. Section 704(c)(1)(B), however, respects the form 
of the transaction as between the partnership and a partner and does 
not recast the transaction as a disguised sale. See H.R. Rep. No. 247, 
101st Cong., 1st Sess. 406 (1989). The final regulations therefore 
adopt the proposed regulations without change.
    Several of the provisions in the proposed regulations refer to 
distributions that are part of ``the same plan or arrangement.'' 
Commentators requested clarification of this term. The reference to 
distributions that are part of the same plan or arrangement was 

[[Page 66728]]
intended to reflect the fact that distributions of multiple properties 
to one partner or distributions of different properties to more than 
one partner over a period of time may be treated as part of the same 
distribution under general principles of taxation, such as the step 
transaction doctrine. The final regulations remove the reference to 
``same plan or arrangement'' and refers to distributions that are part 
of the same distribution. This change is made for simplification only 
and is not intended as a substantive change to the scope of a 
distribution for tax purposes. As under current law, distributions do 
not need to be contemporaneous to be part of the same distribution.
    Several comments were received regarding the effect of a 
partnership termination under section 708(b)(1)(B). One comment 
suggested that it was not clear whether property that had previously 
been contributed to the partnership (and was therefore already subject 
to a five-year period) was subject to a new five- year period after the 
termination. The final regulations clarify that a new five-year period 
does not begin to the extent of any pre-termination gain or loss that 
would have been allocated to a contributing partner under section 
704(c)(1)(A) on a sale of contributed property immediately before the 
termination.
    The legislative history of section 704(c)(1)(B) indicates that a 
constructive termination does not change the application of section 
704(c) to pre-contribution gain or loss on property contributed to the 
partnership before termination. One comment read this legislative 
history as possibly suggesting that a pro rata distribution is deemed 
to occur under section 708(b)(1)(B) for section 704(c)(1)(A) purposes, 
but a different distribution is deemed to occur for section 
704(c)(1)(B) purposes. The comment expressed concern about the 
complexity of such a system. Section 704(c)(1)(B), however, does not 
require or impose such a ``hybrid system.'' The amount of gain or loss 
under section 704(c)(1)(B) is determined by reference to the amount of 
gain or loss that would have been allocated to the partner under 
section 704(c)(1)(A) if the property had been sold. Thus, property of a 
partnership that terminates under section 708(b)(1)(B) is deemed to be 
distributed to the partners in the same manner for both sections.
    Another comment suggested it was unclear whether section 
704(c)(1)(B) could apply to property that had not been contributed by a 
partner to the partnership prior to the termination. The final 
regulations confirm that a new five-year period begins for all property 
that is deemed contributed to the new partnership after the termination 
(which would include property not actually contributed to the 
partnership), except to the extent that such built-in gain or loss 
would have been allocated to the contributing partner under section 
704(c)(1)(A) on a sale of the contributed property immediately before 
the termination.
    Commentators also requested guidance on the interaction of section 
708(b)(1)(B) and section 704(c) in general. The IRS and Treasury 
recognize the need for additional guidance on this issue, but such 
guidance is beyond the scope of these regulations. The IRS and Treasury 
are considering a separate project involving the interaction of section 
704(c) and section 708(b)(1)(B) and invite additional comments and 
suggestions regarding the project.
Exceptions
    The proposed regulations provide that section 704(c)(1)(B) does not 
apply to property contributed to the partnership on or before October 
3, 1989. One commentator requested an exception for property required 
to be contributed under a binding contract entered into on or before 
October 3, 1989. The statutory effective date provisions, however, do 
not contain a binding contract exception. Accordingly, the final 
regulations adopt the proposed regulations without change.
    One commentator suggested an additional exception for distributions 
of an undivided interest in property. The final regulations provide 
that section 704(c)(1)(B) does not apply to such a distribution to the 
extent that the distributed interest does not exceed the undivided 
interest contributed by the distributee partner.
    One commentator also requested an additional exception for 
distributions of fungible property because the partners may not be able 
to track the specific contributed property. The final regulations do 
not provide such an exception. Contributed property may be fungible 
from an economic perspective, but such property is generally not 
fungible for tax purposes because each contributed property will have 
its own individual tax basis.
    The proposed regulations provide an exception for distributions of 
section 704(c) property to a noncontributing partner in liquidation of 
the partnership if the contributing partner receives an interest in the 
contributed property and the built-in gain or loss in that property is 
equal to or greater than the built-in gain or loss that would have 
otherwise been allocated to the contributing partner. One commentator 
suggested that the exception more clearly indicate the amount of built-
in gain or loss that must be reflected in the property distributed to 
the contributing partner. The final regulations clarify that the amount 
of the built-in gain or loss must be equal to the gain or loss that 
would have been allocated to the contributing partner under section 
704(c)(1)(A) if the contributed property had been sold immediately 
before the distribution.
    One commentator also suggested expanding this exception to apply to 
the extent of the built-in gain or loss in the property distributed to 
the contributing partner. This comment is not adopted in the final 
regulations. The exception was intended to apply only in the limited 
situation in which a partnership liquidates and the value of the 
contributed property exceeds the contributing partner's capital 
account. In that situation, the portion of the contributed property in 
excess of the contributing partner's capital account would have to be 
distributed to another partner, thereby triggering section 
704(c)(1)(B). The exception allows a partner to avoid section 
704(c)(1)(B) in this situation, so long as the built-in gain or loss in 
the property distributed to the contributing partner is at least equal 
to the gain or loss that would have been allocated to the contributing 
partner under section 704(c)(1)(A) if the contributed property had been 
sold immediately before the distribution.
Special Rules
    The proposed regulations provide a special rule under section 
704(c)(2) for situations in which the partnership distributes like-kind 
property to a contributing partner within a specified period of the 
distribution of the property contributed by that partner. Under this 
rule, the gain or loss that otherwise would have been recognized on the 
distribution of the contributed property is reduced by the amount of 
the contributing partner's built-in gain or loss in the distributed 
like-kind property. One commentator criticized this rule as 
inconsistent with the statutory provision.
    Section 704(c)(2) provides that ``[u]nder regulations prescribed by 
the Secretary, * * * to the extent of the value of the [like-kind 
property distributed to the contributing partner, the calculation of 
the contributing partner's gain or loss attributable to the 
distribution of the contributed property] shall be [determined] as if 
the contributing partner had contributed to the partnership the [like-
kind] property.'' This provision is generally intended to treat the 
contributing partner as if the partner had exchanged 

[[Page 66729]]
the contributed property for like-kind property in a nontaxable 
exchange outside of the partnership. This allows the contributing 
partner to avoid recognition of gain or loss under section 704(c)(1)(B) 
on the distribution of the contributed property to another partner 
because the contributing partner is treated as having contributed the 
like-kind property, not the property that is actually distributed to 
the other partner.
    If the contributing partner, however, had engaged in a like- kind 
exchange outside of the partnership, the partner's built-in gain or 
loss in the like-kind property received would have been the same as the 
property that was surrendered. The rule in the proposed regulations 
reflects this result by limiting the application of section 704(c)(2) 
to the extent that the built-in gain or loss in the contributed 
property is not preserved in the like-kind property distributed to the 
contributing partner. The IRS and Treasury continue to believe that the 
regulations properly implement Congress' objective with respect to this 
provision. Therefore, the regulations are finalized without change.
    One commentator also suggested a clarification of the interaction 
of the like-kind exception and the disguised sale rules of 
707(a)(2)(B). The proposed regulations provide that the like-kind 
exception reduces any gain that would have otherwise been recognized 
under section 704(c)(1)(B). The proposed regulations also provide that 
section 704(c)(1)(B) applies only to a distribution to a partner within 
the meaning of section 731. There is no suggestion in section 704(c)(2) 
or the proposed regulations that the like-kind exception was intended 
as an exception to the disguised sale provisions. The final regulations 
confirm that the disguised sale provisions can apply to a distribution, 
even if the distribution would otherwise have qualified for the section 
704(c)(2) like-kind exception.
Anti-Abuse Rule
    Commentators made several suggestions for clarifying or modifying 
the anti-abuse rule in the proposed regulations. In particular, these 
commentators requested clarification of the relationship between this 
rule and the general partnership anti-abuse rule in Treas. Reg. section 
1.701-2. The general anti-abuse regulation is a rule of general 
applicability that provides general principles to be applied in 
interpreting and applying all of the provisions of subchapter K. In 
certain situations, however, more specific anti-abuse rules are needed 
to carry out the purpose of a particular provision. The final 
regulations therefore adopt the rule in the proposed regulations 
without modification.

