[Federal Register Volume 62, Number 161 (Wednesday, August 20, 1997)]
[Rules and Regulations]
[Pages 44214-44218]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-22019]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8730]
RIN 1545-AT32
Allocations of Depreciation Recapture Among Partners in a
Partnership
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the
allocation of depreciation recapture among partners in a partnership.
The final regulations amend existing regulations to require that gain
characterized as depreciation recapture be allocated, to the extent
possible, to the partners who took the depreciation or amortization
deductions. The final regulations affect partnerships (and their
partners) that sell or dispose of certain depreciable or amortizable
property.
DATES: These regulations are effective August 20, 1997. For dates of
applicability of these regulations, see Secs. 1.704-3(f) and 1.1245-
1(e)(2)(iv).
FOR FURTHER INFORMATION CONTACT: Daniel J. Coburn, (202) 622-3050 (not
a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
This document amends the Income Tax Regulations (26 CFR part 1)
relating to the characterization and allocation of depreciation
recapture among partners in a partnership. Section 1245 of the Internal
Revenue Code requires taxpayers to recharacterize as ordinary income
some or all of the gain on the disposition of certain types of business
properties. The amount recharacterized as ordinary income (depreciation
recapture) is the lesser of (1) the gain realized on the disposition,
or (2) the total deductions allowed or allowable for depreciation or
amortization from the property.
On December 12, 1996, the IRS published in the Federal Register (61
[[Page 44215]]
FR 65371) a notice of proposed rulemaking (REG-209762-95) to provide
guidance on partnership allocations of depreciation recapture. Although
a public hearing was scheduled for March 27, 1997, the IRS cancelled
the hearing because it received no requests to speak.
Explanation of Provisions
I. General Background
The regulations provide guidance on allocating depreciation
recapture among partners, including depreciation recapture attributable
to contributed property.
The regulations provide that a partner's share of depreciation
recapture is equal to the lesser of (1) the partner's share of total
gain arising from the disposition of the property (gain limitation) or
(2) the partner's share of depreciation or amortization from the
property (as defined in paragraph (e)(2)(ii) of the regulations). This
rule seeks to insure, to the extent possible, that a partner recognizes
recapture on the disposition of property in an amount equal to the
depreciation or amortization deductions from the property previously
taken by the partner. Any depreciation recapture that is not allocated
to a partner due to the gain limitation is allocated among those
partners whose shares of total gain on the disposition of the property
exceed their shares of depreciation or amortization from the property.
This unallocated depreciation recapture is allocated among those
partners in proportion to their relative shares of the total gain on
the disposition of the property.
The regulations provide special rules for determining a partner's
share of depreciation or amortization from contributed property subject
to section 704(c). Under the regulations, a contributing partner's
share of depreciation or amortization includes depreciation or
amortization allowed or allowable prior to contribution. In addition,
the regulations provide that curative and remedial allocations
generally reduce the contributing partner's share of depreciation or
amortization and increase the noncontributing partners' shares of
depreciation or amortization.
II. Changes in Response to Comments
In response to comments, the regulations clarify the effect of
curative and remedial allocations on the partners' shares of
depreciation or amortization from contributed property. The examples
now demonstrate that curative and remedial allocations can reduce the
contributing partner's share of depreciation or amortization to zero,
but not below zero. Once the contributing partner's share of
depreciation or amortization has been reduced to zero, the curative or
remedial allocations do not affect the contributing partner's share of
depreciation or amortization. However, the curative or remedial
allocations continue to affect the noncontributing partners' shares of
depreciation or amortization.
The regulations have also been revised to make it clear that these
amendments to the section 1245 regulations only affect how the
depreciation recapture recognized by the partnership is allocated among
the partners; they do not affect the computation of depreciation
recapture at the partnership level. The regulations recognize that even
absent a gain limitation, remedial and curative allocations may cause
the total of the partners' shares of depreciation to exceed the amount
of depreciation recapture recognized at the partnership level. In such
a case, the partnership's depreciation recapture with respect to the
contributed property is to be allocated among the partners in
proportion to their relative shares of depreciation or amortization
with respect to that property. However, no partner's share of
depreciation recapture from the property can exceed that partner's
share of the total gain arising from the disposition of the property.
