[Federal Register Volume 64, Number 240 (Wednesday, December 15, 1999)]
[Rules and Regulations]
[Pages 69903-69922]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-32400]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8847]
RIN 1545-AS39


Adjustments Following Sales of Partnership Interests

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document finalizes regulations relating to the optional 
adjustments to the basis of partnership property following certain 
transfers of partnership interests under section 743, the calculation 
of gain or loss under section 751(a) following the sale or exchange of 
a partnership interest, the allocation of basis adjustments among 
partnership assets under section 755, the allocation of a partner's 
basis in its partnership interest to properties distributed to the 
partner by the partnership under section 732(c), and the computation of 
a partner's proportionate share of the adjusted basis of depreciable 
property (or depreciable real property) under section 1017. The changes 
will affect partnerships and partners where there are transfers of 
partnership interests, distributions of property, or elections under 
sections 108(b)(5) or (c). In addition, the final regulations under 
section 732(c) reflect changes to the law made by the Taxpayer Relief 
Act of 1997.

DATES: Effective Dates: These regulations are effective December 15, 
1999.
    Applicability Date: These regulations apply to transfers of 
partnership interests and distributions occurring on or after December 
15, 1999.

FOR FURTHER INFORMATION CONTACT: Matthew Lay, (202) 622-3050.

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information in these final regulations have been 
reviewed and approved by the Office of Management and Budget in 
accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1588. Responses to these collections of information 
are mandatory for partnerships that have made an election under section 
754 and for which a section 743 transfer has been made, and for 
partnerships which distribute property in a transaction subject to 
section 732(d).
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The estimated annual burden per respondent varies from 1 hour to 
300 hours, depending on the individual circumstances, with an estimated 
average of 4 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.
    Books or records relating to these collections of information must 
be retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document (a) revises Secs. 1.743-1 and 1.755-1 of the Income 
Tax Regulations (26 CFR part 1), and (b) amends Secs. 1.732-1, 1.732-2, 
1.734-1, 1.751-1, 1.754-1, and Sec. 1.1017-1 of the Income Tax 
Regulations.
    On January 29, 1998, proposed regulations (REG 209682-94) were 
published in the Federal Register (63 FR 4408). Written comments were 
received in response to the notice of proposed rulemaking. One speaker 
provided testimony at a public hearing held on September 10, 1998.
    After consideration of all the comments, the proposed regulations 
under sections 732, 734, 743, 751, 755, and 1017 are adopted, as 
revised by this Treasury Decision.

Explanation of Revisions and Summary of Contents

1. Basis in Distributed Property

    (a) Mandatory application of section 732(d). Section 1.732-1(d)(4) 
of the current regulations requires transferees to apply the special 
basis rule in certain

[[Page 69904]]

cases. In the preamble to the proposed regulations, the IRS and the 
Treasury Department requested comments on the proper scope of section 
732(d), and specifically, under what circumstances, if any, the 
Secretary should continue to exercise his authority to mandate the 
application of section 732(d) to a transferee. Several commentators 
suggested that the mandatory application of section 732(d) no longer 
should be required, because the changes made to section 732(c) by the 
Taxpayer Relief Act of 1997, Public Law 105-34, 111 Stat. 788, 945-46 
(1997), make the distortions targeted by the regulations less likely to 
occur. However, other commentators noted that distortions caused by 
section 732(c) still may occur. Accordingly, the rule contained in 
Sec. 1.732-1(d)(4), which requires the mandatory application of section 
732(d) in certain cases, remains in effect.
    (b) Statement required by partnership. Because partners, rather 
than partnerships, are required to report basis adjustments under 
section 732(d), the final regulations require partnerships to provide 
transferees with such information as is necessary for the transferees 
properly to compute basis adjustments made under section 732(d). This 
information must be provided if a transferee notifies a partnership 
that it plans to make the election under section 732(d) or if a 
partnership makes a distribution subject to the mandatory application 
of section 732(d).
    (c) Effective date. One commentator asked for clarification 
regarding the application of the final regulations to section 732(d) 
adjustments. If section 732(d) applies to a distribution, it is 
necessary to calculate the basis adjustments which would have been 
required under section 743(b) if a section 754 election were in effect 
for the partnership in the taxable year in which the partnership 
interest was transferred to the partner. In calculating these basis 
adjustments, the partnership should apply the final regulations under 
section 743 and 755 if the distribution to which section 732(d) applies 
occurs after December 15, 1999.

2. Basis Adjustments Under Section 743(b)

    (a) Coordination with section 704(c). Where a partnership adopts 
the remedial allocation method, the proposed regulations provide that 
the section 704(c) built-in gain portion of a basis adjustment under 
section 743(b) shall be recovered over the remaining cost recovery 
period for the section 704(c) built-in gain. Some commentators 
suggested that the final regulations should provide this treatment for 
the section 704(c) built-in gain portion of the adjustment regardless 
of the method elected by the partnership for allocating section 704(c) 
built-in gain and loss. The IRS and the Treasury Department continue to 
believe that, except for partnerships which adopt the remedial 
allocation method, it is appropriate for sections 704(c) and 743(b) to 
operate independently. Accordingly, this change has not been adopted.
    In the preamble to the proposed regulations, comments were 
requested concerning the application of the remedial allocation method 
to contributed property where there are no distortions caused by the 
ceiling rule at the time the property was contributed to the 
partnership. Even if it is not clear that the ceiling rule will apply 
at the time the property is contributed because the adjusted basis of 
the contributed property is sufficient so that the non-contributing 
partners will be allocated their appropriate share of depreciation or 
amortization attributable to the property, the partnership's adoption 
of the remedial method still may be relevant due to allocations 
resulting from a subsequent disposition of the property. For instance, 
suppose that partners A and B form a partnership and agree that each 
partner will be allocated a 50 percent share of all partnership items, 
and that the partnership will make allocations under section 704(c) 
using the traditional method. A contributes depreciable property with 
an adjusted tax basis of $40 and a book value of $50, and B contributes 
$50 in cash. At the time of the contribution, it is not readily 
apparent that the ceiling rule will have any application. However, if, 
before any federal income tax depreciation accrues with respect to the 
contributed property, the property's value declines to $40, and the 
property is sold for that amount, there will be no tax gain or loss. 
The book loss of $10 would be shared equally between A and B. In this 
situation, the ceiling rule would prevent B from being allocated the $5 
tax loss to which it otherwise would be entitled. However, if the 
partnership elected to use the remedial method with respect to the 
contributed property, B would be allocated a $5 tax loss, and A would 
be allocated a corresponding $5 tax gain. In addition, if a 
contributing partner transfers its interest in a partnership during a 
period when a section 754 election is in effect, the section 704(c) 
method adopted by the partnership will determine the recovery period 
for the built-in gain portion of the transferee's section 743(b) 
adjustment. The IRS and the Treasury Department believe that under the 
current regulations under section 704(c), a partnership may use the 
remedial method under Sec. 1.704-3, even where it is not readily 
apparent at the time the property is contributed that the ceiling rule 
will be applicable.
    (b) Previously taxed capital. One commentator suggested that the 
second sentence in proposed Sec. 1.743-1(d)(2), relating to the 
correlation between a partner's interest in previously taxed capital 
and the partnership's capital accounts, is redundant and should be 
deleted. This suggestion has been adopted; however, no substantive 
change is intended by the deletion.
    (c) Common basis election. Some commentators suggested that the 
provision in the proposed regulations that permitted the partners to 
elect to apply negative basis adjustments under section 743(b) to the 
partnership's common basis should be deleted. The commentators argued 
that the provision was contrary to the purpose of section 743(b), 
because it permitted basis adjustments under section 743(b) to affect 
nontransferring partners. The commentators also argued that the 
provision would be used by a small number of partnerships and would add 
unnecessary complexity to the regulations. In response to these 
suggestions, the provision that permitted the partners to elect to 
apply negative basis adjustments under section 743(b) to the 
partnership's common basis has been deleted.
    (d) Statements by partners. Some commentators suggested modifying 
the statements which partners are required to provide to the 
partnership in the case of transfers which result in basis adjustments 
under section 743(b). Many of these suggestions have been adopted. For 
example, the regulations specify that the transferee of a partnership 
interest is required to provide the name, address, and taxpayer 
identification number of the transferor only if that information is 
ascertainable by the transferee. The regulations also specify that if a 
partnership interest is transferred to a nominee which is required to 
furnish the statement under Sec. 1.6031(c)-1T to the partnership, the 
nominee may satisfy the notice requirements of both the section 743 and 
6031 regulations by providing a single statement with respect to that 
transfer, but only if the statement satisfies all requirements of both 
regulations.
    The regulations require the transferee to sign the statement under 
penalties of perjury, and require the transferee to provide the amount 
of any liabilities assumed or taken subject to by the transferee, and 
any other information

[[Page 69905]]

necessary for the partnership to compute the transferee's basis in the 
partnership interest. In order to assist the partnership in properly 
calculating depreciation and amortization deductions which may be 
subject to anti-churning provisions, the regulations require the 
transferee to describe its relationship, if any, to the transferor. 
Finally, the statement required by a transferee that acquires an 
interest by death must include the date of the decedent's death.
    One commentator suggested that the statement required by a 
transferee that acquires a partnership interest by sale or exchange 
should be provided within 30 days of the sale or exchange, regardless 
of whether or not the transfer occurs at the end of the calendar year. 
This change has been adopted.
    One commentator suggested that references to the tax matters 
partner in Sec. 1.743-1(k) of the proposed regulations (regarding the 
partnership's obligations where a partner's statement is clearly 
erroneous, or a partner fails to notify the partnership that an 
interest has been transferred and the partnership has actual knowledge 
of the transfer) should be changed. This commentator emphasized that 
while the tax matters partner has a specialized role with respect to 
consolidated administrative and judicial proceedings to determine the 
tax treatment of partnership items at the partnership level, the tax 
matters partner does not have any special responsibilities with respect 
to federal income tax reporting. The final regulations adopt this 
comment. Section 1.743-1(k) now refers to partners who are responsible 
for federal income tax reporting by the partnership.
    (e) Oil and gas. One commentator suggested that the example 
described in Sec. 1.743-1(j)(6) should be changed to describe a non-oil 
and gas property. This change has been made. The commentator also 
suggested that in the case of domestic oil and gas properties that are 
depleted at the partner level, the transferee partner (rather than the 
partnership) should be required to make and allocate basis adjustments 
among such properties. The final regulations adopt this comment.
    The same commentator suggested that the regulations should specify 
a method for adjusting the basis of section 613A(c)(7)(D) properties in 
order to account for percentage depletion made by a partner with 
respect to such properties. Under the principles of Sec. 1.743-1(j), 
percentage depletion should reduce first any carryover basis under 
Sec. 1.613A-3(e)(6)(iv). After the carryover basis has been recovered, 
any further percentage depletion should reduce the section 743 
adjustment for the property.