B. Section 737

Determination of Gain
    The final regulations are clarified to provide that section 737 
applies only to the extent that a transaction is a distribution under 
section 731. In accordance with section 737(d)(2), the final 
regulations also provide that section 737 does not apply to the extent 
that section 751(b) applies to the distribution.
Net Precontribution Gain
    The proposed regulations provide that a distributee partner's net 
precontribution gain is determined without regard to the like-kind 
exception of section 704(c)(2) in situations in which the contributed 
property is not actually distributed to another partner. One 
commentator suggested deleting this provision as superfluous. The final 
regulations adopt the proposed regulations without change. This 
provision clarifies that section 737 does not contain a like-kind 
exception similar to the exception in section 704(c)(2). Section 737 
applies even if the property received by the partner is of a like-kind 
with the contributed property.
Character of Gain
    One commentator suggested that the proposed regulations fail to 
clarify whether there are two groups (ordinary and capital) for 
purposes of determining the character of a partner's net 
precontribution gain or whether there may be an additional section 1231 
group or section 1245 and section 1250 groups. The final regulations 
adopt the proposed regulations without change.
    The proposed regulations provide that character for purposes of a 
partner's net precontribution gain is determined as if the contributed 
property were sold to an unrelated third party. As a result, all of the 
provisions that are relevant in determining the character of gain or 
loss on a sale are relevant in determining the character of the net 
precontribution gain. For example, if the sale of property would have 
resulted in part capital gain and part ordinary income, the character 
of the net precontribution gain for that property is part ordinary and 
part capital. The same approach applies in determining the allocation 
of any adjustment to the partnership's basis in partnership property as 
a result of gain recognized by the distributee partner. A basis 
adjustment attributable to gain treated as capital gain under section 
1231 would be allocated to the property that entered into the 
calculation of the amount of section 1231 gain.
    One commentator also suggested that the proposed regulations do not 
clarify whether character is determined at the partnership or the 
partner level. This determination may be important in situations such 
as section 1231 where the character of the gain or loss may depend on 
the partner's particular tax circumstances. The final regulations 
clarify that the character of the gain or loss is determined at the 
partnership level for this purpose.
Exceptions
    One commentator suggested adding an exception for certain divisive 
transactions in which the contributing partner continued to own an 
indirect interest in the contributed property. The final regulations 
add a new exception under which section 737 does not apply to a 
transfer of contributed property by a transferor partnership to a 
transferee partnership, followed by a distribution of an interest in 
the transferee partnership (and no other property) to the contributing 
partner in complete liquidation of the partner's interest.
    This exception is added because the distributee partner has simply 
converted an interest in the transferor partnership into an interest in 
a transferee partnership that holds the same contributed section 704(c) 
property. The limitations on this exception ensure that the partner's 
basis in the transferee partnership attributable to the contributed 
property is the same as the partner's basis in the transferor 
partnership attributable to that property. This allows a partnership to 
engage in a divisive split-up transaction, while preventing any 
avoidance of section 737 that might occur as a result of the basis 
allocation rules for non-liquidating distributions.
    The proposed regulations provide that section 737 does not apply to 
an incorporation of a partnership other than an incorporation involving 
an actual distribution of partnership property to the partners. One 
commentator suggested that this distinction between methods of 
incorporation creates an unnecessary trap for the unwary and may have a 
chilling effect on the conversion of partnerships into S corporations. 
The final regulations adopt the proposed regulations without change. 
The form of incorporation chosen by the partners is respected for 
Federal tax purposes and, as a result, the distribution of property in 
connection with the incorporation is treated as a distribution for 
purposes of section 737. 

[[Page 66730]]

    One commentator suggested an additional exception for distributions 
of an undivided interest in property similar to that described with 
respect to the regulations under section 704(c)(1)(B). The final 
regulations provide a comparable rule under section 737.
Anti-Abuse Rule
    Commentators made several suggestions regarding the anti-abuse rule 
in the proposed regulations. These suggestions are essentially the same 
as the comments regarding the anti-abuse rule in the section 
704(c)(1)(B) regulations, and thus the comments are discussed above.
Effective Date
    These regulations are effective for distributions by a partnership 
to a partner on or after January 9, 1995.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It has also been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to 
these regulations and, therefore, a Regulatory Flexibility Analysis is 
not required. Pursuant to section 7805(f) of the Internal Revenue Code, 
the notice of proposed rulemaking preceding these regulations was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Drafting Information

    Several persons from the Office of Chief Counsel and the Treasury 
Department participated in the development of these regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

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

    Section 1.704-4 also issued under 26 U.S.C. 704(c) * * *
    Par. 2. Section 1.704-4 is added to read as follows:


Sec. 1.704-4  Distribution of contributed property.

    (a) Determination of gain and loss--(1) In general. A partner that 
contributes section 704(c) property to a partnership must recognize 
gain or loss under section 704(c)(1)(B) and this section on the 
distribution of such property to another partner within five years of 
its contribution to the partnership in an amount equal to the gain or 
loss that would have been allocated to such partner under section 
704(c)(1)(A) and Sec. 1.704-3 if the distributed property had been sold 
by the partnership to the distributee partner for its fair market value 
at the time of the distribution. See Sec. 1.704-3(a)(3)(i) for a 
definition of section 704(c) property.
    (2) Transactions to which section 704(c)(1)(B) applies. Section 
704(c)(1)(B) and this section apply only to the extent that a 
distribution by a partnership is a distribution to a partner acting in 
the capacity of a partner within the meaning of section 731.
    (3) Fair market value of property. The fair market value of the 
distributed section 704(c) property is the price at which the property 
would change hands between a willing buyer and a willing seller at the 
time of the distribution, neither being under any compulsion to buy or 
sell and both having reasonable knowledge of the relevant facts. The 
fair market value that a partnership assigns to distributed section 
704(c) property will be regarded as correct, provided that the value is 
reasonably agreed to among the partners in an arm's-length negotiation 
and the partners have sufficiently adverse interests.
    (4) Determination of five-year period--(i) General rule. The five-
year period specified in paragraph (a)(1) of this section begins on and 
includes the date of contribution.
    (ii) Section 708(b)(1)(B) terminations. A termination of the 
partnership under section 708(b)(1)(B) begins a new five-year period 
for each partner with respect to the built-in gain and built-in loss 
property that the partner is deemed to recontribute to a new 
partnership following the termination, but only to the extent that the 
pre-termination built-in gain or loss, if any, on such property would 
not have been allocated to the contributing partner under section 
704(c)(1)(A) and Sec. 1.704-3 on a sale of the contributed property to 
an unrelated party immediately before the termination. See Sec. 1.704-
3(a)(3)(ii) for the definitions of built-in gain and built-in loss on 
section 704(c) property.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (a). Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for 
contributed property) for each year of the partnership, the fair market 
value of partnership property does not change, all distributions by the 
partnership are subject to section 704(c)(1)(B), and all partners are 
unrelated.

    Example 1. Recognition of gain. (i) On January 1, 1995, A, B, 
and C form partnership ABC as equal partners. A contributes $10,000 
cash and Property A, nondepreciable real property with a fair market 
value of $10,000 and an adjusted tax basis of $4,000. Thus, there is 
a built-in gain of $6,000 on Property A at the time of contribution. 
B contributes $10,000 cash and Property B, nondepreciable real 
property with a fair market value and adjusted tax basis of $10,000. 
C contributes $20,000 cash.
    (ii) On December 31, 1998, Property A and Property B are 
distributed to C in complete liquidation of C's interest in the 
partnership.
    (iii) A would have recognized $6,000 of gain under section 
704(c)(1)(A) and Sec. 1.704-3 on the sale of Property A at the time 
of the distribution ($10,000 fair market value less $4,000 adjusted 
tax basis). As a result, A must recognize $6,000 of gain on the 
distribution of Property A to C. B would not have recognized any 
gain or loss under section 704(c)(1)(A) and Sec. 1.704-3 on the sale 
of Property B at the time of distribution because Property B was not 
section 704(c) property. As a result, B does not recognize any gain 
or loss on the distribution of Property B.
    Example 2. Effect of post-contribution depreciation deductions. 
(i) On January 1, 1995, A, B, and C form partnership ABC as equal 
partners. A contributes Property A, depreciable property with a fair 
market value of $30,000 and an adjusted tax basis of $20,000. 
Therefore, there is a built-in gain of $10,000 on Property A. B and 
C each contribute $30,000 cash. ABC uses the traditional method of 
making section 704(c) allocations described in Sec. 1.704-3(b) with 
respect to Property A.
    (ii) Property A is depreciated using the straight-line method 
over its remaining 10-year recovery period. The partnership has book 
depreciation of $3,000 per year (10 percent of the $30,000 book 
basis), and each partner is allocated $1,000 of book depreciation 
per year (one-third of the total annual book depreciation of 
$3,000). The partnership has a tax depreciation deduction of $2,000 
per year (10 percent of the $20,000 tax basis in Property A). This 
$2,000 tax depreciation deduction is allocated equally between B and 
C, the noncontributing partners with respect to Property A.
    (iii) At the end of the third year, the book value of Property A 
is $21,000 ($30,000 initial book value less $9,000 aggregate book 
depreciation) and the adjusted tax basis is $14,000 ($20,000 initial 
tax basis less $6,000 aggregate tax depreciation). A's remaining 
section 704(c)(1)(A) built-in gain with respect to Property A is 
$7,000 ($21,000 book value less $14,000 adjusted tax basis).
    (iv) On December 31, 1997, Property A is distributed to B in 
complete liquidation of B's interest in the partnership. If Property 
A had been sold for its fair market value at the 

[[Page 66731]]
time of the distribution, A would have recognized $7,000 of gain under 
section 704(c)(1)(A) and Sec. 1.704-3(b). Therefore, A recognizes 
$7,000 of gain on the distribution of Property A to B.
    Example 3. Effect of remedial method. (i) On January 1, 1995, A, 
B, and C form partnership ABC as equal partners. A contributes 
Property A1, nondepreciable real property with a fair market value 
of $10,000 and an adjusted tax basis of $5,000, and Property A2, 
nondepreciable real property with a fair market value and adjusted 
tax basis of $10,000. B and C each contribute $20,000 cash. ABC uses 
the remedial method of making section 704(c) allocations described 
in Sec. 1.704-3(d) with respect to Property A1.
    (ii) On December 31, 1998, when the fair market value of 
Property A1 has decreased to $7,000, Property A1 is distributed to C 
in a current distribution. If Property A1 had been sold by the 
partnership at the time of the distribution, ABC would have 
recognized the $2,000 of remaining built-in gain under section 
704(c)(1)(A) on the sale (fair market value of $7,000 less $5,000 
adjusted tax basis). All of this gain would have been allocated to 
A. ABC would also have recognized a book loss of $3,000 ($10,000 
original book value less $7,000 current fair market value of the 
property). Book loss in the amount of $2,000 would have been 
allocated equally between B and C. Under the remedial method, $2,000 
of tax loss would also have been allocated equally to B and C to 
match their share of the book loss. As a result, $2,000 of gain 
would also have been allocated to A as an offsetting remedial 
allocation. A would have recognized $4,000 of total gain under 
section 704(c)(1)(A) on the sale of Property A1 ($2,000 of section 
704(c) recognized gain plus $2,000 remedial gain). Therefore, A 
recognizes $4,000 of gain on the distribution of Property A1 to C 
under this section.