Example 2 of paragraph (e)(2)(iii) of the regulations has also been
revised to demonstrate more thoroughly how recapture is allocated when
a partner's share of depreciation recapture is capped by the partner's
share of gain from the disposition of the property. As illustrated in
the example, some partnerships may find it necessary to make multiple
reallocations of depreciation recapture from a property if allocations
under the general rule (allocations in proportion to the remaining
partners' shares of gain from the disposition of the property) cause a
remaining partner's share of depreciation to exceed the partner's share
of gain from the disposition of the property.
One commentator requested that the regulations allow but not
require that partnerships allocate depreciation recapture in proportion
to the partners' shares of the gain from the disposition of the
property. This change was not made because the IRS and Treasury
continue to believe that matching depreciation recapture allocations to
depreciation allocations most appropriately carries out the policies
underlying section 1245.
A number of terminology and stylistic changes have also been made
to these regulations. These changes were made for purposes of economy
and should not be interpreted as substantive changes.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It also has been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to these regulations, and because the regulations do not
impose a collection of information on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to
section 7805(f) of the Internal Revenue Code, the notice of proposed
rulemaking preceding these regulations was submitted to the Small
Business Administration for comment on its impact on small business.
Drafting Information: The principal author of these regulations is
Daniel J. Coburn, Office of Assistant Chief Counsel (Passthroughs and
Special Industries), IRS. However, other personnel from the IRS and
Treasury participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read,
in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.704-3 is amended by:
(1) Adding new paragraph (a)(11).
(2) Revising paragraph (f).
The addition and revision read as follows:
Sec. 1.704-3 Contributed property.
(a) * * *
(11) Contributing and noncontributing partners' recapture shares.
For special rules applicable to the allocation of depreciation
recapture with respect to property contributed by a partner to a
partnership, see Secs. 1.1245-1(e)(2) and 1.1250-1(f).
* * * * *
(f) Effective date. With the exception of paragraph (a)(11) of this
section, this section applies to properties contributed
[[Page 44216]]
to a partnership and to restatements pursuant to Sec. 1.704-
1(b)(2)(iv)(f) on or after December 21, 1993. Paragraph (a)(11) of this
section applies to properties contributed by a partner to a partnership
on or after August 20, 1997. However, partnerships may rely on
paragraph (a)(11) of this section for properties contributed before
August 20, 1997 and disposed of on or after August 20, 1997.
Par. 3. Section 1.1245-1 is amended by revising paragraph (e)(2) to
read as follows:
Sec. 1.1245-1 General rule for treatment of gain from dispositions of
certain depreciable property.
* * * * *
(e) * * *
(2)(i) Unless paragraph (e)(3) of this section applies, a partner's
distributive share of gain recognized under section 1245(a)(1) by the
partnership is equal to the lesser of the partner's share of total gain
from the disposition of the property (gain limitation) or the partner's
share of depreciation or amortization with respect to the property (as
determined under paragraph (e)(2)(ii) of this section). Any gain
recognized under section 1245(a)(1) by the partnership that is not
allocated under the first sentence of this paragraph (e)(2)(i) (excess
depreciation recapture) is allocated among the partners whose shares of
total gain from the disposition of the property exceed their shares of
depreciation or amortization with respect to the property. Excess
depreciation recapture is allocated among those partners in proportion
to their relative shares of the total gain (including gain recognized
under section 1245(a)(1)) from the disposition of the property that is
allocated to the partners who are not subject to the gain limitation.
See Example 2 of paragraph (e)(2)(iii) of this section.
(ii)(A) Subject to the adjustments described in paragraphs
(e)(2)(ii)(B) and (e)(2)(ii)(C) of this section, a partner's share of
depreciation or amortization with respect to property equals the total
amount of allowed or allowable depreciation or amortization previously
allocated to that partner with respect to the property.
(B) If a partner transfers a partnership interest, a share of
depreciation or amortization must be allocated to the transferee
partner as it would have been allocated to the transferor partner. If
the partner transfers a portion of the partnership interest, a share of
depreciation or amortization proportionate to the interest transferred
must be allocated to the transferee partner.
(C)(1) A partner's share of depreciation or amortization with
respect to property contributed by the partner includes the amount of
depreciation or amortization allowed or allowable to the partner for
the period before the property is contributed.