3. Sales of Partnership Interests

    One commentator suggested that references to fair market value 
should specify whether fair market value is determined taking into 
account section 7701(g), which generally provides that fair market 
value shall be treated as being not less than the amount of any 
nonrecourse indebtedness to which the property is subject. The 
regulations specify that for purposes of the hypothetical sale employed 
to determine the income or loss realized by a partner upon the sale or 
exchange of its interest in section 751 property, fair market value is 
determined taking into account section 7701(g). Basis adjustments under 
section 743(b) also are allocated by reference to a hypothetical 
transaction. The IRS and the Treasury Department intend to issue 
guidance in the near future which will provide rules for determining 
the fair market value of partnership assets in certain situations, 
including for purposes of allocating section 743(b) basis adjustments 
upon the transfer of a partnership interest. The IRS and the Treasury 
Department anticipate that the guidance will provide that section 
7701(g) will apply in determining the fair market value of partnership 
assets for purposes of allocating section 743(b) basis adjustments.
    One commentator suggested that where a partnership interest is sold 
or exchanged, the transferor and the transferee of a partnership 
interest should be permitted jointly to assign values to partnership 
assets in a written agreement. Because this approach is inconsistent 
with the hypothetical sale approach of the regulations, this suggestion 
has not been adopted.

4. Elections Under Section 754

    One commentator requested that partnerships be granted a one-time 
right to revoke section 754 elections in effect for such partnerships. 
Given the significant changes to the rules made by these final 
regulations as compared to the regulations that were in effect at the 
time that section 754 elections previously were made, the IRS and 
Treasury believe that it is appropriate to provide for a one-time 
revocation of such elections. Accordingly, a partnership having an 
election in effect under section 754 for its taxable year that includes 
December 15, 1999 may revoke such election by attaching a statement to 
the partnership's return for that year. The return must be filed on or 
before the due date (including extensions) for the return for that 
year.

5. Allocation of Basis Adjustments Among Partnership Assets

    (a) Income in respect of a decedent. One commentator requested that 
the final regulations illustrate the allocation of basis adjustments 
among partnership assets where one or more of such assets represents 
income in respect of a decedent. Where a partnership interest is 
transferred as a result of the death of a partner, under section 
1014(c) the transferee's basis in its partnership interest is not 
adjusted for that portion of the interest, if any, which is 
attributable to items representing income in respect of a decedent 
under section 691. Because the transferee's basis in its partnership 
interest does not include the value of assets which represent income in 
respect of a decedent, the section 743(b) adjustment likewise does not 
reflect the value of such assets. George Edward Quick's Trust, 54 TC 
1336 (1970) (acq.), aff'd per curiam, 444 F.2d 90 (8th Cir. 1971); 
Chrissie H. Woodhall, 28 T.C.M. 1438 (1969), aff'd, 454 F.2d 226 (9th 
Cir. 1972); Rev. Rul. 66-325, 1966-2 C.B. 249. Where a partnership 
holds assets that represent income in respect of a decedent, the 
section 743(b) adjustment should be allocated solely to other assets. 
Accordingly, the final regulations provide that if a partnership 
interest is transferred as a result of the death of a partner, and the 
partnership holds assets representing income in respect of a decedent, 
no part of the basis adjustment under section 743(b) is allocated to 
these assets.
    (b) Transferred basis transactions. One commentator called for a 
revised system for allocating basis adjustments under section 743(b) 
which are triggered by exchanges in which the transferee's basis in the 
interest is determined in whole or in part by reference to the 
transferor's basis in the interest. In many such cases, the net section 
743(b) adjustment will be zero. However, a positive or negative section 
743(b) adjustment may result, because the transferee's basis in the 
interest may not be equal to the transferee's share of the 
partnership's bases in its assets.
    The IRS and the Treasury Department believe that, although these 
transferred basis transactions involve transfers which are subject to 
section 743(b), the new, comprehensive basis allocation rules in the 
proposed regulations should not be available. For example, where a 
partnership interest is contributed to a corporation in a transaction 
to which section 351 applies, or to a partnership in a transaction to 
which section 721(a) applies, the transferor merely has changed the 
form of its investment. If

[[Page 69906]]

the allocation rules which apply to other section 743(b) transfers were 
applied to these exchanges, then partners could use these exchanges to 
shift basis from capital gain assets to ordinary income assets, or vice 
versa.
    Therefore, the final regulations contain special basis allocation 
rules for transferred basis exchanges. The special rules generally are 
modeled on the rules for allocating basis adjustments under section 
734(b). The final regulations do not contain a specific anti-abuse rule 
regarding the special basis allocation rules which are applicable to 
such transfers. However, there may be situations where taxpayers will 
attempt to undertake abusive transactions using these special rules. 
For instance, a partner could acquire a partnership interest during a 
year in which no section 754 election is in effect, and then (in a 
related transaction) contribute the property to a wholly-owned 
corporation in order to take advantage of the basis allocation rules 
applicable to transferred basis exchanges. In appropriate situations, 
the IRS may attack such abusive transactions under a variety of 
judicial doctrines, including substance over form or step transaction, 
or under Sec. 1.701-2 of the regulations.
    (c) Unrealized receivables under section 751(c). One commentator 
requested that the final regulations illustrate the effect of 
depreciation recapture on the allocation of basis adjustments among 
partnership assets under section 755. For purposes of this section, the 
final regulations treat depreciation recapture, and any other 
properties or potential gain treated as unrealized receivables under 
section 751(c) and the regulations thereunder, as separate assets that 
are ordinary income property.
    (d) Special rules for securities partnerships and tiered 
partnerships. One commentator suggested that the regulations permit 
securities partnerships to allocate basis adjustments among partnership 
assets using an aggregation method. Another commentator requested that 
the regulations clarify how the regulations would apply to tiered 
partnerships. The IRS and the Treasury Department believe that a method 
for allocating basis adjustments among partnership assets on an 
aggregate basis is not consistent with the hypothetical sale of 
individual assets, which is required by the regulations. In addition, 
the IRS and Treasury Department believe that special rules for tiered 
partnerships would make the regulations more complex. Therefore, these 
changes have not been adopted.

6. Other Comments

    One commentator suggested that for purposes of allocating basis 
adjustments among partnership assets, the values of all partnership 
assets should be determined by reference to the basis of the transferee 
or distributee partner in its partnership interest. This suggestion is 
being considered in connection with a separate project currently under 
review by the IRS and the Treasury Department.
    One commentator suggested that the language of section 743 does not 
authorize regulations that permit both positive and negative 
adjustments as part of the same transaction. The IRS and the Treasury 
Department continue to believe that this aspect of the regulations is 
within the IRS's authority to administer sections 743 and 755.

Special Analyses

    It has been determined that these final regulations are not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has been 
determined that a final regulatory flexibility analysis is required for 
the collection of information in this Treasury decision under 5 U.S.C. 
604. A summary of the analysis is set forth below under the heading 
``Summary of Final Regulatory Flexibility Act Analysis.'' Pursuant to 
section 7805(f) of the Internal Revenue Code, these final regulations 
have been submitted to the Chief Counsel for Advocacy of the Small 
Business Administration for comment on their impact on small business.

Summary of Final Regulatory Flexibility Act Analysis

    This analysis is required under the Regulatory Flexibility Act (5 
U.S.C. chapter 6). In general, the regulations require a transferee 
that acquires an interest in a partnership with an election under 
section 754 in effect to notify the partnership of the transfer. This 
notification must include the name and taxpayer identification number 
of the transferee and the transferee's basis in the acquired 
partnership interest. The partnership is required to include a 
statement with its Form 1065, U.S. Partnership Return of Income, for 
the taxable year in which the partnership acquires knowledge of the 
transfer. This statement must identify the name and taxpayer 
identification number of the transferee, the computation of the basis 
adjustment, and the allocation of that adjustment to partnership 
properties. These requirements will ensure that the partnership has 
notice that a transfer has occurred and that the proper basis 
adjustments are computed. The legal basis for these requirements is 
contained in sections 743(b), 6001, and 7805(a).
    If an interest is transferred in a partnership holding domestic oil 
and gas properties that are depleted at the partner level under 
613A(c)(7)(D), the regulations require the transferee partner (rather 
than the partnership) to make and allocate basis adjustments under 
section 743(b) among such properties.
    There were approximately 1,494,000 partnerships in 1994. However, 
these regulations apply only to partnerships that have made an election 
under section 754. The election under section 754 is generally not made 
unless there has been a transfer of a partnership interest or a 
distribution by the partnership. Moreover, the effects of the election 
attach to specific items of partnership property and may provide only 
temporary benefits for the partners. Except for the one-time revocation 
which is allowed in connection with the promulgation of these final 
regulations, the election cannot be revoked without the consent of the 
Secretary. The IRS and the Treasury Department believe that most 
partnerships do not make the election under section 754. Therefore, 
most partnerships will not be affected by the regulations in any given 
year.
    After a partner conveys information to the partnership concerning a 
transfer of a partnership interest, the partnership must adjust the 
partner's interest in the basis of partnership property. Because these 
basis adjustments will affect the partner's share of depreciation or 
amortization deductions and amounts of gain or loss on the disposition 
of certain items of partnership property, the partnership must prepare 
and maintain special entries on its books. However, in many cases, 
partnership returns are prepared using computer software that can 
prepare and maintain these special entries after the initial year.
    The IRS and the Treasury Department are not aware of any federal 
rules that may duplicate, overlap, or conflict with the rule.
    As an alternative to the disclosure described above, the IRS and 
the Treasury Department considered, but rejected, a rule that would 
have required the partners, and not the partnerships, to make the basis 
adjustments and to determine the effects of the basis adjustments on 
the partners' distributive shares. This alternative was rejected 
because the IRS and the Treasury Department believe that partnerships 
generally have better access to the information necessary to report 
section 743 basis adjustments properly. To

[[Page 69907]]

require the partners rather than the partnerships to bear the burden of 
reporting would require the partnerships to provide the partners with 
significant amounts of information not otherwise needed by the 
partners. There are no known alternative rules that are less burdensome 
to the partnerships and their partners but that accomplish the purpose 
of the statute.
    Finally, because partners, rather than partnerships, are required 
to report basis adjustments under section 732(d), the final regulations 
require partnerships to provide transferees with such information as is 
necessary for the transferees properly to compute basis adjustments 
made under section 732(d). This information must be provided if a 
transferee notifies a partnership that it plans to make the election 
under section 732(d) or if a partnership makes a distribution subject 
to the mandatory application of section 732(d). The IRS and the 
Treasury Department believe that this requirement will apply under 
limited circumstances to a small percentage of partnerships.

Drafting Information

    The principal author of these regulations is Matthew Lay of the 
Office of the Assistant Chief Counsel (Passthroughs and Special 
Industries). However, other personnel from the IRS and the Treasury 
Department participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.732-1 also issued under 26 U.S.C. 732.
    Section 1.732-2 also issued under 26 U.S.C. 732.
    Section 1.734-1 also issued under 26 U.S.C. 734.
    Section 1.743-1 also issued under 26 U.S.C. 743.
    Section 1.751-1 also issued under 26 U.S.C. 751.
    Section 1.755-1 also issued under 26 U.S.C. 755. * * *
    Section 1.1017-1 also issued under 26 U.S.C. 1017. * * *

    Par. 2. Section 1.732-1 is amended as follows:
    1. Revise paragraph (c).
    2. Revise paragraph (d)(1)(ii).
    3. Revise the last sentence of paragraph (d)(1)(v).
    4. Revise paragraph (d)(1)(vi).
    5. Revise paragraph (d)(4)(iii).
    6. Remove the flush text and Examples 1 and 2 following paragraph 
(d)(4)(iii).
    7. Add paragraph (d)(5).
    The additions and revisions read as follows:


Sec. 1.732-1  Basis of distributed property other than money.

