[Federal Register Volume 61, Number 240 (Thursday, December 12, 1996)]
[Proposed Rules]
[Pages 65371-65373]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-31364]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-209762-95]
RIN 1545-AT32


Allocations of Depreciation Recapture Among Partners in a 
Partnership

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations relating to the 
allocation of depreciation recapture among partners in a partnership. 
The proposed regulations amend existing regulations to require that any 
gain characterized as depreciation recapture must be allocated to each 
partner in an amount equal to the lesser of the partner's share of 
total gain from the sale of the property or the partner's share of 
depreciation from the property. The proposed regulations affect 
partnerships and their partners. This document also contains a notice 
of public hearing on the proposed regulations.

DATES: Written comments must be received by March 6, 1997. Outlines of 
oral comments and requests to speak at the public hearing scheduled for 
March 27, 1997, at 10 a.m., must be received by March 6, 1997.

ADDRESSES: Send submissions to CC:DOM:CORP:R [REG-209762-95], room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered between the 
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R [REG-209762-95], Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., 
Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option on 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in room 3313, Internal 
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Daniel 
J. Coburn or Deborah Harrington, (202) 622-3050 (not a toll-free 
number); concerning submissions and the hearing, Evangelista Lee, 
(202) 622-7190 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document proposes to change the current Income Tax Regulations 
(26 CFR part 1) relating to the characterization and allocation of 
depreciation recapture among partners in a partnership.
    Section 1245 of the Internal Revenue Code requires taxpayers to 
recharacterize as ordinary income some or all of the gain on the 
disposition of certain types of business properties. The amount 
recharacterized as ordinary income (recapture gain) is the lesser of: 
(a) the gain realized on disposition, or (b) the total deductions 
allowed or allowable for depreciation or amortization from the 
property. Section 1.1245-1(e)(2) of the Income Tax Regulations 
currently provides that each partner's share of recapture gain will 
generally be determined in accordance with the provisions of section 
704. The regulations also provide that, if the partnership agreement 
provides for the allocation of total gain from the property but does 
not provide for the allocation of recapture gain, recapture gain is 
allocated in the same manner as total gain.
    The current regulations create some uncertainty because it is 
unclear how recapture gain is allocated under section 704. The 
allocation of recapture gain cannot have substantial economic effect 
because classifying a portion of the gain as recapture gain merely 
changes the tax character of the gain. In addition, by allowing the 
partnership to allocate recapture gain in the same manner as total 
gain, the current regulations increase the possibility that a partner 
may receive an allocation of recapture gain in excess of the partner's 
share of depreciation from the property. For example, if a partner 
acquires an interest in a partnership that has fully depreciated the 
property and the property is subsequently sold at a gain, the partner 
may be allocated a portion of the total gain and a portion of the 
recapture gain, even though the partner did not receive any 
depreciation deductions from the property. This mismatch between 
depreciation allocations and recapture allocations should be minimized 
because recapture gain is intended to offset the earlier depreciation 
deductions taken from the property and should therefore be allocated to 
the extent possible to the partner that received those depreciation 
deductions. Finally, the current regulations do not provide guidance on 
the allocation of recapture gain from contributed property subject to 
section 704(c). In the legislative history of the 1984 amendment to 
section 704(c), Congress suggested that Treasury and the Service issue 
regulations governing the allocation of recapture gain inherent in 
property contributed to a partnership. See H.R. Rep. No. 861, 98th 
Cong., 2d Sess. 857 (1984); see also Staff of the Joint Comm. on 
Taxation, 98th Cong., 2d Sess., General Explanation of the Revenue 
Provisions of the Deficit Reduction Act of 1984 214 (Comm. Print 1984). 
In the 1994 preamble to the section 704(c) final regulations, Treasury 
and the Service indicated that this issue would be considered in a 
separate regulations project. 59 FR 66,726 (1994).