    (b) Character of gain or loss--(1) General rule. Gain or loss 
recognized by the contributing partner under section 704(c)(1)(B) and 
this section has the same character as the gain or loss that would have 
resulted if the distributed property had been sold by the partnership 
to the distributee partner at the time of the distribution.
    (2) Example. The following example illustrates the rule of this 
paragraph (b). Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for 
contributed property) for each year of the partnership, the fair market 
value of partnership property does not change, all distributions by the 
partnership are subject to section 704(c)(1)(B), and all partners are 
unrelated.

    Example. Character of gain. (i) On January 1, 1995, A and B form 
partnership AB. A contributes $10,000 and Property A, nondepreciable 
real property with a fair market value of $10,000 and an adjusted 
tax basis of $4,000, in exchange for a 25 percent interest in 
partnership capital and profits. B contributes $60,000 cash for a 75 
percent interest in partnership capital and profits.
    (ii) On December 31, 1998, Property A is distributed to B in a 
current distribution. Property A is used in a trade or business of 
B.
    (iii) A would have recognized $6,000 of gain under section 
704(c)(1)(A) on a sale of Property A at the time of the distribution 
(the difference between the fair market value ($10,000) and the 
adjusted tax basis ($4,000) of the property at that time). Because 
Property A is not a capital asset in the hands of Partner B and B 
holds more than 50 percent of partnership capital and profits, the 
character of the gain on a sale of Property A to B would have been 
ordinary income under section 707(b)(2). Therefore, the character of 
the gain to A on the distribution of Property A to B is ordinary 
income.

    (c) Exceptions--(1) Property contributed on or before October 3, 
1989. Section 704(c)(1)(B) and this section do not apply to property 
contributed to the partnership on or before October 3, 1989.
    (2) Certain liquidations. Section 704(c)(1)(B) and this section do 
not apply to a distribution of an interest in section 704(c) property 
to a partner other than the contributing partner in a liquidation of 
the partnership if--
    (i) The contributing partner receives an interest in the section 
704(c) property contributed by that partner (and no other property); 
and
    (ii) The built-in gain or loss in the interest distributed to the 
contributing partner, determined immediately after the distribution, is 
equal to or greater than the built-in gain or loss on the property that 
would have been allocated to the contributing partner under section 
704(c)(1)(A) and Sec. 1.704-3 on a sale of the contributed property to 
an unrelated party immediately before the distribution.
    (3) Section 708(b)(1)(B) termination. Section 704(c)(1)(B) and this 
section do not apply to a deemed distribution of property caused by a 
termination of the partnership under section 708(b)(1)(B). See 
paragraph (a)(4)(ii) of this section for a special rule regarding a new 
five-year period for certain property deemed contributed to a new 
partnership following a termination of the partnership under section 
708(b)(1)(B). See also Sec. 1.737-2(a) for a similar rule in the 
context of section 737.
    (4) Complete transfer to another partnership. Section 704(c)(1)(B) 
and this section do not apply to a transfer by a partnership 
(transferor partnership) of all of its assets and liabilities to a 
second partnership (transferee partnership) in an exchange described in 
section 721, followed by a distribution of the interest in the 
transferee partnership in liquidation of the transferor partnership as 
part of the same plan or arrangement. A subsequent distribution of 
section 704(c) property by the transferee partnership to a partner of 
the transferee partnership is subject to section 704(c)(1)(B) to the 
same extent that a distribution by the transferor partnership would 
have been subject to section 704(c)(1)(B). See Sec. 1.737-2(b) for a 
similar rule in the context of section 737.
    (5) Incorporation of a partnership. Section 704(c)(1)(B) and this 
section do not apply to an incorporation of a partnership by any method 
of incorporation (other than a method involving an actual distribution 
of partnership property to the partners followed by a contribution of 
that property to a corporation), provided that the partnership is 
liquidated as part of the incorporation transaction. See Sec. 1.737-
2(c) for a similar rule in the context of section 737.
    (6) Undivided interests. Section 704(c)(1)(B) and this section do 
not apply to a distribution of an undivided interest in property to the 
extent that the undivided interest does not exceed the undivided 
interest, if any, contributed by the distributee partner in the same 
property. See Sec. 1.737-2(d)(4) for the application of section 737 in 
a similar context. The portion of the undivided interest in property 
retained by the partnership after the distribution, if any, that is 
treated as contributed by the distributee partner, is reduced to the 
extent of the undivided interest distributed to the distributee 
partner.
    (7) Example. The following example illustrates the rule of 
paragraph (c)(2) of this section. Unless otherwise specified, 
partnership income equals partnership expenses (other than depreciation 
deductions for contributed property) for each year of the partnership, 
the fair market value of partnership property does not change, all 
distributions by the partnership are subject to section 704(c)(1)(B), 
and all partners are unrelated.

    Example. (i) On January 1, 1995, A and B form partnership AB, as 
equal partners. A contributes Property A, nondepreciable real 
property with a fair market value and adjusted tax basis of $20,000. 
B contributes Property B, nondepreciable real property with a fair 
market value of $20,000 and an adjusted tax basis of $10,000. 
Property B therefore has a built-in gain of $10,000 at the time of 
contribution.
    (ii) On December 31, 1998, the partnership liquidates when the 
fair market value of Property A has not changed, but the fair market 
value of Property B has increased to $40,000.
    (iii) In the liquidation, A receives Property A and a 25 percent 
interest in Property B. This interest in Property B has a fair 
market 

[[Page 66732]]
value of $10,000 to A, reflecting the fact that A was entitled to 50 
percent of the $20,000 post-contribution appreciation in Property B. 
The partnership distributes to B a 75 percent interest in Property B 
with a fair market value of $30,000. B's basis in this portion of 
Property B is $10,000 under section 732(b). As a result, B has a 
built-in gain of $20,000 in this portion of Property B immediately 
after the distribution ($30,000 fair market value less $10,000 
adjusted tax basis). This built-in gain is greater than the $10,000 
of built-in gain in Property B at the time of contribution to the 
partnership. B therefore does not recognize any gain on the 
distribution of a portion of Property B to A under this section.

    (d) Special rules--(1) Nonrecognition transactions. Property 
received by the partnership in exchange for section 704(c) property in 
a nonrecognition transaction is treated as the section 704(c) property 
for purposes of section 704(c)(1)(B) and this section to the extent 
that the property received is treated as section 704(c) property under 
Sec. 1.704-3(a)(8). See Sec. 1.737-2(d)(3) for a similar rule in the 
context of section 737.
    (2) Transfers of a partnership interest. The transferee of all or a 
portion of the partnership interest of a contributing partner is 
treated as the contributing partner for purposes of section 
704(c)(1)(B) and this section to the extent of the share of built-in 
gain or loss allocated to the transferee partner. See Sec. 1.704-
3(a)(7).
    (3) Distributions of like-kind property. If section 704(c) property 
is distributed to a partner other than the contributing partner and 
like-kind property (within the meaning of section 1031) is distributed 
to the contributing partner no later than the earlier of (i) 180 days 
following the date of the distribution to the non-contributing partner, 
or (ii) the due date (determined with regard to extensions) of the 
contributing partner's income tax return for the taxable year of the 
distribution to the noncontributing partner, the amount of gain or 
loss, if any, that the contributing partner would otherwise have 
recognized under section 704(c)(1)(B) and this section is reduced by 
the amount of built-in gain or loss in the distributed like-kind 
property in the hands of the contributing partner immediately after the 
distribution. The contributing partner's basis in the distributed like-
kind property is determined as if the like-kind property were 
distributed in an unrelated distribution prior to the distribution of 
any other property distributed as part of the same distribution and is 
determined without regard to the increase in the contributing partner's 
adjusted tax basis in the partnership interest under section 
704(c)(1)(B) and this section. See Sec. 1.707-3 for provisions treating 
the distribution of the like-kind property to the contributing partner 
as a disguised sale in certain situations.
    (4) Example. The following example illustrates the rules of this 
paragraph (d). Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for 
contributed property) for each year of the partnership, the fair market 
value of partnership property does not change, all distributions by the 
partnership are subject to section 704(c)(1)(B), and all partners are 
unrelated.

    Example. Distribution of like-kind property. (i) On January 1, 
1995, A, B, and C form partnership ABC as equal partners. A 
contributes Property A, nondepreciable real property with a fair 
market value of $20,000 and an adjusted tax basis of $10,000. B and 
C each contribute $20,000 cash. The partnership subsequently buys 
Property X, nondepreciable real property of a like-kind to Property 
A with a fair market value and adjusted tax basis of $8,000. The 
fair market value of Property X subsequently increases to $10,000.
    (ii) On December 31, 1998, Property A is distributed to B in a 
current distribution. At the same time, Property X is distributed to 
A in a current distribution. The distribution of Property X does not 
result in the contribution of Property A being properly 
characterized as a disguised sale to the partnership under 
Sec. 1.707-3. A's basis in Property X is $8,000 under section 
732(a)(1). A therefore has $2,000 of built-in gain in Property X 
($10,000 fair market value less $8,000 adjusted tax basis).
    (iii) A would generally recognize $10,000 of gain under section 
704(c)(1)(B) on the distribution of Property A, the difference 
between the fair market value ($20,000) of the property and its 
adjusted tax basis ($10,000). This gain is reduced, however, by the 
amount of the built-in gain of Property X in the hands of A. As a 
result, A recognizes only $8,000 of gain on the distribution of 
Property A to B under section 704(c)(1)(B) and this section.