* * * * *
    (c) Allocation of basis among properties distributed to a partner--
(1) General rule--(i) Unrealized receivables and inventory items. The 
basis to be allocated to properties distributed to a partner under 
section 732(a)(2) or (b) is allocated first to any unrealized 
receivables (as defined in section 751(c)) and inventory items (as 
defined in section 751(d)(2)) in an amount equal to the adjusted basis 
of each such property to the partnership immediately before the 
distribution. If the basis to be allocated is less than the sum of the 
adjusted bases to the partnership of the distributed unrealized 
receivables and inventory items, the adjusted basis of the distributed 
property must be decreased in the manner provided in paragraph 
(c)(2)(i) of this section.
    (ii) Other distributed property. Any basis not allocated to 
unrealized receivables or inventory items under paragraph (c)(1)(i) of 
this section is allocated to any other property distributed to the 
partner in the same transaction by assigning to each distributed 
property an amount equal to the adjusted basis of the property to the 
partnership immediately before the distribution. However, if the sum of 
the adjusted bases to the partnership of such other distributed 
property does not equal the basis to be allocated among the distributed 
property, any increase or decrease required to make the amounts equal 
is allocated among the distributed property as provided in paragraph 
(c)(2) of this section.
    (2) Adjustment to basis allocation--(i) Decrease in basis. Any 
decrease to the basis of distributed property required under paragraph 
(c)(1) of this section is allocated first to distributed property with 
unrealized depreciation in proportion to each property's respective 
amount of unrealized depreciation before any decrease (but only to the 
extent of each property's unrealized depreciation). If the required 
decrease exceeds the amount of unrealized depreciation in the 
distributed property, the excess is allocated to the distributed 
property in proportion to the adjusted bases of the distributed 
property, as adjusted pursuant to the immediately preceding sentence.
    (ii) Increase in basis. Any increase to the basis of distributed 
property required under paragraph (c)(1)(ii) of this section is 
allocated first to distributed property (other than unrealized 
receivables and inventory items) with unrealized appreciation in 
proportion to each property's respective amount of unrealized 
appreciation before any increase (but only to the extent of each 
property's unrealized appreciation). If the required increase exceeds 
the amount of unrealized appreciation in the distributed property, the 
excess is allocated to the distributed property (other than unrealized 
receivables or inventory items) in proportion to the fair market value 
of the distributed property.
    (3) Unrealized receivables and inventory items. If the basis to be 
allocated upon a distribution in liquidation of the partner's entire 
interest in the partnership is greater than the adjusted basis to the 
partnership of the unrealized receivables and inventory items 
distributed to the partner, and if there is no other property 
distributed to which the excess can be allocated, the distributee 
partner sustains a capital loss under section 731(a)(2) to the extent 
of the unallocated basis of the partnership interest.
    (4) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. A is a one-fourth partner in partnership PRS and has 
an adjusted basis in its partnership interest of $650. PRS 
distributes inventory items and Assets X and Y to A in liquidation 
of A's entire partnership interest. The distributed inventory items 
have a basis to the partnership of $100 and a fair market value of 
$200. Asset X has an adjusted basis to the partnership of $50 and a 
fair market value of $400. Asset Y has an adjusted basis to the 
partnership and a fair market value of $100. Neither Asset X nor 
Asset Y consists of inventory items or unrealized receivables. Under 
this paragraph (c), A's basis in its partnership interest is 
allocated first to the inventory items in an amount equal to their 
adjusted basis to the partnership. A, therefore, has an adjusted 
basis in the inventory items of $100. The remaining basis, $550, is 
allocated to the distributed property first in an amount equal to 
the property's adjusted basis to the partnership. Thus, Asset X is 
allocated $50 and Asset Y is allocated $100. Asset X is then 
allocated $350, the amount of unrealized appreciation in Asset

[[Page 69908]]

X. Finally, the remaining basis, $50, is allocated to Assets X and Y 
in proportion to their fair market values: $40 to Asset X (400/500 
x  $50), and $10 to Asset Y (100/500  x  $50). Therefore, after the 
distribution, A has an adjusted basis of $440 in Asset X and $110 in 
Asset Y.
    Example 2. B is a one-fourth partner in partnership PRS and has 
an adjusted basis in its partnership interest of $200. PRS 
distributes Asset X and Asset Y to B in liquidation of its entire 
partnership interest. Asset X has an adjusted basis to the 
partnership and fair market value of $150. Asset Y has an adjusted 
basis to the partnership of $150 and a fair market value of $50. 
Neither of the assets consists of inventory items or unrealized 
receivables. Under this paragraph (c), B's basis is first assigned 
to the distributed property to the extent of the partnership's basis 
in each distributed property. Thus, Asset X and Asset Y are each 
assigned $150. Because the aggregate adjusted basis of the 
distributed property, $300, exceeds the basis to be allocated, $200, 
a decrease of $100 in the basis of the distributed property is 
required. Assets X and Y have unrealized depreciation of zero and 
$100, respectively. Thus, the entire decrease is allocated to Asset 
Y. After the distribution, B has an adjusted basis of $150 in Asset 
X and $50 in Asset Y.
    Example 3. C, a partner in partnership PRS, receives a 
distribution in liquidation of its entire partnership interest of 
$6,000 cash, inventory items having an adjusted basis to the 
partnership of $6,000, and real property having an adjusted basis to 
the partnership of $4,000. C's basis in its partnership interest is 
$9,000. The cash distribution reduces C's basis to $3,000, which is 
allocated entirely to the inventory items. The real property has a 
zero basis in C's hands. The partnership bases not carried over to C 
for the distributed properties are lost unless an election under 
section 754 is in effect requiring the partnership to adjust the 
bases of remaining partnership properties under section 734(b).
    Example 4. Assume the same facts as in Example 3 of this 
paragraph except C receives a distribution in liquidation of its 
entire partnership interest of $1,000 cash and inventory items 
having a basis to the partnership of $6,000. The cash distribution 
reduces C's basis to $8,000, which can be allocated only to the 
extent of $6,000 to the inventory items. The remaining $2,000 basis, 
not allocable to the distributed property, constitutes a capital 
loss to partner C under section 731(a)(2). If the election under 
section 754 is in effect, see section 734(b) for adjustment of the 
basis of undistributed partnership property.

    (5) Effective date. This paragraph (c) applies to distributions of 
property from a partnership that occur on or after December 15, 1999.
    (d) * * *
    (1) * * *
    (ii) Where an election under section 754 is in effect, see section 
743(b) and Secs. 1.743-1 and 1.732-2.
* * * * *
    (v) * * * (For a shift of transferee's basis adjustment under 
section 743(b) to like property, see Sec. 1.743-1(g).)
    (vi) The provisions of this paragraph (d)(1) may be illustrated by 
the following example:

    Example. (i) Transferee partner, T, purchased a one-fourth 
interest in partnership PRS for $17,000. At the time T purchased the 
partnership interest, the election under section 754 was not in 
effect and the partnership inventory had a basis to the partnership 
of $14,000 and a fair market value of $16,000. T's purchase price 
reflected $500 of this difference. Thus, $4,000 of the $17,000 paid 
by T for the partnership interest was attributable to T's share of 
partnership inventory with a basis of $3,500. Within 2 years after T 
acquired the partnership interest, T retired from the partnership 
and received in liquidation of its entire partnership interest the 
following property:

------------------------------------------------------------------------
                                                      Assets
                                         -------------------------------
                                          Adjusted basis    Fair market
                                              to PRS           value
------------------------------------------------------------------------
Cash....................................          $1,500          $1,500
Inventory...............................           3,500           4,000
Asset X.................................           2,000           4,000
Asset Y.................................           4,000           5,000
------------------------------------------------------------------------

    (ii) The fair market value of the inventory received by T was 
one-fourth of the fair market value of all partnership inventory and 
was T's share of such property. It is immaterial whether the 
inventory T received was on hand when T acquired the interest. In 
accordance with T's election under section 732(d), the amount of T's 
share of partnership basis that is attributable to partnership 
inventory is increased by $500 (one-fourth of the $2,000 difference 
between the fair market value of the property, $16,000, and its 
$14,000 basis to the partnership at the time T purchased its 
interest). This adjustment under section 732(d) applies only for 
purposes of distributions to T, and not for purposes of partnership 
depreciation, depletion, or gain or loss on disposition. Thus, the 
amount to be allocated among the properties received by T in the 
liquidating distribution is $15,500 ($17,000, T's basis for the 
partnership interest, reduced by the amount of cash received, 
$1,500). This amount is allocated as follows: The basis of the 
inventory items received is $4,000, consisting of the $3,500 common 
partnership basis, plus the basis adjustment of $500 which T would 
have had under section 743(b). The remaining basis of $11,500 
($15,500 minus $4,000) is allocated among the remaining property 
distributed to T by assigning to each property the adjusted basis to 
the partnership of such property and adjusting that basis by any 
required increase or decrease. Thus, the adjusted basis to T of 
Asset X is $5,111 ($2,000, the adjusted basis of Asset X to the 
partnership, plus $2,000, the amount of unrealized appreciation in 
Asset X, plus $1,111 ($4,000/$9,000 multiplied by $2,500)). 
Similarly, the adjusted basis of Asset Y to T is $6,389 ($4,000, the 
adjusted basis of Asset Y to the partnership, plus $1,000, the 
amount of unrealized appreciation in Asset Y, plus, $1,389 ($5,000/
$9,000 multiplied by $2,500)).
* * * * *
    (4) * * *
    (iii) A basis adjustment under section 743(b) would change the 
basis to the transferee partner of the property actually distributed.
    (5) Required statements. If a transferee partner notifies a 
partnership that it plans to make the election under section 732(d) 
under paragraph (d)(3) of this section, or if a partnership makes a 
distribution to which paragraph (d)(4) of this section applies, the 
partnership must provide the transferee with such information as is 
necessary for the transferee properly to compute the transferee's basis 
adjustments under section 732(d).
* * * * *
    Par. 3. Section 1.732-2 is amended by revising the sentence at the 
end of the Example in paragraph (b) to read as follows:


Sec. 1.732-2  Special partnership basis of distributed property.

* * * * *
    (b) * * *
    Example. * * * See Sec. 1.743-1(g).
* * * * *
    Par. 4. In Sec. 1.734-1, paragraph (e) is added to read as follows:


Sec. 1.734-1  Optional adjustment to basis of undistributed partnership 
property.

* * * * *
    (e) Recovery of adjustments to basis of partnership property--(1) 
Increases in basis. For purposes of section 168, if the basis of a 
partnership's recovery property is increased as a result of the 
distribution of property to a partner, then the increased portion of 
the basis

[[Page 69909]]

must be taken into account as if it were newly-purchased recovery 
property placed in service when the distribution occurs. Consequently, 
any applicable recovery period and method may be used to determine the 
recovery allowance with respect to the increased portion of the basis. 
However, no change is made for purposes of determining the recovery 
allowance under section 168 for the portion of the basis for which 
there is no increase.
    (2) Decreases in basis. For purposes of section 168, if the basis 
of a partnership's recovery property is decreased as a result of the 
distribution of property to a partner, then the decrease in basis must 
be accounted for over the remaining recovery period of the property 
beginning with the recovery period in which the basis is decreased.
    (3) Effective date. This paragraph (e) applies to distributions of 
property from a partnership that occur on or after December 15, 1999.
    Par. 5. Section 1.743-1 is revised to read as follows:


Sec. 1.743-1  Optional adjustment to basis of partnership property.