Explanation of Provisions

    The proposed regulations provide guidance on allocating recapture 
gain among partners, including recapture gain attributable to 
contributed property. The proposed regulations provide that a partner's 
share of recapture gain is equal to the lesser of (1) the partner's 
share of total gain arising from the disposition of the property, or 
(2) the partner's share of depreciation or amortization from the 
property. This rule seeks to insure, to the extent possible, that a 
partner recognizes recapture on the disposition of property in an 
amount equal to the depreciation or amortization deductions previously 
taken by the partner on the property. If recapture gain remains 
unallocated under the general rule, the remaining unallocated gain is 
allocated among those partners whose shares of total gain on the 
disposition of the property exceed their shares of depreciation or 
amortization with respect to the property. Recapture gain may be 
unallocated under the general rule if, for example, the total gain 
allocated to a partner on the sale of the property is less than the 
amount of depreciation previously allocated to that partner.
    The proposed regulations provide special rules for determining a 
partner's share of depreciation or amortization from contributed 
property subject to section 704(c). The proposed regulations provide 
that a contributing partner's share of depreciation or amortization 
includes depreciation or amortization allowed or allowable prior to 
contribution. In addition, the proposed regulations provide that 
curative and

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remedial allocations generally reduce the contributing partner's share 
of depreciation or amortization and increase the noncontributing 
partners' shares of depreciation or amortization.
    Treasury and the Service request comments on whether these special 
rules can be incorporated into accounting systems that track section 
704(c) allocations for partnerships with multiple section 704(c) 
properties.

Proposed Effective Date

    These amendments are proposed to apply to properties acquired by a 
partnership on or after the date the regulations are published as final 
regulations in the Federal Register.

Special Analyses

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

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are timely submitted to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for March 27, 1997, at 10:00 
a.m. in room 3313 of the Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. Because of access restrictions, visitors 
will not be admitted beyond the Internal Revenue Building lobby more 
than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments by March 6, 1997, and submit an outline of the 
topics to be discussed and the time to be devoted to each topic (signed 
original and eight (8) copies) by March 6, 1997.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

    Drafting Information: The principal authors of these regulations 
are Daniel J. Coburn and Deborah Harrington, Office of Assistant 
Chief Counsel (Passthroughs and Special Industries), IRS. However, 
other personnel from the IRS and Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements. Proposed 
Amendments to the Regulations
    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read, 
in part, as follows:

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

    Par. 2. Section 1.704-3 is amended as follows:
    1. Paragraphs (a)(9) and (a)(10) are redesignated as paragraphs 
(a)(10) and (a)(11), respectively.
    2. New paragraph (a)(9) is added.
    The addition reads as follows:


Sec. 1.704-3  Contributed property.

    (a) * * *
    (9) Contributing and noncontributing partners' recapture shares. 
For special rules applicable to the allocation of recapture gain with 
respect to property contributed by a partner to a partnership, see 
Secs. 1.1245-1(e)(2) and 1.1250-1(f).
* * * * *
    Par. 3. Section 1.1245-1 is amended by revising paragraph (e)(2) to 
read as follows:


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

* * * * *
    (e) * * *
    (2)(i) Unless paragraph (e)(3) of this section applies, a partner's 
distributive share of gain recognized under section 1245(a)(1) by the 
partnership is equal to the lesser of the partner's share of the total 
gain from the disposition of the property or the partner's share of the 
depreciation or amortization with respect to the property. Any gain 
recognized under section 1245(a)(1) by the partnership that is not 
allocated under the first sentence of this paragraph is allocated among 
the partners whose shares of total gain exceed their shares of 
depreciation or amortization with respect to the property and is 
allocated to those partners in proportion to (but not in excess of) 
their shares of the total gain (including gain recognized under section 
1245(a)(1)) from the disposition of the property.
    (ii) A partner's share of depreciation or amortization with respect 
to property equals the total amount of allowed or allowable 
depreciation or amortization previously allocated to that partner with 
respect to the property. If a partner transfers a partnership interest, 
a share of depreciation or amortization must be allocated to the 
transferee partner as it would have been allocated to the transferor 
partner. If the partner transfers a portion of the partnership 
interest, a share of depreciation or amortization proportionate to the 
interest transferred must be allocated to the transferee partner.
    (iii)(A) A partner's share of depreciation or amortization with 
respect to property contributed by the partner includes the amount of 
depreciation or amortization allowed or allowable to the partner for 
the period prior to the property's contribution.
    (B) The partners' shares of depreciation or amortization with 
respect to property contributed by a partner must be adjusted to 
account for any curative allocations. (See Sec. 1.704-3(c) for a 
description of the curative allocation method). The contributing 
partner's share of depreciation or amortization with respect to the 
contributed property is decreased (but not below zero) by the amount of 
any curative allocation of ordinary income to the contributing partner 
with respect to the contributed property and by the amount of any 
curative allocation of deduction or loss (other than capital loss) 
allocated to the noncontributing partners with respect to the 
contributed property. A noncontributing partner's share of depreciation 
or amortization with respect to the contributed property is increased 
by the noncontributing partner's share of any curative allocation of 
ordinary income to the contributing partner with respect to the 
contributed property and by the amount of any curative allocation of 
deduction or loss (other than capital loss) allocated to the 
noncontributing partner with respect to the contributed property. The 
partners' shares of depreciation or amortization with respect to 
property from which curative allocations of depreciation or 
amortization are taken is determined without regard to those curative 
allocations.