    (e) Basis adjustments--(1) Contributing partner's basis in the 
partnership interest. The basis of the contributing partner's interest 
in the partnership is increased by the amount of the gain, or decreased 
by the amount of the loss, recognized by the partner under section 
704(c)(1)(B) and this section. This increase or decrease is taken into 
account in determining (i) the contributing partner's adjusted tax 
basis under section 732 for any property distributed to the partner in 
a distribution that is part of the same distribution as the 
distribution of the contributed property, other than like-kind property 
described in paragraph (d)(3) of this section (pertaining to the 
special rule for distributions of like-kind property), and (ii) the 
amount of the gain recognized by the contributing partner under section 
731 or section 737, if any, on a distribution of money or property to 
the contributing partner that is part of the same distribution as the 
distribution of the contributed property. For a determination of basis 
in a distribution subject to section 737, see Sec. 1.737-3(a).
    (2) Partnership's basis in partnership property. The partnership's 
adjusted tax basis in the distributed section 704(c) property is 
increased or decreased immediately before the distribution by the 
amount of gain or loss recognized by the contributing partner under 
section 704(c)(1)(B) and this section. Any increase or decrease in 
basis is therefore taken into account in determining the distributee 
partner's adjusted tax basis in the distributed property under section 
732. For a determination of basis in a distribution subject to section 
737, see Sec. 1.737-3(b).
    (3) Section 754 adjustments. The basis adjustments to partnership 
property made pursuant to paragraph (e)(2) of this section are not 
elective and must be made regardless of whether the partnership has an 
election in effect under section 754. Any adjustments to the bases of 
partnership property (including the distributed section 704(c) 
property) under section 734(b) pursuant to a section 754 election must 
be made after (and must take into account) the adjustments to basis 
made under paragraph (e)(2) of this section. See Sec. 1.737-3(c)(4) for 
a similar rule in the context of section 737.
    (4) Example. The following example illustrates the rules of this 
paragraph (e). Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for 
contributed property) for each year of the partnership, the fair market 
value of partnership property does not change, all distributions by the 
partnership are subject to section 704(c)(1)(B), and all partners are 
unrelated.

    Example. Basis adjustment.  On January 1, 1995, A, B, and C form 
partnership ABC as equal partners. A contributes $10,000 cash and 
Property A, nondepreciable real property with a fair market value of 
$10,000 and an adjusted tax basis of $4,000. B and C each contribute 
$20,000 cash.
    (ii) On December 31, 1998, Property A is distributed to B in a 
current distribution.
    (iii) Under paragraph (a) of this section, A recognizes $6,000 
of gain on the distribution of Property A because that is the amount 
of gain that would have been allocated to A under section 
704(c)(1)(A) and Sec. 1.704-3 on a sale of Property A for its fair 
market value at the time of the distribution (fair market value of 
Property A ($10,000) less its 

[[Page 66733]]
adjusted tax basis at the time of distribution ($4,000)). The adjusted 
tax basis of A's partnership interest is increased from $14,000 to 
$20,000 to reflect this gain. The partnership's adjusted tax basis 
in Property A is increased from $4,000 to $10,000 immediately prior 
to its distribution to B. B's adjusted tax basis in Property A is 
therefore $10,000 under section 732(a)(1).

    (f) Anti-abuse rule--(1) In general. The rules of section 
704(c)(1)(B) and this section must be applied in a manner consistent 
with the purpose of section 704(c)(1)(B). Accordingly, if a principal 
purpose of a transaction is to achieve a tax result that is 
inconsistent with the purpose of section 704(c)(1)(B), the Commissioner 
can recast the transaction for federal tax purposes as appropriate to 
achieve tax results that are consistent with the purpose of section 
704(c)(1)(B) and this section. Whether a tax result is inconsistent 
with the purpose of section 704(c)(1)(B) and this section must be 
determined based on all the facts and circumstances. See Sec. 1.737-4 
for an anti-abuse rule and examples in the context of section 737.
    (2) Examples. The following examples illustrate the anti-abuse rule 
of this paragraph (f). The examples set forth below do not delineate 
the boundaries of either permissible or impermissible types of 
transactions. Further, the addition of any facts or circumstances that 
are not specifically set forth in an example (or the deletion of any 
facts or circumstances) may alter the outcome of the transaction 
described in the example. Unless otherwise specified, partnership 
income equals partnership expenses (other than depreciation deductions 
for contributed property) for each year of the partnership, the fair 
market value of partnership property does not change, all distributions 
by the partnership are subject to section 704(c)(1)(B), and all 
partners are unrelated.

    Example 1. Distribution in substance made within five-year 
period; results inconsistent with the purpose of section 
704(c)(1)(B). (i) On January 1, 1995, A, B, and C form partnership 
ABC as equal partners. A contributes Property A, nondepreciable real 
property with a fair market value of $10,000 and an adjusted tax 
basis of $1,000. B and C each contributes $10,000 cash.
    (ii) On December 31, 1998, the partners desire to distribute 
Property A to B in complete liquidation of B's interest in the 
partnership. If Property A were distributed at that time, however, A 
would recognize $9,000 of gain under section 704(c)(1)(B), the 
difference between the $10,000 fair market value and the $1,000 
adjusted tax basis of Property A, because Property A was contributed 
to the partnership less than five years before December 31, 1998. On 
becoming aware of this potential gain recognition, and with a 
principal purpose of avoiding such gain, the partners amend the 
partnership agreement on December 31, 1998, and take any other steps 
necessary to provide that substantially all of the economic risks 
and benefits of Property A are borne by B as of December 31, 1998, 
and that substantially all of the economic risks and benefits of all 
other partnership property are borne by A and C. The partnership 
holds Property A until January 5, 2000, at which time it is 
distributed to B in complete liquidation of B's interest in the 
partnership.
    (iii) The actual distribution of Property A occurred more than 
five years after the contribution of the property to the 
partnership. The steps taken by the partnership on December 31, 
1998, however, are the functional equivalent of an actual 
distribution of Property A to B in complete liquidation of B's 
interest in the partnership as of that date. Section 704(c)(1)(B) 
requires recognition of gain when contributed section 704(c) 
property is in substance distributed to another partner within five 
years of its contribution to the partnership. Allowing a 
contributing partner to avoid section 704(c)(1)(B) through 
arrangements such as those in this Example 1 that have the effect of 
a distribution of property within five years of the date of its 
contribution to the partnership would effectively undermine the 
purpose of section 704(c)(1)(B) and this section. As a result, the 
steps taken by the partnership on December 31, 1998, are treated as 
causing a distribution of Property A to B for purposes of section 
704(c)(1)(B) on that date, and A recognizes gain of $9,000 under 
section 704(c)(1)(B) and this section at that time.
    (iv) Alternatively, if on becoming aware of the potential gain 
recognition to A on a distribution of Property A on December 31, 
1998, the partners had instead agreed that B would continue as a 
partner with no changes to the partnership agreement or to B's 
economic interest in partnership operations, the distribution of 
Property A to B on January 5, 2000, would not have been inconsistent 
with the purpose of section 704(c)(1)(B) and this section. In that 
situation, Property A would not have been distributed until after 
the expiration of the five-year period specified in section 
704(c)(1)(B) and this section. Deferring the distribution of 
Property A until the end of the five-year period for a principal 
purpose of avoiding the recognition of gain under section 
704(c)(1)(B) and this section is not inconsistent with the purpose 
of section 704(c)(1)(B). Therefore, A would not have recognized gain 
on the distribution of Property A in that case.
    Example 2. Suspension of five-year period in manner consistent 
with the purpose of section 704(c)(1)(B). (i) A, B, and C form 
partnership ABC on January 1, 1995, to conduct bona fide business 
activities. A contributes Property A, nondepreciable real property 
with a fair market value of $10,000 and an adjusted tax basis of 
$1,000, in exchange for a 49.5 percent interest in partnership 
capital and profits. B contributes $10,000 in cash for a 49.5 
percent interest in partnership capital and profits. C contributes 
cash for a 1 percent interest in partnership capital and profits. A 
and B are wholly owned subsidiaries of the same affiliated group and 
continue to control the management of Property A by virtue of their 
controlling interests in the partnership. The partnership is formed 
pursuant to a plan a principal purpose of which is to minimize the 
period of time that A would have to remain a partner with a 
potential acquiror of Property A.
    (ii) On December 31, 1997, D is admitted as a partner to the 
partnership in exchange for $10,000 cash.
    (iii) On January 5, 2000, Property A is distributed to D in 
complete liquidation of D's interest in the partnership.
    (iv) The distribution of Property A to D occurred more than five 
years after the contribution of the property to the partnership. On 
these facts, however, a principal purpose of the transaction was to 
minimize the period of time that A would have to remain partners 
with a potential acquiror of Property A, and treating the five-year 
period of section 704(c)(1)(B) as running during a time when 
Property A was still effectively owned through the partnership by 
members of the contributing affiliated group of which A is a member 
is inconsistent with the purpose of section 704(c)(1)(B). Prior to 
the admission of D as a partner, the pooling of assets between A and 
B, on the one hand, and C, on the other hand, although sufficient to 
constitute ABC as a valid partnership for federal income tax 
purposes, is not a sufficient pooling of assets for purposes of 
running the five-year period with respect to the distribution of 
Property A to D. Allowing a contributing partner to avoid section 
704(c)(1)(B) through arrangements such as those in this Example 2 
would have the effect of substantially nullifying the five-year 
requirement of section 704(c)(1)(B) and this section and elevating 
the form of the transaction over its substance. As a result, with 
respect to the distribution of Property A to D, the five-year period 
of section 704(c)(1)(B) is tolled until the admission of D as a 
partner on December 31, 1997. Therefore, the distribution of 
Property A occurred before the end of the five-year period of 
section 704(c)(1)(B), and A recognizes gain of $9,000 under section 
704(c)(1)(B) on the distribution.