    (a) Generally. The basis of partnership property is adjusted as a 
result of the transfer of an interest in a partnership by sale or 
exchange or on the death of a partner only if the election provided by 
section 754 (relating to optional adjustments to the basis of 
partnership property) is in effect with respect to the partnership. 
Whether or not the election provided in section 754 is in effect, the 
basis of partnership property is not adjusted as the result of a 
contribution of property, including money, to the partnership.
    (b) Determination of adjustment. In the case of the transfer of an 
interest in a partnership, either by sale or exchange or as a result of 
the death of a partner, a partnership that has an election under 
section 754 in effect--
    (1) Increases the adjusted basis of partnership property by the 
excess of the transferee's basis for the transferred partnership 
interest over the transferee's share of the adjusted basis to the 
partnership of the partnership's property; or
    (2) Decreases the adjusted basis of partnership property by the 
excess of the transferee's share of the adjusted basis to the 
partnership of the partnership's property over the transferee's basis 
for the transferred partnership interest.
    (c) Determination of transferee's basis in the transferred 
partnership interest. In the case of the transfer of a partnership 
interest by sale or exchange or as a result of the death of a partner, 
the transferee's basis in the transferred partnership interest is 
determined under section 742 and Sec. 1.742-1. See also section 752 and 
Secs. 1.752-1 through 1.752-5.
    (d) Determination of transferee's share of the adjusted basis to 
the partnership of the partnership's property--(1) Generally. A 
transferee's share of the adjusted basis to the partnership of 
partnership property is equal to the sum of the transferee's interest 
as a partner in the partnership's previously taxed capital, plus the 
transferee's share of partnership liabilities. Generally, a 
transferee's interest as a partner in the partnership's previously 
taxed capital is equal to--
    (i) The amount of cash that the transferee would receive on a 
liquidation of the partnership following the hypothetical transaction, 
as defined in paragraph (d)(2) of this section (to the extent 
attributable to the acquired partnership interest); increased by
    (ii) The amount of tax loss (including any remedial allocations 
under Sec. 1.704-3(d)), that would be allocated to the transferee from 
the hypothetical transaction (to the extent attributable to the 
acquired partnership interest); and decreased by
    (iii) The amount of tax gain (including any remedial allocations 
under Sec. 1.704-3(d)), that would be allocated to the transferee from 
the hypothetical transaction (to the extent attributable to the 
acquired partnership interest).
    (2) Hypothetical transaction defined. For purposes of paragraph 
(d)(1) of this section, the hypothetical transaction means the 
disposition by the partnership of all of the partnership's assets, 
immediately after the transfer of the partnership interest, in a fully 
taxable transaction for cash equal to the fair market value of the 
assets.
    (3) Examples. The provisions of this paragraph (d) are illustrated 
by the following examples:

    Example 1. (i) A is a member of partnership PRS in which the 
partners have equal interests in capital and profits. The 
partnership has made an election under section 754, relating to the 
optional adjustment to the basis of partnership property. A sells 
its interest to T for $22,000. The balance sheet of the partnership 
at the date of sale shows the following:

------------------------------------------------------------------------
                                                      Assets
                                         -------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
Cash....................................          $5,000          $5,000
Accounts receivable.....................          10,000          10,000
Inventory...............................          20,000          21,000
Depreciable assets......................          20,000          40,000
                                         -------------------------------
    Total...............................          55,000          76,000
------------------------------------------------------------------------


------------------------------------------------------------------------
                                              Liabilities and Capital
                                         -------------------------------
                                           Adjusted per     Fair market
                                               books           value
------------------------------------------------------------------------
Liabilities.............................         $10,000         $10,000
Capital:
    A...................................          15,000          22,000
    B...................................          15,000          22,000
    C...................................          15,000          22,000
                                         -------------------------------
        Total...........................          55,000          76,000
------------------------------------------------------------------------


[[Page 69910]]

    (ii) The amount of the basis adjustment under section 743(b) is 
the difference between the basis of T's interest in the partnership 
and T's share of the adjusted basis to the partnership of the 
partnership's property. Under section 742, the basis of T's interest 
is $25,333 (the cash paid for A's interest, $22,000, plus $3,333, 
T's share of partnership liabilities). T's interest in the 
partnership's previously taxed capital is $15,000 ($22,000, the 
amount of cash T would receive if PRS liquidated immediately after 
the hypothetical transaction, decreased by $7,000, the amount of tax 
gain allocated to T from the hypothetical transaction). T's share of 
the adjusted basis to the partnership of the partnership's property 
is $18,333 ($15,000 share of previously taxed capital, plus $3,333 
share of the partnership's liabilities). The amount of the basis 
adjustment under section 743(b) to partnership property therefore, 
is $7,000, the difference between $25,333 and $18,333.
    Example 2. A, B, and C form partnership PRS, to which A 
contributes land (Asset 1) with a fair market value of $1,000 and an 
adjusted basis to A of $400, and B and C each contribute $1,000 
cash. Each partner has $1,000 credited to it on the books of the 
partnership as its capital contribution. The partners share in 
profits equally. During the partnership's first taxable year, Asset 
1 appreciates in value to $1,300. A sells its one-third interest in 
the partnership to T for $1,100, when an election under section 754 
is in effect. The amount of tax gain that would be allocated to T 
from the hypothetical transaction is $700 ($600 section 704(c) 
built-in gain, plus one-third of the additional gain). Thus, T's 
interest in the partnership's previously taxed capital is $400 
($1,100, the amount of cash T would receive if PRS liquidated 
immediately after the hypothetical transaction, decreased by $700, 
T's share of gain from the hypothetical transaction). The amount of 
T's basis adjustment under section 743(b) to partnership property is 
$700 (the excess of $1,100, T's cost basis for its interest, over 
$400, T's share of the adjusted basis to the partnership of 
partnership property).

    (e) Allocation of basis adjustment. For the allocation of the basis 
adjustment under this section among the individual items of partnership 
property, see section 755 and the regulations thereunder.
    (f) Subsequent transfers. Where there has been more than one 
transfer of a partnership interest, a transferee's basis adjustment is 
determined without regard to any prior transferee's basis adjustment. 
In the case of a gift of an interest in a partnership, the donor is 
treated as transferring, and the donee as receiving, that portion of 
the basis adjustment attributable to the gifted partnership interest. 
The provisions of this paragraph (f) are illustrated by the following 
example:

    Example. (i) A, B, and C form partnership PRS. A and B each 
contribute $1,000 cash, and C contributes land with a basis and fair 
market value of $1,000. When the land has appreciated in value to 
$1,300, A sells its interest to T1 for $1,100 (one-third of $3,300, 
the fair market value of the partnership property). An election 
under section 754 is in effect; therefore, T1 has a basis adjustment 
under section 743(b) of $100.
    (ii) After the land has further appreciated in value to $1,600, 
T1 sells its interest to T2 for $1,200 (one-third of $3,600, the 
fair market value of the partnership property). T2 has a basis 
adjustment under section 743(b) of $200. This amount is determined 
without regard to any basis adjustment under section 743(b) that T1 
may have had in the partnership assets.
    (iii) During the following year, T2 makes a gift to T3 of fifty 
percent of T2's interest in PRS. At the time of the transfer, T2 has 
a $200 basis adjustment under section 743(b). T2 is treated as 
transferring $100 of the basis adjustment to T3 with the gift of the 
partnership interest.

    (g) Distributions--(1) Distribution of adjusted property to the 
transferee--(i) Coordination with section 732. If a partnership 
distributes property to a transferee and the transferee has a basis 
adjustment for the property, the basis adjustment is taken into account 
under section 732. See Sec. 1.732-2(b).
    (ii) Coordination with section 734. For certain adjustments to the 
common basis of remaining partnership property after the distribution 
of adjusted property to a transferee, see Sec. 1.734-2(b).
    (2) Distribution of adjusted property to another partner--(i) 
Coordination with section 732. If a partner receives a distribution of 
property with respect to which another partner has a basis adjustment, 
the distributee does not take the basis adjustment into account under 
section 732.
    (ii) Reallocation of basis. A transferee with a basis adjustment in 
property that is distributed to another partner reallocates the basis 
adjustment among the remaining items of partnership property under 
Sec. 1.755-1(c).
    (3) Distributions in complete liquidation of a partner's interest. 
If a transferee receives a distribution of property (whether or not the 
transferee has a basis adjustment in such property) in liquidation of 
its interest in the partnership, the adjusted basis to the partnership 
of the distributed property immediately before the distribution 
includes the transferee's basis adjustment for the property in which 
the transferee relinquished an interest (either because it remained in 
the partnership or was distributed to another partner). Any basis 
adjustment for property in which the transferee is deemed to relinquish 
its interest is reallocated among the properties distributed to the 
transferee under Sec. 1.755-1(c).
    (4) Coordination with other provisions. The rules of sections 
704(c)(1)(B), 731, 737, and 751 apply before the rules of this 
paragraph (g).
    (5) Example. The provisions of this paragraph (g) are illustrated 
by the following example:

    Example. (i) A, B, and C are equal partners in partnership PRS. 
Each partner originally contributed $10,000 in cash, and PRS used 
the contributions to purchase five nondepreciable capital assets. 
PRS has no liabilities. After five years, PRS's balance sheet 
appears as follows:

------------------------------------------------------------------------
                                                      Assets
                                         -------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
Asset 1.................................         $10,000         $10,000
Asset 2.................................           4,000           6,000
Asset 3.................................           6,000           6,000
Asset 4.................................           7,000           4,000
Asset 5.................................           3,000          13,000
                                         -------------------------------
    Total...............................          30,000          39,000
------------------------------------------------------------------------


[[Page 69911]]


------------------------------------------------------------------------
                                                      Capital
                                         -------------------------------
                                           Adjusted per     Fair market
                                               books           value
------------------------------------------------------------------------
Partner A...............................         $10,000         $13,000
Partner B...............................          10,000          13,000
Partner C...............................          10,000          13,000
                                         -------------------------------
    Total...............................          30,000          39,000
------------------------------------------------------------------------

    (ii) A sells its interest to T for $13,000 when PRS has an 
election in effect under section 754. T receives a basis adjustment 
under section 743(b) in the partnership property that is equal to 
$3,000 (the excess of T's basis in the partnership interest, 
$13,000, over T's share of the adjusted basis to the partnership of 
partnership property, $10,000). The basis adjustment is allocated 
under section 755, and the partnership's balance sheet appears as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                                      Assets
                                                                 -----------------------------------------------
                                                                                    Fair market        Basis
                                                                  Adjusted basis       value        adjustment
----------------------------------------------------------------------------------------------------------------
Asset 1.........................................................         $10,000         $10,000          $0.00
Asset 2.........................................................           4,000           6,000         666.67
Asset 3.........................................................           6,000           6,000           0.00
Asset 4.........................................................           7,000           4,000      (1,000.00)
Asset 5.........................................................           3,000          13,000       3,333.33
                                                                 -----------------------------------------------
    Total.......................................................          30,000          39,000       3,000.00
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                                      Capital
                                                                 -----------------------------------------------
                                                                   Adjusted per     Fair market
                                                                       books           value       Special basis
----------------------------------------------------------------------------------------------------------------
Partner T.......................................................         $10,000         $13,000          $3,000
Partner B.......................................................          10,000          13,000               0
Partner C.......................................................          10,000          13,000               0
                                                                 -----------------------------------------------
    Total.......................................................          30,000          39,000           3,000
----------------------------------------------------------------------------------------------------------------