(2) A partner's share of depreciation or amortization with respect
to property contributed by a partner is adjusted to account for any
curative allocations. (See Sec. 1.704-3(c) for a description of the
traditional method with curative allocations.) The contributing
partner's share of depreciation or amortization with respect to the
contributed property is decreased (but not below zero) by the amount of
any curative allocation of ordinary income to the contributing partner
with respect to that property and by the amount of any curative
allocation of deduction or loss (other than capital loss) to the
noncontributing partners with respect to that property. A
noncontributing partner's share of depreciation or amortization with
respect to the contributed property is increased by the noncontributing
partner's share of any curative allocation of ordinary income to the
contributing partner with respect to that property and by the amount of
any curative allocation of deduction or loss (other than capital loss)
to the noncontributing partner with respect to that property. The
partners' shares of depreciation or amortization with respect to
property from which curative allocations of depreciation or
amortization are taken is determined without regard to those curative
allocations. See Example 3(iii) of paragraph (e)(2)(iii) of this
section.
(3) A partner's share of depreciation or amortization with respect
to property contributed by a partner is adjusted to account for any
remedial allocations. (See Sec. 1.704-3(d) for a description of the
remedial allocation method.) The contributing partner's share of
depreciation or amortization with respect to the contributed property
is decreased (but not below zero) by the amount of any remedial
allocation of income to the contributing partner with respect to that
property. A noncontributing partner's share of depreciation or
amortization with respect to the contributed property is increased by
the amount of any remedial allocation of depreciation or amortization
to the noncontributing partner with respect to that property. See
Example 3(iv) of paragraph (e)(2)(iii) of this section.
(4) If, under paragraphs (e)(2)(ii)(C)(2) and (e)(2)(ii)(C)(3) of
this section, the partners' shares of depreciation or amortization with
respect to a contributed property exceed the adjustments reflected in
the adjusted basis of the property under Sec. 1.1245-2(a) at the
partnership level, then the partnership's gain recognized under section
1245(a)(1) with respect to that property is allocated among the
partners in proportion to their relative shares of depreciation or
amortization (subject to any gain limitation that might apply).
(5) This paragraph (e)(2)(ii)(C) also applies in determining a
partner's share of depreciation or amortization with respect to
property for which differences between book value and adjusted tax
basis are created when a partnership revalues partnership property
pursuant to Sec. 1.704-1(b)(2)(iv)(f).
(iii) Examples. The application of this paragraph (e)(2) may be
illustrated by the following examples:
Example 1. Recapture allocations. (i) Facts. A and B each
contribute $5,000 cash to form AB, a general partnership. The
partnership agreement provides that depreciation deductions will be
allocated 90 percent to A and 10 percent to B, and, on the sale of
depreciable property, A will first be allocated gain to the extent
necessary to equalize A's and B's capital accounts. Any remaining
gain will be allocated 50 percent to A and 50 percent to B. In its
first year of operations, AB purchases depreciable equipment for
$5,000. AB depreciates the equipment over its 5-year recovery period
and elects to use the straight-line method. In its first year of
operations, AB's operating income equals its expenses (other than
depreciation). (To simplify this example, AB's depreciation
deductions are determined without regard to any first-year
depreciation conventions.)
(ii) Year 1. In its first year of operations, AB has $1,000 of
depreciation from the partnership equipment. In accordance with the
partnership agreement, AB allocates 90 percent ($900) of the
depreciation to A and 10 percent ($100) of the depreciation to B. At
the end of the year, AB sells the equipment for $5,200, recognizing
$1,200 of gain ($5,200 amount realized less $4,000 adjusted tax
basis). In accordance with the partnership agreement, the first $800
of gain is allocated to A to equalize the partners' capital
accounts, and the remaining $400 of gain is allocated $200 to A and
$200 to B.
(iii) Recapture allocations. $1,000 of the gain from the sale of
the equipment is treated as section 1245(a)(1) gain. Under paragraph
(e)(2)(i) of this section, each partner's share of the section
1245(a)(1) gain is equal to the lesser of the partner's share of
total gain recognized on the sale of the equipment or the partner's
share of total depreciation with respect to the equipment. Thus, A's
share of the section 1245(a)(1) gain is $900 (the lesser of A's
share of the total gain ($1,000) and A's share of depreciation
($900)). B's share of the section 1245(a)(1) gain is $100 (the
lesser of B's share of the total gain ($200) and B's share of
depreciation ($100)). Accordingly, $900 of the $1,000 of total gain
allocated to A is treated as ordinary income and $100 of
[[Page 44217]]
the $200 of total gain allocated to B is treated as ordinary income.