    (g) Effective date. This section applies to distributions by a 
partnership to a partner on or after January 9, 1995.
    Par. 3. Sections 1.737-1, 1.737-2, 1.737-3, 1.737-4, and 1.737-5 
are added to read as follows:


Sec. 1.737-1  Recognition of precontribution gain.

    (a) Determination of gain--(1) In general. A partner that receives 
a distribution of property (other than money) must recognize gain under 
section 737 and this section in an amount equal to the lesser of the 
excess distribution (as defined in paragraph (b) of this section) or 
the partner's net precontribution gain (as defined in paragraph (c) of 
this section). Gain recognized under section 737 and this section is in 
addition to any gain recognized under section 731.

[[Page 66734]]

    (2) Transactions to which section 737 applies. Section 737 and this 
section apply only to the extent that a distribution by a partnership 
is a distribution to a partner acting in the capacity of a partner 
within the meaning of section 731, except that section 737 and this 
section do not apply to the extent that section 751(b) applies to the 
distribution.
    (b) Excess distribution--(1) Definition. The excess distribution is 
the amount (if any) by which the fair market value of the distributed 
property (other than money) exceeds the distributee partner's adjusted 
tax basis in the partner's partnership interest.
    (2) Fair market value of property. The fair market value of the 
distributed property is the price at which the property would change 
hands between a willing buyer and a willing seller at the time of the 
distribution, neither being under any compulsion to buy or sell and 
both having reasonable knowledge of the relevant facts. The fair market 
value that a partnership assigns to distributed property will be 
regarded as correct, provided that the value is reasonably agreed to 
among the partners in an arm's-length negotiation and the partners have 
sufficiently adverse interests.
    (3) Distributee partner's adjusted tax basis--(i) General rule. In 
determining the amount of the excess distribution, the distributee 
partner's adjusted tax basis in the partnership interest includes any 
basis adjustment resulting from the distribution that is subject to 
section 737 (for example, adjustments required under section 752) and 
from any other distribution or transaction that is part of the same 
distribution, except for--
    (A) The increase required under section 737(c)(1) for the gain 
recognized by the partner under section 737; and
    (B) The decrease required under section 733(2) for any property 
distributed to the partner other than property previously contributed 
to the partnership by the distributee partner. See Sec. 1.704-4(e)(1) 
for a rule in the context of section 704(c)(1)(B). See also Sec. 1.737-
3(b)(2) for a special rule for determining a partner's adjusted tax 
basis in distributed property previously contributed by the partner to 
the partnership.
    (ii) Advances or drawings. The distributee partner's adjusted tax 
basis in the partnership interest is determined as of the last day of 
the partnership's taxable year if the distribution to which section 737 
applies is properly characterized as an advance or drawing against the 
partner's distributive share of income. See Sec. 1.731-1(a)(1)(ii).
    (c) Net precontribution gain--(1) General rule. The distributee 
partner's net precontribution gain is the net gain (if any) that would 
have been recognized by the distributee partner under section 
704(c)(1)(B) and Sec. 1.704-4 if all property that had been contributed 
to the partnership by the distributee partner within five years of the 
distribution and is held by the partnership immediately before the 
distribution had been distributed by the partnership to another partner 
other than a partner who owns, directly or indirectly, more than 50 
percent of the capital or profits interest in the partnership. See 
Sec. 1.704-4 for provisions determining a contributing partner's gain 
or loss under section 704(c)(1)(B) on an actual distribution of 
contributed section 704(c) property to another partner.
    (2) Special rules--(i) Property contributed on or before October 3, 
1989. Property contributed to the partnership on or before October 3, 
1989, is not taken into account in determining a partner's net 
precontribution gain. See Sec. 1.704-4(c)(1) for a similar rule in the 
context of section 704(c)(1)(B).
    (ii) Section 734(b)(1)(A) adjustments. For distributions to a 
distributee partner of money by a partnership with a section 754 
election in effect that are part of the same distribution as the 
distribution of property subject to section 737, for purposes of 
paragraph (a) and (c)(1) of this section the distributee partner's net 
precontribution gain is reduced by the basis adjustments (if any) made 
to section 704(c) property contributed by the distributee partner under 
section 734(b)(1)(A). See Sec. 1.737-3(c)(4) for rules regarding basis 
adjustments for partnerships with a section 754 election in effect.
    (iii) Transfers of a partnership interest. The transferee of all or 
a portion of a contributing partner's partnership interest succeeds to 
the transferor's net precontribution gain, if any, in an amount 
proportionate to the interest transferred. See Sec. 1.704-3(a)(7) and 
Sec. 1.704-4(d)(2) for similar provisions in the context of section 
704(c)(1)(A) and section 704(c)(1)(B).
    (iv) Section 704(c)(1)(B) gain recognized in related distribution. 
A distributee partner's net precontribution gain is determined after 
taking into account any gain or loss recognized by the partner under 
section 704(c)(1)(B) and Sec. 1.704-4 (or that would have been 
recognized by the partner except for the like-kind exception in section 
704(c)(2) and Sec. 1.704-4(d)(3)) on an actual distribution to another 
partner of section 704(c) property contributed by the distributee 
partner that is part of the same distribution as the distribution to 
the distributee partner.
    (v) Section 704(c)(2) disregarded. A distributee partner's net 
precontribution gain is determined without regard to the provisions of 
section 704(c)(2) and Sec. 1.704-4(d)(3) in situations in which the 
property contributed by the distributee partner is not actually 
distributed to another partner in a distribution related to the section 
737 distribution.
    (d) Character of gain. The character of the gain recognized by the 
distributee partner under section 737 and this section is determined 
by, and is proportionate to, the character of the partner's net 
precontribution gain. For this purpose, all gains and losses on section 
704(c) property taken into account in determining the partner's net 
precontribution gain are netted according to their character. Character 
is determined at the partnership level for this purpose, and any 
character with a net negative amount is disregarded. The character of 
the partner's gain under section 737 is the same as, and in proportion 
to, any character with a net positive amount. Character for this 
purpose is determined as if the section 704(c) property had been sold 
by the partnership to an unrelated third party at the time of the 
distribution and includes any item that would have been taken into 
account separately by the contributing partner under section 702(a) and 
Sec. 1.702-1(a).
    (e) Examples. The following examples illustrate the provisions of 
this section. Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for 
contributed property) for each year of the partnership, the fair market 
value of partnership property does not change, all distributions by the 
partnership are subject to section 737, and all partners are unrelated.

    Example 1. Calculation of excess distribution and net 
precontribution gain. (i) On January 1, 1995, A, B, and C form 
partnership ABC as equal partners. A contributes Property A, 
depreciable real property with a fair market value of $30,000 and an 
adjusted tax basis of $20,000. B contributes Property B, 
nondepreciable real property with a fair market value and adjusted 
tax basis of $30,000. C contributes $30,000 cash.
    (ii) Property A has 10 years remaining on its cost recovery 
schedule and is depreciated using the straight-line method. The 
partnership uses the traditional method for allocating items under 
section 704(c) described in Sec. 1.704-3(b)(1) for Property A. The 
partnership has book depreciation of $3,000 per year (10 percent of 
the $30,000 book basis in Property A) and each partner 

[[Page 66735]]
is allocated $1,000 of book depreciation per year (one-third of the 
total annual book depreciation of $3,000). The partnership also has 
tax depreciation of $2,000 per year (10 percent of the $20,000 
adjusted tax basis in Property A). This $2,000 tax depreciation is 
allocated equally between B and C, the noncontributing partners with 
respect to Property A.
    (iii) At the end of 1997, the book value of Property A is 
$21,000 ($30,000 initial book value less $9,000 aggregate book 
depreciation) and its adjusted tax basis is $14,000 ($20,000 initial 
tax basis less $6,000 aggregate tax depreciation).
    (iv) On December 31, 1997, Property B is distributed to A in 
complete liquidation of A's partnership interest. The adjusted tax 
basis of A's partnership interest at that time is $20,000. The 
amount of the excess distribution is $10,000, the difference between 
the fair market value of the distributed Property B ($30,000) and 
A's adjusted tax basis in A's partnership interest ($20,000). A's 
net precontribution gain is $7,000, the difference between the book 
value of Property A ($21,000) and its adjusted tax basis at the time 
of the distribution ($14,000). A recognizes gain of $7,000 on the 
distribution, the lesser of the excess distribution and the net 
precontribution gain.
    Example 2. Determination of distributee partner's basis. (i) On 
January 1, 1995, A, B, and C form general partnership ABC as equal 
partners. A contributes Property A, nondepreciable real property 
with a fair market value of $10,000 and an adjusted tax basis of 
$4,000. B and C each contributes $10,000 cash.
    (ii) The partnership purchases Property B, nondepreciable real 
property with a fair market value of $9,000, subject to a $9,000 
nonrecourse liability. This nonrecourse liability is allocated 
equally among the partners under section 752, increasing A's 
adjusted tax basis in A's partnership interest from $4,000 to 
$7,000.
    (iii) On December 31, 1998, A receives $2,000 cash and Property 
B, subject to the $9,000 liability, in a current distribution.
    (iv) In determining the amount of the excess distribution, the 
adjusted tax basis of A's partnership interest is adjusted to take 
into account the distribution of money and the shift in liabilities. 
A's adjusted tax basis is therefore increased to $11,000 for this 
purpose ($7,000 initial adjusted tax basis, less $2,000 distribution 
of money, less $3,000 (decrease in A's share of the $9,000 
partnership liability), plus $9,000 (increase in A's individual 
liabilities)). As a result of this basis adjustment, the adjusted 
tax basis of A's partnership interest ($11,000) is greater than the 
fair market value of the distributed property ($9,000) and 
therefore, there is no excess distribution. A recognizes no gain 
under section 737.
    Example 3. Net precontribution gain reduced for gain recognized 
under section 704(c)(1)(B). (i) On January 1, 1995, A, B, and C form 
partnership ABC as equal partners. A contributes Properties A1 and 
A2, nondepreciable real properties located in the United States each 
with a fair market value of $10,000 and an adjusted tax basis of 
$6,000. B contributes Property B, nondepreciable real property 
located outside the United States, with a fair market value and 
adjusted tax basis of $20,000. C contributes $20,000 cash.
    (ii) On December 31, 1998, Property B is distributed to A in 
complete liquidation of A's interest and, as part of the same 
distribution, Property A1 is distributed to B in a current 
distribution.
    (iii) A's net precontribution gain before the distribution is 
$8,000 ($20,000 fair market value of Properties A1 and A2 less 
$12,000 adjusted tax basis of such properties). A recognizes $4,000 
of gain under section 704(c)(1)(B) and Sec. 1.704-4 on the 
distribution of Property A1 to B ($10,000 fair market value of 
Property A1 less $6,000 adjusted tax basis of Property A1). This 
gain is taken into account in determining A's excess distribution 
and net precontribution gain. As a result, A's net precontribution 
gain is reduced from $8,000 to $4,000, and the adjusted tax basis in 
A's partnership interest is increased by $4,000 to $16,000.
    (iv) A recognizes gain of $4,000 on the receipt of Property B 
under section 737, an amount equal to the lesser of the excess 
distribution of $4,000 ($20,000 fair market value of Property B less 
$16,000 adjusted tax basis of A's interest in the partnership) and 
A's remaining net precontribution gain of $4,000.
    Example 4. Character of gain. (i) On January 1, 1995, A, B, and 
C form partnership ABC as equal partners. A contributes the 
following nondepreciable property to the partnership:

------------------------------------------------------------------------
                                                       Fair             
                                                      market    Adjusted
                                                      value    tax basis
------------------------------------------------------------------------
Property A1.......................................    $30,000    $20,000
Property A2.......................................     30,000     38,000
Property A3.......................................     10,000      9,000
------------------------------------------------------------------------

    (ii) The character of gain or loss on Property A1 and Property 
A2 is long-term, U.S.-source capital gain or loss. The character of 
gain on Property A3 is long-term, foreign-source capital gain. B 
contributes Property B, nondepreciable real property with a fair 
market value and adjusted tax basis of $70,000. C contributes 
$70,000 cash.
    (iii) On December 31, 1998, Property B is distributed to A in 
complete liquidation of A's interest in the partnership. A 
recognizes $3,000 of gain under section 737, an amount equal to the 
excess distribution of $3,000 ($70,000 fair market value of Property 
B less $67,000 adjusted tax basis in A's partnership interest) and 
A's net precontribution gain of $3,000 ($70,000 aggregate fair 
market value of properties contributed by A less $67,000 aggregate 
adjusted tax basis of such properties).
    (iv) In determining the character of A's gain, all gains and 
losses on property taken into account in determining A's net 
precontribution gain are netted according to their character and 
allocated to A's recognized gain under section 737 based on the 
relative proportions of the net positive amounts. U.S.-source and 
foreign-source gains must be netted separately because A would have 
been required to take such gains into account separately under 
section 702. As a result, A's net precontribution gain of $3,000 
consists of $2,000 of net long-term, U.S.-source capital gain 
($10,000 gain on Property A1 and $8,000 loss on Property A2) and 
$1,000 of net long-term, foreign-source capital gain ($1,000 gain on 
Property A3).
    (v) The character of A's gain under paragraph (d) of this 
section is therefore $2,000 long-term, U.S.-source capital gain 
($3,000 gain recognized under section 737  x  $2,000 net long-term, 
U.S.-source capital gain/$3,000 total net precontribution gain) and 
$1,000 long-term, foreign-source capital gain ($3,000 gain 
recognized under section 737  x  $1,000 net long-term, foreign-
source capital gain/$3,000 total net precontribution gain).


Sec. 1.737-2  Exceptions and special rules.

    (a) Section 708(b)(1)(B) terminations. Section 737 and this section 
do not apply to a deemed distribution of property caused by a 
termination of the partnership under section 708(b)(1)(B). See 
Sec. 1.704-4(c)(3) for a similar rule in the context of section 
704(c)(1)(B).
    (b) Transfers to another partnership--(1) Complete transfer. 
Section 737 and this section do not apply to a transfer by a 
partnership (transferor partnership) of all of its assets and 
liabilities to a second partnership (transferee partnership) in an 
exchange described in section 721, followed by a distribution of the 
interest in the transferee partnership in liquidation of the transferor 
partnership as part of the same plan or arrangement. See Sec. 1.704-
4(c)(4) for a similar rule in the context of section 704(c)(1)(B).
    (2) Certain divisive transactions. Section 737 and this section do 
not apply to a transfer by a partnership (transferor partnership) of 
all of the section 704(c) property contributed by a partner to a second 
partnership (transferee partnership) in an exchange described in 
section 721, followed by a distribution as part of the same plan or 
arrangement of an interest in the transferee partnership (and no other 
property) in complete liquidation of the interest of the partner that 
originally contributed the section 704(c) property to the transferor 
partnership.
    (3) Subsequent distributions. A subsequent distribution of property 
by the transferee partnership to a partner of the transferee 
partnership that was formerly a partner of the transferor partnership 
is subject to section 737 to the same extent that a distribution from 
the transferor partnership would have been subject to section 737.
    (c) Incorporation of a partnership. Section 737 and this section do 
not apply to an incorporation of a partnership by any method of 
incorporation (other than a method involving an actual distribution of 

[[Page 66736]]
partnership property to the partners followed by a contribution of that 
property to a corporation), provided that the partnership is liquidated 
as part of the incorporation transaction. See Sec. 1.704-4(c)(5) for a 
similar rule in the context of section 704(c)(1)(B).
    (d) Distribution of previously contributed property--(1) General 
rule. Any portion of the distributed property that consists of property 
previously contributed by the distributee partner (including property 
treated as contributed by the partner in connection with a termination 
of the partnership under section 708(b)(1)(B)) (previously contributed 
property) is not taken into account in determining the amount of the 
excess distribution or the partner's net precontribution gain. See 
Sec. 1.737-3(b)(2) for a special rule for determining the basis of 
previously contributed property in the hands of a distributee partner 
who contributed the property to the partnership.
    (2) Limitation for distribution of previously contributed interest 
in an entity. An interest in an entity previously contributed to the 
partnership is not treated as previously contributed property to the 
extent that the value of the interest is attributable to property 
contributed to the entity after the interest was contributed to the 
partnership. The preceding sentence does not apply to the extent that 
the property contributed to the entity was contributed to the 
partnership by the partner that also contributed the interest in the 
entity to the partnership.
    (3) Nonrecognition transactions. Property received by the 
partnership in exchange for contributed section 704(c) property in a 
nonrecognition transaction is treated as the contributed property with 
regard to the contributing partner for purposes of section 737 to the 
extent that the property received is treated as section 704(c) property 
under Sec. 1.704-3(a)(8). See Sec. 1.704-4(d)(1) for a similar rule in 
the context of section 704(c)(1)(B).
    (4) Undivided interests. The distribution of an undivided interest 
in property is treated as the distribution of previously contributed 
property to the extent that the undivided interest does not exceed the 
undivided interest, if any, contributed by the distributee partner in 
the same property. See Sec. 1.704-4(c)(6) for the application of 
section 704(c)(1)(B) in a similar context. The portion of the undivided 
interest in property retained by the partnership after the 
distribution, if any, that is treated as contributed by the distributee 
partner, is reduced to the extent of the undivided interest distributed 
to the distributee partner.
    (e) Examples. The following examples illustrate the rules of this 
section. Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for 
contributed property) for each year of the partnership, the fair market 
value of partnership property does not change, all distributions by the 
partnership are subject to section 737, and all partners are unrelated.

    Example 1. Distribution of previously contributed property. (i) 
On January 1, 1995, A, B, and C form partnership ABC as equal 
partners. A contributes the following nondepreciable real property 
to the partnership:

------------------------------------------------------------------------
                                                       Fair             
                                                      market    Adjusted
                                                      value    tax basis
------------------------------------------------------------------------
Property A1.......................................    $20,000    $10,000
Property A2.......................................     10,000      6,000
------------------------------------------------------------------------