    (iii) Assume that PRS distributes Asset 2 to T in partial 
liquidation of T's interest in the partnership. T has a basis 
adjustment under section 743(b) of $666.67 in Asset 2. Under 
paragraph (g)(1)(i) of this section, T takes the basis adjustment 
into account under section 732. Therefore, T will have a basis in 
Asset 2 of $4,666.67 following the distribution.
    (iv) Assume instead that PRS distributes Asset 5 to C in 
complete liquidation of C's interest in PRS. T has a basis 
adjustment under section 743(b) of $3,333.33 in Asset 5. Under 
paragraph (g)(2)(i) of this section, C does not take T's basis 
adjustment into account under section 732. Therefore, the 
partnership's basis for purposes of sections 732 and 734 is $3,000. 
Under paragraph (g)(2)(ii) of this section, T's $3,333.33 basis 
adjustment is reallocated among the remaining partnership assets 
under Sec. 1.755-1(c).
    (v) Assume instead that PRS distributes Asset 5 to T in complete 
liquidation of its interest in PRS. Under paragraph (g)(3) of this 
section, immediately prior to the distribution of Asset 5 to T, PRS 
must adjust the basis of Asset 5. Therefore, immediately prior to 
the distribution, PRS's basis in Asset 5 is equal to $6,000, which 
is the sum of (A) $3,000, PRS's common basis in Asset 5, plus (B) 
$3,333.33, T's basis adjustment to Asset 5, plus (C) ($333.33), the 
sum of T's basis adjustments in Assets 2 and 4. For purposes of 
sections 732 and 734, therefore, PRS will be treated as having a 
basis in Asset 5 equal to $6,000.

    (h) Contributions of adjusted property--(1) Section 721(a) 
transactions. If, in a transaction described in section 721(a), a 
partnership (the upper tier) contributes to another partnership (the 
lower tier) property with respect to which a basis adjustment has been 
made, the basis adjustment is treated as contributed to the lower-tier 
partnership, regardless of whether the lower-tier partnership makes a 
section 754 election. The lower tier's basis in the contributed assets 
and the upper tier's basis in the partnership interest received in the 
transaction are determined with reference to the basis adjustment. 
However, that portion of the basis of the upper tier's interest in the 
lower tier attributable to the basis adjustment must be segregated and 
allocated solely to the transferee partner for whom the basis 
adjustment was made. Similarly, that portion of the lower tier's basis 
in its assets attributable to the basis adjustment must be segregated 
and allocated solely to the upper tier and the transferee. A partner 
with a basis adjustment in property held by a partnership that 
terminates under section 708(b)(1)(B) will continue to have the same 
basis adjustment with respect to property deemed contributed by the 
terminated partnership to the new partnership under Sec. 1.708-
1(b)(1)(iv), regardless of whether the new partnership makes a section 
754 election.
    (2) Section 351 transactions--(i) Basis in transferred property. A 
corporation's adjusted tax basis in property transferred to the 
corporation by a partnership in a transaction described in section 351 
is determined with reference to any basis adjustments to the property 
under section 743(b) (other than any basis adjustment that reduces a 
partner's gain under paragraph (h)(2)(ii) of this section).
    (ii) Partnership gain. The amount of gain, if any, recognized by 
the partnership on a transfer of property by the partnership to a 
corporation in a transfer described in section 351 is determined 
without reference to any basis adjustment to the transferred property 
under section 743(b). The amount of gain, if any, recognized by the 
partnership on the transfer that is allocated to a partner with a basis 
adjustment in the transferred property is

[[Page 69912]]

adjusted to reflect the partner's basis adjustment in the transferred 
property.
    (iii) Basis in stock. The partnership's adjusted tax basis in stock 
received from a corporation in a transfer described in section 351 is 
determined without reference to the basis adjustment in property 
transferred to the corporation in the section 351 exchange. A partner 
with a basis adjustment in property transferred to the corporation, 
however, has a basis adjustment in the stock received by the 
partnership in the section 351 exchange in an amount equal to the 
partner's basis adjustment in the transferred property, reduced by any 
basis adjustment that reduced the partner's gain under paragraph 
(h)(2)(ii) of this section.
    (iv) Example. The following example illustrates the principles of 
this paragraph (h):

    Example. (i) A, B, and C are equal partners in partnership PRS. 
The partnership's only asset, Asset 1, has an adjusted tax basis of 
$60 and a fair market value of $120. Asset 1 is a nondepreciable 
capital asset and is not section 704(c) property. A has a basis in 
its partnership interest of $40, and a positive section 743(b) 
adjustment of $20 in Asset 1. In a transaction to which section 351 
applies, PRS contributes Asset 1 to X, a corporation, in exchange 
for $15 in cash and X stock with a fair market value of $105.
    (ii) Under paragraph (h)(2)(ii) of this section, PRS realizes 
$60 of gain on the transfer of Asset 1 to X ($120, its amount 
realized, minus $60, its adjusted basis), but recognizes only $15 of 
that gain under section 351(b)(1). Of this amount, $5 is allocated 
to each partner. A must use $5 of its basis adjustment in Asset 1 to 
offset A's share of PRS's gain. Under paragraph (h)(2)(iii) of this 
section, PRS's basis in the stock received from X is $60. However, A 
has a basis adjustment in the stock received by PRS equal to $15 
(its basis adjustment in Asset 1, $20, reduced by the portion of the 
adjustment which reduced A's gain, $5). Under paragraph (h)(2)(i) of 
this section, X's basis in Asset 1 equals $75 (PRS's common basis in 
the asset, $60, plus A's basis adjustment under section 743(b), $20, 
less the portion of the adjustment which reduced A's gain, $5).

    (i) [Reserved].
    (j) Effect of basis adjustment--(1) In general. The basis 
adjustment constitutes an adjustment to the basis of partnership 
property with respect to the transferee only. No adjustment is made to 
the common basis of partnership property. Thus, for purposes of 
calculating income, deduction, gain, and loss, the transferee will have 
a special basis for those partnership properties the bases of which are 
adjusted under section 743(b) and this section. The adjustment to the 
basis of partnership property under section 743(b) has no effect on the 
partnership's computation of any item under section 703.
    (2) Computation of partner's distributive share of partnership 
items. The partnership first computes its items of income, deduction, 
gain, or loss at the partnership level under section 703. The 
partnership then allocates the partnership items among the partners, 
including the transferee, in accordance with section 704, and adjusts 
the partners' capital accounts accordingly. The partnership then 
adjusts the transferee's distributive share of the items of partnership 
income, deduction, gain, or loss, in accordance with paragraphs (j)(3) 
and (4) of this section, to reflect the effects of the transferee's 
basis adjustment under section 743(b). These adjustments to the 
transferee's distributive shares must be reflected on Schedules K and 
K-1 of the partnership's return (Form 1065). These adjustments to the 
transferee's distributive shares do not affect the transferee's capital 
account.
    (3) Effect of basis adjustment in determining items of income, 
gain, or loss--(i) In general. The amount of a transferee's income, 
gain, or loss from the sale or exchange of a partnership asset in which 
the transferee has a basis adjustment is equal to the transferee's 
share of the partnership's gain or loss from the sale of the asset 
(including any remedial allocations under Sec. 1.704-3(d)), minus the 
amount of the transferee's positive basis adjustment for the 
partnership asset (determined by taking into account the recovery of 
the basis adjustment under paragraph (j)(4)(i)(B) of this section) or 
plus the amount of the transferee's negative basis adjustment for the 
partnership asset (determined by taking into the account the recovery 
of the basis adjustment under paragraph (j)(4)(ii)(B) of this section).
    (ii) Examples. The following examples illustrate the principles of 
this paragraph (j)(3):

    Example 1. A and B form equal partnership PRS. A contributes 
nondepreciable property with a fair market value of $50 and an 
adjusted tax basis of $100. PRS will use the traditional allocation 
method under Sec. 1.704-3(b). B contributes $50 cash. A sells its 
interest to T for $50. PRS has an election in effect to adjust the 
basis of partnership property under section 754. T receives a 
negative $50 basis adjustment under section 743(b) that, under 
section 755, is allocated to the nondepreciable property. PRS then 
sells the property for $60. PRS recognizes a book gain of $10 
(allocated equally between T and B) and a tax loss of $40. T will 
receive an allocation of $40 of tax loss under the principles of 
section 704(c). However, because T has a negative $50 basis 
adjustment in the nondepreciable property, T recognizes a $10 gain 
from the partnership's sale of the property.
    Example 2. A and B form equal partnership PRS. A contributes 
nondepreciable property with a fair market value of $100 and an 
adjusted tax basis of $50. B contributes $100 cash. PRS will use the 
traditional allocation method under Sec. 1.704-3(b). A sells its 
interest to T for $100. PRS has an election in effect to adjust the 
basis of partnership property under section 754. Therefore, T 
receives a $50 basis adjustment under section 743(b) that, under 
section 755, is allocated to the nondepreciable property. PRS then 
sells the nondepreciable property for $90. PRS recognizes a book 
loss of $10 (allocated equally between T and B) and a tax gain of 
$40. T will receive an allocation of the entire $40 of tax gain 
under the principles of section 704(c). However, because T has a $50 
basis adjustment in the property, T recognizes a $10 loss from the 
partnership's sale of the property.
    Example 3. A and B form equal partnership PRS. PRS will make 
allocations under section 704(c) using the remedial allocation 
method described in Sec. 1.704-3(d). A contributes nondepreciable 
property with a fair market value of $100 and an adjusted tax basis 
of $150. B contributes $100 cash. A sells its partnership interest 
to T for $100. PRS has an election in effect to adjust the basis of 
partnership property under section 754. T receives a negative $50 
basis adjustment under section 743(b) that, under section 755, is 
allocated to the property. The partnership then sells the property 
for $120. The partnership recognizes a $20 book gain and a $30 tax 
loss. The book gain will be allocated equally between the partners. 
The entire $30 tax loss will be allocated to T under the principles 
of section 704(c). To match its $10 share of book gain, B will be 
allocated $10 of remedial gain, and T will be allocated an 
offsetting $10 of remedial loss. T was allocated a total of $40 of 
tax loss with respect to the property. However, because T has a 
negative $50 basis adjustment to the property, T recognizes a $10 
gain from the partnership's sale of the property.

