[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