    (ii) A's total net precontribution gain on the contributed 
property is $14,000 ($10,000 on Property A1 plus $4,000 on Property 
A2). B contributes $10,000 cash and Property B, nondepreciable real 
property with a fair market value and adjusted tax basis of $20,000. 
C contributes $30,000 cash.
    (iii) On December 31, 1998, Property A2 and Property B are 
distributed to A in complete liquidation of A's interest in the 
partnership. Property A2 was previously contributed by A and is 
therefore not taken into account in determining the amount of the 
excess distribution or A's net precontribution gain. The adjusted 
tax basis of Property A2 in the hands of A is also determined under 
section 732 as if that property were the only property distributed 
to A.
    (iv) As a result of excluding Property A2 from these 
determinations, the amount of the excess distribution is $10,000 
($20,000 fair market value of distributed Property B less $10,000 
adjusted tax basis in A's partnership interest). A's net 
precontribution gain is also $10,000 ($14,000 total net 
precontribution gain less $4,000 gain with respect to previously 
contributed Property A2). A therefore recognizes $10,000 of gain on 
the distribution, the lesser of the excess distribution and the net 
precontribution gain.
    Example 2. Distribution of a previously contributed interest in 
an entity. (i) On January 1, 1995, A, B, and C form partnership ABC 
as equal partners. A contributes Property A, nondepreciable real 
property with a fair market value of $10,000 and an adjusted tax 
basis of $5,000, and all of the stock of Corporation X with a fair 
market value and adjusted tax basis of $500. B contributes $500 cash 
and Property B, nondepreciable real property with a fair market 
value and adjusted tax basis of $10,000. Partner C contributes 
$10,500 cash. On December 31, 1996, ABC contributes Property B to 
Corporation X in a nonrecognition transaction under section 351.
    (ii) On December 31, 1998, all of the stock of Corporation X is 
distributed to A in complete liquidation of A's interest in the 
partnership. The stock is treated as previously contributed property 
with respect to A only to the extent of the $500 fair market value 
of the Corporation X stock contributed by A. The fair market value 
of the distributed stock for purposes of determining the amount of 
the excess distribution is therefore $10,000 ($10,500 total fair 
market value of Corporation X stock less $500 portion treated as 
previously contributed property). The $500 fair market value and 
adjusted tax basis of the Corporation X stock is also not taken into 
account in determining the amount of the excess distribution and the 
net precontribution gain.
    (iii) A recognizes $5,000 of gain under section 737, the amount 
of the excess distribution ($10,000 fair market value of distributed 
property less $5,000 adjusted tax basis in A's partnership interest) 
and A's net precontribution gain ($10,000 fair market value of 
Property A less $5,000 adjusted tax basis in Property A).
    Example 3. Distribution of undivided interest in property. (i) 
On January 1, 1995, A and B form partnership AB as equal partners. A 
contributes $500 cash and an undivided one-half interest in Property 
X. B contributes $500 cash and an undivided one-half interest in 
Property X.
    (ii) On December 31, 1998, an undivided one-half interest in 
Property X is distributed to A in a current distribution. The 
distribution of the undivided one-half interest in Property X is 
treated as a distribution of previously contributed property because 
A contributed an undivided one-half interest in Property X. As a 
result, A does not recognize any gain under section 737 on the 
distribution.


Sec. 1.737-3  Basis adjustments; Recovery rules.

    (a) Distributee partner's adjusted tax basis in the partnership 
interest. The distributee partner's adjusted tax basis in the 
partnership interest is increased by the amount of gain recognized by 
the distributee partner under section 737 and this section. This 
increase is not taken into account in determining the amount of gain 
recognized by the partner under section 737(a)(1) and this section or 
in determining the amount of gain recognized by the partner under 
section 731(a) on the distribution of money in the same distribution or 
any related distribution. See Sec. 1.704-4(e)(1) for a determination of 
the distributee partner's adjusted tax basis in a distribution subject 
to section 704(c)(1)(B).
    (b) Distributee partner's adjusted tax basis in distributed 
property--(1) In general. The distributee partner's adjusted tax basis 
in the distributed property is determined under section 732 (a) or (b) 
as applicable. The increase in the distributee partner's adjusted tax 
basis in the partnership interest under paragraph (a) of this section 
is taken into account in determining the distributee partner's adjusted 
tax basis 

[[Page 66737]]
in the distributed property other than property previously contributed 
by the partner. See Sec. 1.704-4(e)(2) for a determination of basis in 
a distribution subject to section 704(c)(1)(B).
    (2) Previously contributed property. The distributee partner's 
adjusted tax basis in distributed property that the partner previously 
contributed to the partnership is determined as if it were distributed 
in a separate and independent distribution prior to the distribution 
that is subject to section 737 and Sec. 1.737-1.
    (c) Partnership's adjusted tax basis in partnership property--(1) 
Increase in basis. The partnership's adjusted tax basis in eligible 
property is increased by the amount of gain recognized by the 
distributee partner under section 737.
    (2) Eligible property. Eligible property is property that----
    (i) Entered into the calculation of the distributee partner's net 
precontribution gain;
    (ii) Has an adjusted tax basis to the partnership less than the 
property's fair market value at the time of the distribution;
    (iii) Would have the same character of gain on a sale by the 
partnership to an unrelated party as the character of any of the gain 
recognized by the distributee partner under section 737; and
    (iv) Was not distributed to another partner in a distribution 
subject to section 704(c)(1)(B) and Sec. 1.704-4 that was part of the 
same distribution as the distribution subject to section 737.
    (3) Method of adjustment. For the purpose of allocating the basis 
increase under paragraph (c)(2) of this section among the eligible 
property, all eligible property of the same character is treated as a 
single group. Character for this purpose is determined in the same 
manner as the character of the recognized gain is determined under 
Sec. 1.737-1(d). The basis increase is allocated among the separate 
groups of eligible property in proportion to the character of the gain 
recognized under section 737. The basis increase is then allocated 
among property within each group in the order in which the property was 
contributed to the partnership by the partner, starting with the 
property contributed first, in an amount equal to the difference 
between the property's fair market value and its adjusted tax basis to 
the partnership at the time of the distribution. For property that has 
the same character and was contributed in the same (or a related) 
transaction, the basis increase is allocated based on the respective 
amounts of unrealized appreciation in such properties at the time of 
the distribution.
    (4) Section 754 adjustments. The basis adjustments to partnership 
property made pursuant to paragraph (c)(1) of this section are not 
elective and must be made regardless of whether the partnership has an 
election in effect under section 754. Any adjustments to the bases of 
partnership property (including eligible property as defined in 
paragraph (c)(2) of this section) under section 734(b) pursuant to a 
section 754 election (other than basis adjustments under section 
734(b)(1)(A) described in the following sentence) must be made after 
(and must take into account) the adjustments to basis made under 
paragraph (a) and paragraph (c)(1) of this section. Basis adjustments 
under section 734(b)(1)(A) that are attributable to distributions of 
money to the distributee partner that are part of the same distribution 
as the distribution of property subject to section 737 are made before 
the adjustments to basis under paragraph (a) and paragraph (c)(1) of 
this section. See Sec. 1.737-1(c)(2)(ii) for the effect, if any, of 
basis adjustments under section 734(b)(1)(A) on a partner's net 
precontribution gain. See also Sec. 1.704-4(e)(3) for a similar rule 
regarding basis adjustments pursuant to a section 754 election in the 
context of section 704(c)(1)(B).
    (d) Recovery of increase to adjusted tax basis. Any increase to the 
adjusted tax basis of partnership property under paragraph (c)(1) of 
this section is recovered using any applicable recovery period and 
depreciation (or other cost recovery) method (including first-year 
conventions) available to the partnership for newly purchased property 
(of the type adjusted) placed in service at the time of the 
distribution.
    (e) Examples. The following examples illustrate the rules of this 
section. Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for 
contributed property) for each year of the partnership, the fair market 
value of partnership property does not change, all distributions by the 
partnership are subject to section 737, and all partners are unrelated.
    (e) Example 1. Partner's basis in distributed property. (i) On 
January 1, 1995, A, B, and C form partnership ABC as equal partners. 
A contributes Property A, nondepreciable real property with a fair 
market value of $10,000 and an adjusted tax basis of $5,000. B 
contributes Property B, nondepreciable real property with a fair 
market value and adjusted tax basis of $10,000. C contributes 
$10,000 cash.
    (ii) On December 31, 1998, Property B is distributed to A in 
complete liquidation of A's interest in the partnership. A 
recognizes $5,000 of gain under section 737, an amount equal to the 
excess distribution of $5,000 ($10,000 fair market value of Property 
B less $5,000 adjusted tax basis in A's partnership interest) and 
A's net precontribution gain of $5,000 ($10,000 fair market value of 
Property A less $5,000 adjusted tax basis of such property).
    (iii) A's adjusted tax basis in A's partnership interest is 
increased by the $5,000 of gain recognized under section 737. This 
increase is taken into account in determining A's basis in the 
distributed property. Therefore, A's adjusted tax basis in 
distributed Property B is $10,000 under section 732(b).
    Example 2. Partner's basis in distributed property in connection 
with gain recognized under section 704(c)(1)(B). (i) On January 1, 
1995, A, B, and C form partnership ABC as equal partners. A 
contributes the following nondepreciable real property to the 
partnership:

------------------------------------------------------------------------
                                                       Fair             
                                                      market    Adjusted
                                                      value    tax basis
------------------------------------------------------------------------
Property A1.......................................    $10,000      5,000
Property A2.......................................     10,000      2,000
------------------------------------------------------------------------

    (ii) B contributes $10,000 cash and Property B, nondepreciable 
real property, with a fair market value and adjusted tax basis of 
$10,000. C contributes $20,000 cash.
    (iii) On December 31, 1998, Property B is distributed to A in a 
current distribution and Property A1 is distributed to B in a 
current distribution. A recognizes $5,000 of gain under section 
704(c)(1)(B) and Sec. 1.704-4 on the distribution of Property A1 to 
B, the difference between the fair market value of such property 
($10,000) and the adjusted tax basis in distributed Property A1 
($5,000). The adjusted tax basis of A's partnership interest is 
increased by this $5,000 of gain under section 704(c)(1)(B) and 
Sec. 1.704-4(e)(1).
    (iv) The increase in the adjusted tax basis of A's partnership 
interest is taken into account in determining the amount of the 
excess distribution. As a result, there is no excess distribution 
because the fair market value of Property B ($10,000) is less than 
the adjusted tax basis of A's interest in the partnership at the 
time of distribution ($12,000). A therefore recognizes no gain under 
section 737 on the receipt of Property B. A's adjusted tax basis in 
Property B is $10,000 under section 732(a)(1). The adjusted tax 
basis of A's partnership interest is reduced from $12,000 to $2,000 
under section 733. See Example 3 of Sec. 1.737-1(e).
    Example 3. Partnership's basis in partnership property after a 
distribution with section 737 gain. (i) On January 31, 1995, A, B, 
and C form partnership ABC as equal partners. A contributes the 
following nondepreciable property to the partnership:

------------------------------------------------------------------------
                                                       Fair             
                                                      market    Adjusted
                                                      value    tax basis
------------------------------------------------------------------------
Property A1.......................................     $1,000       $500
Property A2.......................................      4,000      1,500
Property A3.......................................      4,000      6,000
Property A4.......................................      6,000      4,000
------------------------------------------------------------------------

    (ii) The character of gain or loss on Properties A1, A2, and A3 
is long-term, U.S.-

[[Page 66738]]
source capital gain or loss. The character of gain on Property A4 is 
long-term, foreign-source capital gain. B contributes Property B, 
nondepreciable real property with a fair market value and adjusted 
tax basis of $15,000. C contributes $15,000 cash.
    (iii) On December 31, 1998, Property B is distributed to A in 
complete liquidation of A's interest in the partnership. A 
recognizes gain of $3,000 under section 737, an amount equal to the 
excess distribution of $3,000 ($15,000 fair market value of Property 
B less $12,000 adjusted tax basis in A's partnership interest) and 
A's net precontribution gain of $3,000 ($15,000 aggregate fair 
market value of the property contributed by A less $12,000 aggregate 
adjusted tax basis of such property).
    (iv) $2,000 of A's gain is long-term, foreign-source capital 
gain ($3,000 total gain under section 737 x $2,000 net long-term, 
foreign-source capital gain/$3,000 total net precontribution gain). 
$1,000 of A's gain is long-term, U.S.-source capital gain ($3,000 
total gain under section 737 x $1,000 net long-term, U.S.-source 
capital gain/$3,000 total net precontribution gain).
    (v) The partnership must increase the adjusted tax basis of the 
property contributed by A by $3,000. All property contributed by A 
is eligible property. Properties A1, A2, and A3 have the same 
character and are grouped into a single group for purposes of 
allocating this basis increase. Property A4 is in a separate 
character group.
    (vi) $2,000 of the basis increase must be allocated to long-
term, foreign-source capital assets because $2,000 of the gain 
recognized by A was long-term, foreign-source capital gain. The 
adjusted tax basis of Property A4 is therefore increased from $4,000 
to $6,000. $1,000 of the increase must be allocated to Properties A1 
and A2 because $1,000 of the gain recognized by A is long-term, 
U.S.-source capital gain. No basis increase is allocated to Property 
A3 because its fair market value is less than its adjusted tax 
basis. The $1,000 basis increase is allocated between Properties A1 
and A2 based on the unrealized appreciation in each asset before 
such basis adjustment. As a result, the adjusted tax basis of 
Property A1 is increased by $167 ($1,000 x $500/$3,000) and the 
adjusted tax basis of Property A2 is increased by $833 ($1,000 x 
$2,500/3,000).


Sec. 1.737-4  Anti-abuse rule.

    (a) In general. The rules of section 737 and Secs. 1.737-1, 1.737-
2, and 1.737-3 must be applied in a manner consistent with the purpose 
of section 737. Accordingly, if a principal purpose of a transaction is 
to achieve a tax result that is inconsistent with the purpose of 
section 737, the Commissioner can recast the transaction for federal 
tax purposes as appropriate to achieve tax results that are consistent 
with the purpose of section 737. Whether a tax result is inconsistent 
with the purpose of section 737 must be determined based on all the 
facts and circumstances. See Sec. 1.704-4(f) for an anti-abuse rule and 
examples in the context of section 704(c)(1)(B). The anti-abuse rule 
and examples under section 704(c)(1)(B) and Sec. 1.704-4(f) are 
relevant to section 737 and Secs. 1.737-1, 1.737-2, and 1.737-3 to the 
extent that the net precontribution gain for purposes of section 737 is 
determined by reference to section 704(c)(1)(B).
    (b) Examples. The following examples illustrate the rules of this 
section. The examples set forth below do not delineate the boundaries 
of either permissible or impermissible types of transactions. Further, 
the addition of any facts or circumstances that are not specifically 
set forth in an example (or the deletion of any facts or circumstances) 
may alter the outcome of the transaction described in the example. 
Unless otherwise specified, partnership income equals partnership 
expenses (other than depreciation deductions for contributed property) 
for each year of the partnership, the fair market value of partnership 
property does not change, all distributions by the partnership are 
subject to section 737, and all partners are unrelated.

    Example 1. Increase in distributee partner's basis by temporary 
contribution; results inconsistent with the purpose of section 737. 
(i) On January 1, 1995, A, B, and C form partnership ABC as equal 
partners. A contributes Property A1, nondepreciable real property 
with a fair market value of $10,000 and an adjusted tax basis of 
$1,000. B contributes Property B, nondepreciable real property with 
a fair market value of $10,000 and an adjusted tax basis of $10,000. 
C contributes $10,000 cash.
    (ii) On January 1, 1999, pursuant to a plan a principal purpose 
of which is to avoid gain under section 737, A transfers to the 
partnership Property A2, nondepreciable real property with a fair 
market value and adjusted tax basis of $9,000. A treats the transfer 
as a contribution to the partnership pursuant to section 721 and 
increases the adjusted tax basis of A's partnership interest from 
$1,000 to $10,000. On January 1, 1999, the partnership agreement is 
amended and all other necessary steps are taken so that 
substantially all of the economic risks and benefits of Property A2 
are retained by A. On February 1, 1999, Property B is distributed to 
A in a current distribution. If the contribution of Property A2 is 
treated as a contribution to the partnership for purposes of section 
737, there is no excess distribution because the fair market value 
of distributed Property B ($10,000) does not exceed the adjusted tax 
basis of A's interest in the partnership ($10,000), and therefore 
section 737 does not apply. A's adjusted tax basis in distributed 
Property B is $10,000 under section 732(a)(1) and the adjusted tax 
basis of A's partnership interest is reduced to zero under section 
733.
    (iii) On March 1, 2000, A receives Property A2 from the 
partnership in complete liquidation of A's interest in the 
partnership. A recognizes no gain on the distribution of Property A2 
because the property was previously contributed property. See 
Sec. 1.737-2(d).
    (iv) Although A has treated the transfer of Property A2 as a 
contribution to the partnership that increased the adjusted tax 
basis of A's interest in the partnership, it would be inconsistent 
with the purpose of section 737 to recognize the transfer as a 
contribution to the partnership. Section 737 requires recognition of 
gain when the value of distributed property exceeds the distributee 
partner's adjusted tax basis in the partnership interest. Section 
737 assumes that any contribution or other transaction that affects 
a partner's adjusted tax basis in the partnership interest is a 
contribution or transaction in substance and is not engaged in with 
a principal purpose of avoiding recognition of gain under section 
737. Because the transfer of Property A2 to the partnership was not 
a contribution in substance and was made with a principal purpose of 
avoiding recognition of gain under section 737, the Commissioner can 
disregard the contribution of Property A2 for this purpose. As a 
result, A recognizes gain of $9,000 under section 737 on the receipt 
of Property B, an amount equal to the lesser of the excess 
distribution of $9,000 ($10,000 fair market value of distributed 
Property B less the $1,000 adjusted tax basis of A's partnership 
interest, determined without regard to the transitory contribution 
of Property A2) or A's net precontribution gain of $9,000 on 
Property A1.
    Example 2. Increase in distributee partner's basis; section 752 
liability shift; results consistent with the purpose of section 737. 
(i) On January 1, 1995, A and B form general partnership AB as equal 
partners. A contributes Property A, nondepreciable real property 
with a fair market value of $10,000 and an adjusted tax basis of 
$1,000. B contributes Property B, nondepreciable real property with 
a fair market value and adjusted tax basis of $10,000. The 
partnership also borrows $10,000 on a recourse basis and purchases 
Property C. The $10,000 liability is allocated equally between A and 
B under section 752, thereby increasing the adjusted tax basis in 
A's partnership interest to $6,000.
    (ii) On December 31, 1998, the partners agree that A is to 
receive Property B in a current distribution. If A were to receive 
Property B at that time, A would recognize $4,000 of gain under 
section 737, an amount equal to the lesser of the excess 
distribution of $4,000 ($10,000 fair market value of Property B less 
$6,000 adjusted tax basis in A's partnership interest) or A's net 
precontribution gain of $9,000 ($10,000 fair market value of 
Property A less $1,000 adjusted tax basis of Property A).
    (iii) With a principal purpose of avoiding such gain, A and B 
agree that A will be solely liable for the repayment of the $10,000 
partnership liability and take the steps necessary so that the 
entire amount of the liability is allocated to A under section 752. 
The adjusted tax basis in A's partnership interest is thereby 
increased from $6,000 to $11,000 to reflect A's share of the $5,000 
of liability previously allocated to B. As a result of this increase 
in A's adjusted tax basis, there is no excess distribution because 
the 

[[Page 66739]]
fair market value of distributed Property B ($10,000) is less than the 
adjusted tax basis of A's partnership interest. Recognizing A's 
increased adjusted tax basis as a result of the shift in liabilities 
is consistent with the purpose of section 737 and this section. 
Section 737 requires recognition of gain only when the value of the 
distributed property exceeds the distributee partner's adjusted tax 
basis in the partnership interest. The $10,000 recourse liability is 
a bona fide liability of the partnership that was undertaken for a 
substantial business purpose and A's and B's agreement that A will 
assume responsibility for repayment of that debt has substance. 
Therefore, the increase in A's adjusted tax basis in A's interest in 
the partnership due to the shift in partnership liabilities under 
section 752 is respected, and A recognizes no gain under section 
737.


Sec. 1.737-5  Effective date.

    Sections 1.737-1, 1.737-2, 1.737-3, and 1.737-4 apply to 
distributions by a partnership to a partner on or after January 9, 
1995.

    Dated: December 13, 1995.
Margaret Milner Richardson,
Commissioner of Internal Revenue.

    Approved:
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-30870 Filed 12-22-95; 8:45 am]
BILLING CODE 4830-01-U