Example 2. Recapture allocation subject to gain limitation. (i)
Facts. A, B, and C form general partnership ABC. The partnership
agreement provides that depreciation deductions will be allocated
equally among the partners, but that gain from the sale of
depreciable property will be allocated 75 percent to A and 25
percent to B. ABC purchases depreciable personal property for $300
and subsequently allocates $100 of depreciation deductions each to
A, B, and C, reducing the adjusted tax basis of the property to $0.
ABC then sells the property for $440. ABC allocates $330 of the gain
to A (75 percent of $440) and allocates $110 of the gain to B (25
percent of $440). No gain is allocated to C.
(ii) Application of gain limitation. Each partner's share of
depreciation with respect to the property is $100. C's share of the
total gain from the disposition of the property, however, is $0. As
a result, under the gain limitation provision in paragraph (e)(2)(i)
of this section, C's share of section 1245(a)(1) gain is limited to
$0.
(iii) Excess depreciation recapture. Under paragraph (e)(2)(i)
of this section, the $100 of section 1245(a)(1) gain that cannot be
allocated to C under the gain limitation provision (excess
depreciation recapture) is allocated to A and B (the partners not
subject to the gain limitation at the time of the allocation) in
proportion to their relative shares of total gain from the
disposition of the property. A's relative share of the total gain
allocated to A and B is 75 percent ($330 of $440 total gain). B's
relative share of the total gain allocated to A and B is 25 percent
($110 of $440 total gain). However, under the gain limitation
provision of paragraph (e)(2)(i) of this section, B cannot be
allocated 25 percent of the excess depreciation recapture ($25)
because that would result in a total allocation of $125 of
depreciation recapture to B (a $100 allocation equal to B's share of
depreciation plus a $25 allocation of excess depreciation
recapture), which is in excess of B's share of the total gain from
the disposition of the property ($110). Therefore, only $10 of
excess depreciation recapture is allocated to B and the remaining
$90 of excess depreciation recapture is allocated to A. A is not
subject to the gain limitation because A's share of the total gain
($330) still exceeds A's share of section 1245(a)(1) gain ($190).
Accordingly, all $110 of the total gain allocated to B is treated as
ordinary income ($100 share of depreciation allocated to B plus $10
of excess depreciation recapture) and $190 of the total gain
allocated to A is treated as ordinary income ($100 share of
depreciation allocated to A plus $90 of excess depreciation
recapture).
Example 3. Determination of partners' shares of depreciation
with respect to contributed property. (i) Facts.C and D form
partnership CD as equal partners. C contributes depreciable personal
property C1 with an adjusted tax basis of $800 and a fair market
value of $2,800. Prior to the contribution, C claimed $200 of
depreciation from C1. At the time of the contribution, C1 is
depreciable under the straight-line method and has four years
remaining on its 5-year recovery period. D contributes $2,800 cash,
which CD uses to purchase depreciable personal property D1, which is
depreciable over seven years under the straight-line method. (To
simplify the example, all depreciation is determined without regard
to any first-year depreciation conventions.)
(ii) Traditional method. C1 generates $700 of book depreciation
(\1/4\ of $2,800 book value) and $200 of tax depreciation (\1/4\ of
$800 adjusted tax basis) each year. C and D will each be allocated
$350 of book depreciation from C1 in year 1. Under the traditional
method of making section 704(c) allocations, D will be allocated the
entire $200 of tax depreciation from C1 in year 1. D1 generates $400
of book and tax depreciation each year (\1/7\ of $2,800 book value
and adjusted tax basis). C and D will each be allocated $200 of book
and tax depreciation from D1 in year 1. As a result, after the first
year of partnership operations, C's share of depreciation with
respect to C1 is $200 (the depreciation taken by C prior to
contribution) and D's share of depreciation with respect to C1 is
$200 (the amount of tax depreciation allocated to D). C and D each
have a $200 share of depreciation with respect to D1. At the end of
four years, C's share of depreciation with respect to C1 will be
$200 (the depreciation taken by C prior to contribution) and D's
share of depreciation with respect to C1 will be $800 (four years of
$200 depreciation per year). At the end of four years, C and D will
each have an $800 share of depreciation with respect to D1 (four
years of $200 depreciation per year).