    (4) Effect of basis adjustment in determining items of deduction--
(i) Increases--(A) Additional deduction. The amount of any positive 
basis adjustment that is recovered by the transferee in any year is 
added to the transferee's distributive share of the partnership's 
depreciation or amortization deductions for the year. The basis 
adjustment is adjusted under section 1016(a)(2) to reflect the recovery 
of the basis adjustment.
    (B) Recovery period--(1) In general. Except as provided in 
paragraph (j)(4)(i)(B)(2) of this section, for purposes of section 168, 
if the basis of a partnership's recovery property is increased as a 
result of the transfer of a partnership interest, then the increased 
portion of the basis is taken into account as if it were newly-
purchased recovery

[[Page 69913]]

property placed in service when the transfer occurs. Consequently, any 
applicable recovery period and method may be used to determine the 
recovery allowance with respect to the increased portion of the basis. 
However, no change is made for purposes of determining the recovery 
allowance under section 168 for the portion of the basis for which 
there is no increase.
    (2) Remedial allocation method. If a partnership elects to use the 
remedial allocation method described in Sec. 1.704-3(d) with respect to 
an item of the partnership's recovery property, then the portion of any 
increase in the basis of the item of the partnership's recovery 
property under section 743(b) that is attributable to section 704(c) 
built-in gain is recovered over the remaining recovery period for the 
partnership's excess book basis in the property as determined in the 
final sentence of Sec. 1.704-3(d)(2). Any remaining portion of the 
basis increase is recovered under paragraph (j)(4)(i)(B)(1) of this 
section.
    (C) Examples. The provisions of this paragraph (j)(4)(i) are 
illustrated by the following examples:

    Example 1. (i) A, B, and C are equal partners in partnership 
PRS, which owns Asset 1, an item of depreciable property that has a 
fair market value in excess of its adjusted tax basis. C sells its 
interest in PRS to T while PRS has an election in effect under 
section 754. PRS, therefore, increases the basis of Asset 1 with 
respect to T.
    (ii) Assume that in the year following the transfer of the 
partnership interest to T, T's distributive share of the 
partnership's common basis depreciation deductions from Asset 1 is 
$1,000. Also assume that, under paragraph (j)(4)(i)(B) of this 
section, the amount of the basis adjustment under section 743(b) 
that T recovers during the year is $500. The total amount of 
depreciation deductions from Asset 1 reported by T is equal to 
$1,500.
    Example 2. (i) A and B form equal partnership PRS. A contributes 
property with an adjusted basis of $100,000 and a fair market value 
of $500,000. B contributes $500,000 cash. When PRS is formed, the 
property has five years remaining in its recovery period. The 
partnership's adjusted basis of $100,000 will, therefore, be 
recovered over the five years remaining in the property's recovery 
period. PRS elects to use the remedial allocation method under 
Sec. 1.704-3(d) with respect to the property. If PRS had purchased 
the property at the time of the partnership's formation, the basis 
of the property would have been recovered over a 10-year period. The 
$400,000 of section 704(c) built-in gain will, therefore, be 
amortized under Sec. 1.704-3(d) over a 10-year period beginning at 
the time of the partnership's formation.
    (ii)(A) Except for the depreciation deductions, PRS's expenses 
equal its income in each year of the first two years commencing with 
the year the partnership is formed. After two years, A's share of 
the adjusted basis of partnership property is $120,000, while B's is 
$440,000:

----------------------------------------------------------------------------------------------------------------
                                                                         Capital accounts
                                                 ---------------------------------------------------------------
                                                         A                               B
                                                 ---------------------------------------------------------------
                                                       Book             Tax            Book             Tax
----------------------------------------------------------------------------------------------------------------
Initial Contribution............................        $500,000        $100,000        $500,000        $500,000
Depreciation Year 1.............................        (30,000)  ..............        (30,000)        (20,000)
Remedial........................................  ..............          10,000  ..............        (10,000)
                                                 ---------------------------------------------------------------
                                                         470,000         110,000         470,000         470,000
Depreciation Year 2.............................        (30,000)  ..............        (30,000)        (20,000)
Remedial........................................  ..............          10,000  ..............        (10,000)
                                                 ---------------------------------------------------------------
                                                         440,000         120,000         440,000         440,000
----------------------------------------------------------------------------------------------------------------

    (B) A sells its interest in PRS to T for its fair market value 
of $440,000. A valid election under section 754 is in effect with 
respect to the sale of the partnership interest. Accordingly, PRS 
makes an adjustment, pursuant to section 743(b), to increase the 
basis of partnership property. Under section 743(b), the amount of 
the basis adjustment is equal to $320,000. Under section 755, the 
entire basis adjustment is allocated to the property.
    (iii) At the time of the transfer, $320,000 of section 704(c) 
built-in gain from the property was still reflected on the 
partnership's books, and all of the basis adjustment is attributable 
to section 704(c) built-in gain. Therefore, the basis adjustment 
will be recovered over the remaining recovery period for the section 
704(c) built-in gain under Sec. 1.704-3(d).

    (ii) Decreases--(A) Reduced deduction. The amount of any negative 
basis adjustment allocated to an item of depreciable or amortizable 
property that is recovered in any year first decreases the transferee's 
distributive share of the partnership's depreciation or amortization 
deductions from that item of property for the year. If the amount of 
the basis adjustment recovered in any year exceeds the transferee's 
distributive share of the partnership's depreciation or amortization 
deductions from the item of property, then the transferee's 
distributive share of the partnership's depreciation or amortization 
deductions from other items of partnership property is decreased. The 
transferee then recognizes ordinary income to the extent of the excess, 
if any, of the amount of the basis adjustment recovered in any year 
over the transferee's distributive share of the partnership's 
depreciation or amortization deductions from all items of property.
    (B) Recovery period. For purposes of section 168, if the basis of 
an item of a partnership's recovery property is decreased as the result 
of the transfer of an interest in the partnership, then the decrease is 
recovered over the remaining useful life of the item of the 
partnership's recovery property. The portion of the decrease that is 
recovered in any year during the recovery period is equal to the 
product of--
    (1) The amount of the decrease to the item's adjusted basis 
(determined as of the date of the transfer); multiplied by
    (2) A fraction, the numerator of which is the portion of the 
adjusted basis of the item recovered by the partnership in that year, 
and the denominator of which is the adjusted basis of the item on the 
date of the transfer (determined prior to any basis adjustments).
    (C) Examples. The provisions of this paragraph (j)(4)(ii) are 
illustrated by the following examples:

    Example 1. (i) A, B, and C are equal partners in partnership 
PRS, which owns Asset 2, an item of depreciable property that has a 
fair market value that is less than its adjusted tax basis. C sells 
its interest in PRS to T while PRS has an election in effect under 
section 754. PRS, therefore, decreases the basis of Asset 2 with 
respect to T.
    (ii) Assume that in the year following the transfer of the 
partnership interest to T, T's distributive share of the 
partnership's common basis depreciation deductions from Asset 2 is 
$1,000. Also assume that, under paragraph (j)(4)(ii)(B) of this 
section, the amount of the basis adjustment under section 743(b) 
that T recovers during the year is $500. The total amount of 
depreciation

[[Page 69914]]

deductions from Asset 2 reported by T is equal to $500.
    Example 2. (i) A and B form equal partnership PRS. A contributes 
property with an adjusted basis of $100,000 and a fair market value 
of $50,000. B contributes $50,000 cash. When PRS is formed, the 
property has five years remaining in its recovery period. The 
partnership's adjusted basis of $100,000 will, therefore, be 
recovered over the five years remaining in the property's recovery 
period. PRS uses the traditional allocation method under Sec. 1.704-
3(b) with respect to the property. As a result, B will receive 
$5,000 of depreciation deductions from the property in each of years 
1-5, and A, as the contributing partner, will receive $15,000 of 
depreciation deductions in each of these years.
    (ii) Except for the depreciation deductions, PRS's expenses 
equal its income in each of the first two years commencing with the 
year the partnership is formed. After two years, A's share of the 
adjusted basis of partnership property is $70,000, while B's is 
$40,000. A sells its interest in PRS to T for its fair market value 
of $40,000. A valid election under section 754 is in effect with 
respect to the sale of the partnership interest. Accordingly, PRS 
makes an adjustment, pursuant to section 743(b), to decrease the 
basis of partnership property. Under section 743(b), the amount of 
the adjustment is equal to ($30,000). Under section 755, the entire 
adjustment is allocated to the property.
    (iii) The basis of the property at the time of the transfer of 
the partnership interest was $60,000. In each of years 3 through 5, 
the partnership will realize depreciation deductions of $20,000 from 
the property. Thus, one third of the negative basis adjustment 
($10,000) will be recovered in each of years 3 through 5. 
Consequently, T will be allocated, for tax purposes, depreciation of 
$15,000 each year from the partnership and will recover $10,000 of 
its negative basis adjustment. Thus, T's net depreciation deduction 
from the partnership in each year is $5,000.
    Example 3. (i) A, B, and C are equal partners in partnership 
PRS, which owns Asset 2, an item of depreciable property that has a 
fair market value that is less than its adjusted tax basis. C sells 
its interest in PRS to T while PRS has an election in effect under 
section 754. PRS, therefore, decreases the basis of Asset 2 with 
respect to T.
    (ii) Assume that in the year following the transfer of the 
partnership interest to T, T's distributive share of the 
partnership's common basis depreciation deductions from Asset 2 is 
$500. PRS allocates no other depreciation to T. Also assume that, 
under paragraph (j)(4)(ii)(B) of this section, the amount of the 
negative basis adjustment that T recovers during the year is $1,000. 
T will report $500 of ordinary income because the amount of the 
negative basis adjustment recovered during the year exceeds T's 
distributive share of the partnership's common basis depreciation 
deductions from Asset 2.

    (5) Depletion. Where an adjustment is made under section 743(b) to 
the basis of partnership property subject to depletion, any depletion 
allowance is determined separately for each partner, including the 
transferee partner, based on the partner's interest in such property. 
See Sec. 1.702-1(a)(8). For partnerships that hold oil and gas 
properties that are depleted at the partner level under section 
613A(c)(7)(D), the transferee partner (and not the partnership) must 
make the basis adjustments, if any, required under section 743(b) with 
respect to such properties. See Sec. 1.613A-3(e)(6)(iv).
    (6) Example. The provisions of paragraph (j)(5) of this section are 
illustrated by the following example:

    Example. A, B, and C each contributes $5,000 cash to form 
partnership PRS, which purchases a coal property for $15,000. A, B, 
and C have equal interests in capital and profits. C subsequently 
sells its partnership interest to T for $100,000 when the election 
under section 754 is in effect. T has a basis adjustment under 
section 743(b) for the coal property of $95,000 (the difference 
between T's basis, $100,000, and its share of the basis of 
partnership property, $5,000). Assume that the depletion allowance 
computed under the percentage method would be $21,000 for the 
taxable year so that each partner would be entitled to $7,000 as its 
share of the deduction for depletion. However, under the cost 
depletion method, at an assumed rate of 10 percent, the allowance 
with respect to T's one-third interest which has a basis to him of 
$100,000 ($5,000, plus its basis adjustment of $95,000) is $10,000, 
although the cost depletion allowance with respect to the one-third 
interest of A and B in the coal property, each of which has a basis 
of $5,000, is only $500. For partners A and B, the percentage 
depletion is greater than cost depletion and each will deduct $7,000 
based on the percentage depletion method. However, as to T, the 
transferee partner, the cost depletion method results in a greater 
allowance and T will, therefore, deduct $10,000 based on cost 
depletion. See section 613(a).