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    (C) The partners' shares of depreciation or amortization with 
respect to property contributed by a partner must be adjusted to 
account for any remedial allocations. (See Sec. 1.704-3(d) for a 
description of the remedial allocation method.) The contributing 
partner's share of depreciation or amortization with respect to the 
contributed property is decreased (but not below zero) by the amount of 
any remedial allocation of ordinary income to the contributing partner 
with respect to the contributed property. A noncontributing partner's 
share of depreciation or amortization with respect to the contributed 
property is increased by the amount of any remedial allocation of 
depreciation or amortization to the noncontributing partner with 
respect to the contributed property.
    (D) The principles of this paragraph (e)(2)(iii) apply in 
determining the effect of remedial or curative allocations on a 
partner's share of depreciation or amortization with respect to 
property for which differences between book value and adjusted tax 
basis are created when a partnership revalues partnership property 
pursuant to Sec. 1.704-1(b)(2)(iv)(f).
    (iv) Examples. The application of this paragraph (e)(2) may be 
illustrated by the following examples:

    Example 1. Recapture allocations. (i) Facts. A and B each 
contribute $5,000 cash to form AB, a general partnership. The 
partnership agreement provides that depreciation deductions will be 
allocated 90 percent to A and 10 percent to B, and, on the sale of 
depreciable property, A will first be allocated gain to the extent 
necessary to equalize A's and B's capital accounts. Any remaining 
gain will be allocated 50 percent to A and 50 percent to B. In its 
first year of operations, AB purchases depreciable equipment for 
$5,000. AB depreciates the equipment over its 5-year recovery period 
and elects to use the straight-line method. In its first year of 
operations, AB's operating income equals its expenses (other than 
depreciation).
    (ii) Year 1. In its first year of operations, AB has $1,000 of 
depreciation from the partnership equipment. (To simplify this 
example, the partnership's depreciation deductions are determined 
without regard to any first-year depreciation conventions.) In 
accordance with the partnership agreement, AB allocates 90 percent 
($900) of the depreciation to A and 10 percent ($100) of the 
depreciation to B. At the end of the year, AB sells the equipment 
for $5,200, recognizing $1,200 of gain ($5,200 amount realized less 
$4,000 adjusted tax basis). In accordance with the partnership 
agreement, the first $800 of gain is allocated to A to equalize the 
partners' capital accounts, and the remaining $400 of gain is 
allocated $200 to A and $200 to B.
    (iii) Recapture allocations. $1,000 of the gain from the sale of 
the equipment is treated as gain recognized under section 
1245(a)(1). Under paragraph (e)(2)(i) of this section, each 
partner's share of this section 1245 gain is the lesser of the 
partner's share of total gain recognized on the sale of the 
equipment or the partner's share of total depreciation with respect 
to the equipment. Thus, A's share of the section 1245 gain is $900 
(the lesser of A's share of total gain ($1,000) and A's share of 
depreciation ($900)) and B's share of the section 1245 gain is $100 
(the lesser of B's share of total gain ($200) and B's share of 
depreciation ($100)). Accordingly, $900 of the $1,000 of total gain 
allocated to A will be treated as ordinary income and $100 of the 
$200 of total gain allocated to B will be treated as ordinary 
income.
    Example 2. Recapture allocation limited by gain share. Assume 
the same facts as in Example 1, except that the partnership 
agreement provides that gains and losses from the sale of 
depreciable property will be allocated equally between the partners. 
On the sale of the equipment, the partnership's total gain of $1,200 
is allocated $600 to A and $600 to B. Under paragraph (e)(2)(i) of 
this section, A's share of the section 1245 gain is limited to $600 
(the amount of total gain allocated to A) even though A's share of 
the total depreciation from the equipment was $900. The remaining 
$400 of section 1245 gain must be allocated to B. Accordingly, all 
$600 of total gain allocated to A is treated as ordinary income and 