(iii) Effect of curative allocations. (A) Year 1. If the
partnership elects to make curative allocations under Sec. 1.704-
3(c) using depreciation from D1, the results will be the same as
under the traditional method, except that $150 of the $200 of tax
depreciation from D1 that would be allocated to C under the
traditional method will be allocated to D as additional depreciation
with respect to C1. As a result, after the first year of partnership
operations, C's share of depreciation with respect to C1 will be
reduced to $50 (the total depreciation taken by C prior to
contribution ($200) decreased by the amount of the curative
allocation to D ($150)). D's share of depreciation with respect to
C1 will be $350 (the depreciation allocated to D under the
traditional method ($200) increased by the amount of the curative
allocation to D ($150)). C and D will each have a $200 share of
depreciation with respect to D1.
(B) Year 4. At the end of four years, C's share of depreciation
with respect to C1 will be reduced to $0 (the total depreciation
taken by C prior to contribution ($200) decreased, but not below
zero, by the amount of the curative allocations to D ($600)), and
D's share of depreciation with respect to C1 will be $1,400 (the
total depreciation allocated to D under the traditional method
($800) increased by the amount of the curative allocations to D
($600)). However, CD's section 1245(a)(1) gain with respect to C1
will not be more than $1,000 (CD's tax depreciation ($800) plus C's
tax depreciation prior to contribution ($200)). Under paragraph
(e)(2)(ii)(C)(4) of this section, because the partners' shares of
depreciation with respect to C1 exceed the adjustments reflected in
the property's adjusted basis, CD's section 1245(a)(1) gain will be
allocated in proportion to the partners' relative shares of
depreciation with respect to C1. Because C's share of depreciation
with respect to C1 is $0, and D's share of depreciation with respect
to C1 is $1,400, all of CD's $1,000 of section 1245(a)(1) gain will
be allocated to D. At the end of four years, C and D will each have
an $800 share of depreciation with respect to D1 (four years of $200
depreciation per year).
(iv) Effect of remedial allocations. (A) Year 1. If the
partnership elects to make remedial allocations under Sec. 1.704-
3(d), there will be $600 of book depreciation from C1 in year 1.
(Under the remedial allocation method, the amount by which C1's book
basis ($2,800) exceeds its tax basis ($800) is depreciated over a 5-
year life, rather than a 4-year life.) C and D will each be
allocated one-half ($300) of the total book depreciation. As under
the traditional method, D will be allocated all $200 of tax
depreciation from C1. Because the ceiling rule would cause a
disparity of $100 between D's book and tax allocations of
depreciation, D will also receive a $100 remedial allocation of
depreciation with respect to C1, and C will receive a $100 remedial
allocation of income with respect to C1. As a result, after the
first year of partnership operations, D's share of depreciation with
respect to C1 is $300 (the depreciation allocated to D under the
traditional method ($200) increased by the amount of the remedial
allocation ($100)). C's share of depreciation with respect to C1 is
$100 (the total depreciation taken by C prior to contribution ($200)
decreased by the amount of the remedial allocation of income
($100)). C and D will each have a $200 share of depreciation with
respect to D1.
(B) Year 5. At the end of five years, C's share of depreciation
with respect to C1 will be $0 (the total depreciation taken by C
prior to contribution ($200) decreased, but not below zero, by the
total amount of the remedial allocations of income to C ($600)). D's
share of depreciation with respect to C1 will be $1,400 (the total
depreciation allocated to D under the traditional method ($800)
increased by the total amount of the remedial allocations of
depreciation to D ($600)). However, CD's section 1245(a)(1) gain
with respect to C1 will not be more than $1,000 (CD's tax
depreciation ($800) plus C's tax depreciation prior to contribution
($200)). Under paragraph (e)(2)(ii)(C)(4) of this section, because
the partners' shares of depreciation with respect to C1 exceed the
adjustments reflected in the property's adjusted basis, CD's section
1245(a)(1) gain will be allocated in proportion to the partners'
relative shares of depreciation with respect to C1. Because C's
share of depreciation with respect to C1 is $0, and D's share of
depreciation with respect to C1 is $1,400, all of CD's $1,000 of
section 1245(a)(1) gain will be allocated to D. At the end of five
years, C and D will each have a $1,000 share of depreciation with
respect to D1 (five years of $200 depreciation per year).
(iv) Effective date. This paragraph (e)(2) is effective for
properties acquired by a partnership on or after August 20,
[[Page 44218]]
1997. However, partnerships may rely on this paragraph (e)(2) for
properties acquired before August 20, 1997 and disposed of on or after
August 20, 1997.
* * * * *
Michael P. Dolan,
Acting Commissioner of Internal Revenue.
Approved: July 8, 1997.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 97-22019 Filed 8-19-97; 8:45 am]
BILLING CODE 4830-01-U