    (k) Returns--(1) Statement of adjustments--(i) In general. A 
partnership that must adjust the bases of partnership properties under 
section 743(b) must attach a statement to the partnership return for 
the year of the transfer setting forth the name and taxpayer 
identification number of the transferee as well as the computation of 
the adjustment and the partnership properties to which the adjustment 
has been allocated.
    (ii) Special rule. Where an interest is transferred in a 
partnership which holds oil and gas properties that are depleted at the 
partner level under section 613A(c)(7)(D), the transferee must attach a 
statement to the transferee's return for the year of the transfer, 
setting forth the computation of the basis adjustment under section 
743(b) which is allocable to such properties and the specific 
properties to which the adjustment has been allocated.
    (iii) Example. The provisions of paragraph (k)(1)(ii) of this 
section are illustrated by the following example:

    Example. (i) Partnership XYZ owns a single section 613A(c)(7)(D) 
domestic oil and gas property (Property) and other non-depletable 
assets. A, a partner in XYZ with an adjusted tax basis in Property 
of $100 (excluding any prior adjustments under section 743(b)), 
sells its partnership interest to B for $800 cash. Under 
Sec. 1.613A-3(e)(6)(iv), A's adjusted basis of $100 in Property 
carries over to B.
    (ii) Under section 755, XYZ determines that Property accounts 
for 50% of the fair market value of all partnership assets. The 
remaining 50% of B's purchase price ($400) is attributable to non-
depletable property. XYZ must provide a statement to B containing 
the portion of B's adjusted basis attributable to non-depletable 
property ($400). Under this paragraph (k)(1), XYZ must report basis 
adjustments under section 743(b) to non-depletable property. B must 
report basis adjustments under section 743(b) to Property.

    (2) Requirement that transferee notify partnership--(i) Sale or 
exchange. A transferee that acquires, by sale or exchange, an interest 
in a partnership with an election under section 754 in effect for the 
taxable year of the transfer, must notify the partnership, in writing, 
within 30 days of the sale or exchange. The written notice to the 
partnership must be signed under penalties of perjury and must include 
the names and addresses of the transferee and (if ascertainable) of the 
transferor, the taxpayer identification numbers of the transferee and 
(if ascertainable) of the transferor, the relationship (if any) between 
the transferee and the transferor, the date of the transfer, the amount 
of any liabilities assumed or taken subject to by the transferee, and 
the amount of any money, the fair market value of any other property 
delivered or to be delivered for the transferred interest in the 
partnership, and any other information necessary for the partnership to 
compute the transferee's basis.
    (ii) Transfer on death. A transferee that acquires, on the death of 
a partner, an interest in a partnership with an election under section 
754 in effect for the taxable year of the transfer, must notify the 
partnership, in writing, within one year of the death of the deceased 
partner. The written notice to the partnership must be signed under 
penalties of perjury and must include the names and addresses of the 
deceased partner and the transferee, the taxpayer identification 
numbers of the deceased partner and the transferee, the relationship 
(if any) between the

[[Page 69915]]

transferee and the transferor, the deceased partner's date of death, 
the date on which the transferee became the owner of the partnership 
interest, the fair market value of the partnership interest on the 
applicable date of valuation set forth in section 1014, and the manner 
in which the fair market value of the partnership interest was 
determined.
    (iii) Nominee reporting. If a partnership interest is transferred 
to a nominee which is required to furnish the statement under section 
6031(c)(1) to the partnership, the nominee may satisfy the notice 
requirement contained in this paragraph (k)(2) by providing the 
statement required under Sec. 1.6031(c)-1T, provided that the statement 
satisfies all requirements of Sec. 1.6031(c)-1T and this paragraph 
(k)(2).
    (3) Reliance. In making the adjustments under section 743(b) and 
any statement or return relating to such adjustments under this 
section, a partnership may rely on the written notice provided by a 
transferee pursuant to paragraph (k)(2) of this section to determine 
the transferee's basis in a partnership interest. The previous sentence 
shall not apply if any partner who has responsibility for federal 
income tax reporting by the partnership has knowledge of facts 
indicating that the statement is clearly erroneous.
    (4) Partnership not required to make or report adjustments under 
section 743(b) until it has notice of the transfer. A partnership is 
not required to make the adjustments under section 743(b) (or any 
statement or return relating to those adjustments) with respect to any 
transfer until it has been notified of the transfer. For purposes of 
this section, a partnership is notified of a transfer when either--
    (i) The partnership receives the written notice from the transferee 
required under paragraph (k)(2) of this section; or
    (ii) Any partner who has responsibility for federal income tax 
reporting by the partnership has knowledge that there has been a 
transfer of a partnership interest.
    (5) Effect on partnership of the failure of the transferee to 
comply. If the transferee fails to provide the partnership with the 
written notice required by paragraph (k)(2) of this section, the 
partnership must attach a statement to its return in the year that the 
partnership is otherwise notified of the transfer. This statement must 
set forth the name and taxpayer identification number (if 
ascertainable) of the transferee. In addition, the following statement 
must be prominently displayed in capital letters on the first page of 
the partnership's return for such year, and on the first page of any 
schedule or information statement relating to such transferee's share 
of income, credits, deductions, etc.: ``RETURN FILED PURSUANT TO 
Sec. 1.743-1(k)(5).'' The partnership will then be entitled to report 
the transferee's share of partnership items without adjustment to 
reflect the transferee's basis adjustment in partnership property. If, 
following the filing of a return pursuant to this paragraph (k)(5), the 
transferee provides the applicable written notice to the partnership, 
the partnership must make such adjustments as are necessary to adjust 
the basis of partnership property (as of the date of the transfer) in 
any amended return otherwise to be filed by the partnership or in the 
next annual partnership return of income to be regularly filed by the 
partnership. At such time, the partnership must also provide the 
transferee with such information as is necessary for the transferee to 
amend its prior returns to properly reflect the adjustment under 
section 743(b).
    (l) Effective date. This section applies to transfers of 
partnership interests that occur on or after December 15, 1999.
    Par. 6. Section 1.751-1 is amended by:
    1. Revising paragraphs (a)(2) and (a)(3).
    2. Revising paragraph (c)(3).
    3. Removing paragraph (c)(4)(x).
    4. Adding a sentence at the end of paragraph (f).
    5. Revising Example 1 of paragraph (g).
    The addition and revisions read as follows:


Sec. 1.751-1  Unrealized receivables and inventory items.

* * * * *
    (a) * * *
    (2) Determination of gain or loss. The income or loss realized by a 
partner upon the sale or exchange of its interest in section 751 
property is the amount of income or loss from section 751 property 
(including any remedial allocations under Sec. 1.704-3(d)) that would 
have been allocated to the partner (to the extent attributable to the 
partnership interest sold or exchanged) if the partnership had sold all 
of its property in a fully taxable transaction for cash in an amount 
equal to the fair market value of such property (taking into account 
section 7701(g)) immediately prior to the partner's transfer of the 
interest in the partnership. Any gain or loss recognized that is 
attributable to section 751 property will be ordinary gain or loss. The 
difference between the amount of capital gain or loss that the partner 
would realize in the absence of section 751 and the amount of ordinary 
income or loss determined under this paragraph (a)(2) is the 
transferor's capital gain or loss on the sale of its partnership 
interest.
    (3) Statement required. A partner selling or exchanging any part of 
an interest in a partnership that has any section 751 property at the 
time of sale or exchange must submit with its income tax return for the 
taxable year in which the sale or exchange occurs a statement setting 
forth separately the following information--
    (i) The date of the sale or exchange;
    (ii) The amount of any gain or loss attributable to the section 751 
property; and
    (iii) The amount of any gain or loss attributable to capital gain 
or loss on the sale of the partnership interest.
* * * * *
    (c) Unrealized receivables. * * *
    (3) In determining the amount of the sale price attributable to 
such unrealized receivables, or their value in a distribution treated 
as a sale or exchange, full account shall be taken not only of the 
estimated cost of completing performance of the contract or agreement, 
but also of the time between the sale or distribution and the time of 
payment.
* * * * *
    (f) * * * The rules contained in paragraphs (a)(2) and (a)(3) of 
this section apply to transfers of partnership interests that occur on 
or after December 15, 1999.
    (g) * * *

    Example 1. (i)(A) A and B are equal partners in personal service 
partnership PRS. B transfers its interest in PRS to T for $15,000 
when PRS's balance sheet (reflecting a cash receipts and 
disbursements method of accounting) is as follows:

[[Page 69916]]



------------------------------------------------------------------------
                                                      Assets
                                         -------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
Cash....................................          $3,000          $3,000
Loans Receivable........................          10,000          10,000
Capital Assets..........................           7,000           5,000
Unrealized Receivables..................               0          14,000
                                         -------------------------------
    Total...............................          20,000          32,000
------------------------------------------------------------------------


------------------------------------------------------------------------
                                              Liabilities and Capital
                                         -------------------------------
                                           Adjusted per     Fair market
                                               books           value
------------------------------------------------------------------------
Liabilities.............................          $2,000          $2,000
Capital:
    A...................................           9,000          15,000
    B...................................           9,000          15,000
                                         -------------------------------
        Total...........................          20,000          32,000
------------------------------------------------------------------------

    (B) None of the assets owned by PRS is section 704(c) property, 
and the capital assets are nondepreciable. The total amount realized 
by B is $16,000, consisting of the cash received, $15,000, plus 
$1,000, B's share of the partnership liabilities assumed by T. See 
section 752. B's undivided half-interest in the partnership property 
includes a half-interest in the partnership's unrealized receivables 
items. B's basis for its partnership interest is $10,000 ($9,000, 
plus $1,000, B's share of partnership liabilities). If section 
751(a) did not apply to the sale, B would recognize $6,000 of 
capital gain from the sale of the interest in PRS. However, section 
751(a) does apply to the sale.
    (ii) If PRS sold all of its section 751 property in a fully 
taxable transaction immediately prior to the transfer of B's 
partnership interest to T, B would have been allocated $7,000 of 
ordinary income from the sale of PRS's unrealized receivables. 
Therefore, B will recognize $7,000 of ordinary income with respect 
to the unrealized receivables. The difference between the amount of 
capital gain or loss that the partner would realize in the absence 
of section 751 ($6,000) and the amount of ordinary income or loss 
determined under paragraph (a)(2) of this section ($7,000) is the 
transferor's capital gain or loss on the sale of its partnership 
interest. In this case, B will recognize a $1,000 capital loss.
* * * * *
    Par. 7. Section 1.754-1 is amended as follows:
    1. Designate the text following the heading of paragraph (c) as 
paragraph (c)(1).
    2. Add a heading to newly designated paragraph (c)(1).
    3. Add paragraph (c)(2).
    The additions read as follows:


Sec. 1.754-1  Time and manner of making election to adjust basis of 
partnership property.

* * * * *
    (c) Revocation of election--(1) In general. * * *
    (2) Revocations made for first taxable year ending after December 
15, 1999. Notwithstanding paragraph (c)(1) of this section, any 
partnership having an election in effect under this section for its 
taxable year that includes December 15, 1999 may revoke such election 
by attaching a statement to the partnership's return for such year. For 
the revocation to be valid, the statement must be filed not later than 
the time prescribed by Sec. 1.6031(a)-1(e) (including extensions 
thereof) for filing the return for such taxable year, and must set 
forth the name and address of the partnership revoking the election, be 
signed by any one of the partners who is authorized to sign the 
partnership's federal income tax return, and contain a declaration that 
the partnership revokes its election under section 754 to apply the 
provisions of section 734(b) and 743(b). In addition, the following 
statement must be prominently displayed in capital letters on the first 
page of the partnership's return for such year: ``RETURN FILED PURSUANT 
TO 1.754-1(c)(2).''
    Par. 8. Section 1.755-1 is revised to read as follows:


Sec. 1.755-1  Rules for allocation of basis.