$400 of the $600 of total gain allocated to B is treated as ordinary 
income.
    Example 3. Determination of partners' shares of depreciation 
with respect to contributed property. (i) Facts. C and D form 
partnership CD as equal partners. C contributes depreciable personal 
property C1 with an adjusted tax basis of $800 and a fair market 
value of $2,800. D contributes $2,800 cash. Prior to contributing 
C1, C claimed $200 of depreciation from C1. At the time of 
contribution, C1 has four years remaining on its 5-year recovery 
period and is depreciable under the straight-line method. At the 
time CD is formed, it purchases depreciable personal property D1 for 
$2,800, which is depreciable over seven years under the straight-
line method. (To simplify the example, all depreciation is 
determined without regard to any first-year depreciation 
conventions).
    (ii) Traditional method. C and D will each be allocated $350 of 
the total of $700 of book depreciation from C1 in year 1. Under the 
traditional method of making section 704(c) allocations, C will not 
be allocated any tax depreciation from C1 and D will be allocated 
the entire $200 of tax depreciation from C1. C and D will each be 
allocated $200 of book and tax depreciation from D1. As a result, 
after the first year of partnership operations, C's share of 
depreciation with respect to C1 is $200 (the depreciation taken by C 
prior to contribution) and D's share of depreciation with respect to 
C1 is $200 (the amount of tax depreciation allocated to D). C and D 
each have a $200 share of depreciation with respect to D1.
    (iii) Effect of curative allocations. If the partnership elects 
to make curative allocations under Sec. 1.704-3(c) using 
depreciation from D1, the results in year 1 will be the same as 
under the traditional method, except that $150 of the $200 of tax 
depreciation from D1 that would have been allocated to C under the 
traditional method will be allocated to D as additional depreciation 
with respect to C1. As a result, after the first year of partnership 
operations, C's share of depreciation with respect to C1 will be 
reduced to $50 (the total depreciation taken by C prior to 
contribution ($200) decreased by the amount of the curative 
allocation to D ($150)). C's share of depreciation with respect to 
D1 will still be $200 and D's share of depreciation with respect to 
C1 will be $350 (the depreciation allocated to D under the 
traditional method ($200) increased by the amount of the curative 
allocation to D ($150)). D's share of depreciation with respect to 
D1 will still be $200.
    (iv) Effect of remedial allocations. If the partnership elects 
the remedial allocation method for making section 704(c) allocations 
under Sec. 1.704-3(d), there will be $600 of total book depreciation 
from C1 in year 1. (Under the remedial allocation method, the amount 
by which C1's book basis ($2,800) exceeds its tax basis ($800) is 
depreciated over a 5-year life, rather than a 4-year life). C and D 
will each be allocated one-half ($300) of the total book 
depreciation. As under the traditional method, C will be allocated 
$0 of tax depreciation from C1 and D will be allocated $200 of tax 
depreciation from C1. Because the ceiling rule would cause a 
disparity of $100 between D's book and tax allocations of 
depreciation, D will also receive a $100 remedial allocation of 
depreciation with respect to C1, and C will receive a $100 remedial 
allocation of income with respect to C1. As a result, after the 
first year of partnership operations, D's share of depreciation with 
respect to C1 is $300 (the depreciation allocated to D under the 
traditional method ($200) increased by the amount of the remedial 
allocation ($100)). C's share of depreciation with respect to C1 is 
$100 (the total depreciation taken by C prior to contribution ($200) 
decreased by the amount of the remedial allocation of income 
($100)). As under the traditional method, C and D each have a $200 
share of depreciation with respect to D1.

    (v) Effective date. This paragraph (e)(2) is effective for 
properties acquired by the partnership on or after [the date the 
regulations are published as final regulations in the Federal 
Register].
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-31364 Filed 12-11-96; 8:45 am]
BILLING CODE 4830-01-U