    (a) Generally. A partnership that has an election in effect under 
section 754 must adjust the basis of partnership property under the 
provisions of section 734(b) and section 743(b) pursuant to the 
provisions of this section. The basis adjustment is first allocated 
between the two classes of property described in section 755(b). These 
classes of property consist of capital assets and section 1231(b) 
property (capital gain property), and any other property of the 
partnership (ordinary income property). For purposes of this section, 
properties and potential gain treated as unrealized receivables under 
section 751(c) and the regulations thereunder shall be treated as 
separate assets that are ordinary income property. The portion of the 
basis adjustment allocated to each class is then allocated among the 
items within the class. Adjustments under section 743(b) are allocated 
under paragraph (b) of this section. Adjustments under section 734(b) 
are allocated under paragraph (c) of this section.
    (b) Adjustments under section 743(b)--(1) Generally. (i) For 
exchanges in which the transferee's basis in the interest is determined 
in whole or in part by reference to the transferor's basis in the 
interest, paragraph (b)(5) of this section shall apply. For all other 
transfers which result in a basis adjustment under section 743(b), 
paragraphs (b)(2) through (b)(4) of this section shall apply. Except as 
provided in paragraph (b)(5) of this section, the portion of the basis 
adjustment allocated to one class of property may be an increase while 
the portion allocated to the other class is a decrease. This would be 
the case even though the total amount of the basis adjustment is zero. 
Except as provided in paragraph (b)(5) of this section, the portion of 
the basis adjustment allocated to one item of property within a class 
may be an increase while the portion allocated to another is a 
decrease. This would be the case even though the basis adjustment 
allocated to the class is zero.
    (ii) Hypothetical transaction. For purposes of paragraphs (b)(2) 
through (b)(4) of this section, the allocation of

[[Page 69917]]

the basis adjustment under section 743(b) between the classes of 
property and among the items of property within each class are made 
based on the allocations of income, gain, or loss (including remedial 
allocations under Sec. 1.704-3(d)) that the transferee partner would 
receive (to the extent attributable to the acquired partnership 
interest) if, immediately after the transfer of the partnership 
interest, all of the partnership's property were disposed of in a fully 
taxable transaction for cash in an amount equal to the fair market 
value of such property (the hypothetical transaction).
    (2) Allocations between classes of property--(i) In general. The 
amount of the basis adjustment allocated to the class of ordinary 
income property is equal to the total amount of income, gain, or loss 
(including any remedial allocations under Sec. 1.704-3(d)) that would 
be allocated to the transferee (to the extent attributable to the 
acquired partnership interest) from the sale of all ordinary income 
property in the hypothetical transaction. The amount of the basis 
adjustment to capital gain property is equal to--
    (A) The total amount of the basis adjustment under section 743(b); 
less
    (B) The amount of the basis adjustment allocated to ordinary income 
property under the preceding sentence; provided, however, that in no 
event may the amount of any decrease in basis allocated to capital gain 
property exceed the partnership's basis (or in the case of property 
subject to the remedial allocation method, the transferee's share of 
any remedial loss under Sec. 1.704-3(d) from the hypothetical 
transaction) in capital gain property. In the event that a decrease in 
basis allocated to capital gain property would otherwise exceed the 
partnership's basis in capital gain property, the excess must be 
applied to reduce the basis of ordinary income property.
    (ii) Examples. The provisions of this paragraph (b)(2) are 
illustrated by the following examples:

    Example 1. (i) A and B form equal partnership PRS. A contributes 
$50,000 and Asset 1, a nondepreciable capital asset with a fair 
market value of $50,000 and an adjusted tax basis of $25,000. B 
contributes $100,000. PRS uses the cash to purchase Assets 2, 3, and 
4. After a year, A sells its interest in PRS to T for $120,000. At 
the time of the transfer, A's share of the partnership's basis in 
partnership assets is $75,000. Therefore, T receives a $45,000 basis 
adjustment.
    (ii) Immediately after the transfer of the partnership interest 
to T, the adjusted basis and fair market value of PRS's assets are 
as follows:

------------------------------------------------------------------------
                                                      Assets
                                         -------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
Capital Gain Property:
    Asset 1.............................         $25,000         $75,000
    Asset 2.............................         100,000         117,500
Ordinary Income Property:
    Asset 3.............................          40,000          45,000
    Asset 4.............................          10,000           2,500
                                         -------------------------------
        Total...........................         175,000         240,000
------------------------------------------------------------------------

    (iii) If PRS sold all of its assets in a fully taxable 
transaction at fair market value immediately after the transfer of 
the partnership interest to T, the total amount of capital gain that 
would be allocated to T is equal to $46,250 ($25,000 section 704(c) 
built-in gain from Asset 1, plus fifty percent of the $42,500 
appreciation in capital gain property). T would also be allocated a 
$1,250 ordinary loss from the sale of the ordinary income property.
    (iv) The amount of the basis adjustment that is allocated to 
ordinary income property is equal to ($1,250) (the amount of the 
loss allocated to T from the hypothetical sale of the ordinary 
income property).
    (v) The amount of the basis adjustment that is allocated to 
capital gain property is equal to $46,250 (the amount of the basis 
adjustment, $45,000, less ($1,250), the amount of loss allocated to 
T from the hypothetical sale of the ordinary income property).
    Example 2. (i) A and B form equal partnership PRS. A and B each 
contribute $1,000 cash which the partnership uses to purchase Assets 
1, 2, 3, and 4. After a year, A sells its partnership interest to T 
for $1,000. T's basis adjustment under section 743(b) is zero.
    (ii) Immediately after the transfer of the partnership interest 
to T, the adjusted basis and fair market value of PRS's assets are 
as follows:

------------------------------------------------------------------------
                                                      Assets
                                         -------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
Capital Gain Property:
    Asset 1.............................            $500            $750
    Asset 2.............................             500             500
Ordinary Income Property:
    Asset 3.............................             500             250
    Asset 4.............................             500             500
                                         -------------------------------
        Total...........................           2,000           2,000
------------------------------------------------------------------------

    (iii) If, immediately after the transfer of the partnership 
interest to T, PRS sold all of its assets in a fully taxable 
transaction at fair market value, T would be allocated a loss of 
$125 from the sale of the ordinary income property. Thus, the amount 
of the basis adjustment to ordinary income property is ($125). The 
amount of the basis adjustment to capital gain property is $125 
(zero, the amount of the basis adjustment under section 743(b), less 
($125), amount of the basis adjustment allocated to ordinary income 
property).

    (3) Allocation within the class--(i) Ordinary income property. The 
amount of the basis adjustment to each item of property within the 
class of ordinary income property is equal to--

[[Page 69918]]

    (A) The amount of income, gain, or loss (including any remedial 
allocations under Sec. 1.704-3(d)) that would be allocated to the 
transferee (to the extent attributable to the acquired partnership 
interest) from the hypothetical sale of the item; reduced by
    (B) The product of--
    (1) Any decrease to the amount of the basis adjustment to ordinary 
income property required pursuant to the last sentence of paragraph 
(b)(2)(i) of this section; multiplied by
    (2) A fraction, the numerator of which is the fair market value of 
the item of property to the partnership and the denominator of which is 
the total fair market value of all of the partnership's items of 
ordinary income property.
    (ii) Capital gain property. The amount of the basis adjustment to 
each item of property within the class of capital gain property is 
equal to--
    (A) The amount of income, gain, or loss (including any remedial 
allocations under Sec. 1.704-3(d)) that would be allocated to the 
transferee (to the extent attributable to the acquired partnership 
interest) from the hypothetical sale of the item; minus
    (B) The product of--
    (1) The total amount of gain or loss (including any remedial 
allocations under Sec. 1.704-3(d)) that would be allocated to the 
transferee (to the extent attributable to the acquired partnership 
interest) from the hypothetical sale of all items of capital gain 
property, minus the amount of the positive basis adjustment to all 
items of capital gain property or plus the amount of the negative basis 
adjustment to capital gain property; multiplied by
    (2) A fraction, the numerator of which is the fair market value of 
the item of property to the partnership, and the denominator of which 
is the fair market value of all of the partnership's items of capital 
gain property.
    (iii) Examples. The provisions of this paragraph (b)(3) are 
illustrated by the following examples:

    Example 1. (i) Assume the same facts as Example 1 in paragraph 
(b)(2)(ii) of this section. Of the $45,000 basis adjustment, $46,250 
was allocated to capital gain property. The amount allocated to 
ordinary income property was ($1,250).
    (ii) Asset 1 is a capital gain asset, and T would be allocated 
$37,500 from the sale of Asset 1 in the hypothetical transaction. 
Therefore, the amount of the adjustment to Asset 1 is $37,500.
    (iii) Asset 2 is a capital gain asset, and T would be allocated 
$8,750 from the sale of Asset 2 in the hypothetical transaction. 
Therefore, the amount of the adjustment to Asset 2 is $8,750.
    (iv) Asset 3 is ordinary income property, and T would be 
allocated $2,500 from the sale of Asset 3 in the hypothetical 
transaction. Therefore, the amount of the adjustment to Asset 3 is 
$2,500.
    (v) Asset 4 is ordinary income property, and T would be 
allocated ($3,750) from the sale of Asset 4 in the hypothetical 
transaction. Therefore, the amount of the adjustment to Asset 4 is 
($3,750).
    Example 2. (i) Assume the same facts as Example 1 in paragraph 
(b)(2)(ii) of this section, except that A sold its interest in PRS 
to T for $110,000 rather than $120,000. T, therefore, receives a 
basis adjustment under section 743(b) of $35,000. Of the $35,000 
basis adjustment, ($1,250) is allocated to ordinary income property, 
and $36,250 is allocated to capital gain property.
    (ii) Asset 3 is ordinary income property, and T would be 
allocated $2,500 from the sale of Asset 3 in the hypothetical 
transaction. Therefore, the amount of the adjustment to Asset 3 is 
$2,500.
    (iii) Asset 4 is ordinary income property, and T would be 
allocated ($3,750) from the sale of Asset 4 in the hypothetical 
transaction. Therefore, the amount of the adjustment to Asset 4 is 
($3,750).
    (iv) Asset 1 is a capital gain asset, and T would be allocated 
$37,500 from the sale of Asset 1 in the hypothetical transaction. 
Asset 2 is a capital gain asset, and T would be allocated $8,750 
from the sale of Asset 2 in the hypothetical transaction. The total 
amount of gain that would be allocated to T from the sale of the 
capital gain assets in the hypothetical transaction is $46,250, 
which exceeds the amount of the basis adjustment allocated to 
capital gain property by $10,000. The amount of the adjustment to 
Asset 1 is $33,604 ($37,500 minus $3,896 ($10,000  x  $75,000/
192,500)). The amount of the basis adjustment to Asset 2 is $2,646 
($8,750 minus $6,104 ($10,000  x  $117,500/192,500)).

    (4) Income in respect of a decedent--(i) In general. Where a 
partnership interest is transferred as a result of the death of a 
partner, under section 1014(c) the transferee's basis in its 
partnership interest is not adjusted for that portion of the interest, 
if any, which is attributable to items representing income in respect 
of a decedent under section 691. See Sec. 1.742-1. Accordingly, if a 
partnership interest is transferred as a result of the death of a 
partner, and the partnership holds assets representing income in 
respect of a decedent, no part of the basis adjustment under section 
743(b) is allocated to these assets. See Sec. 1.743-1(b).
    (ii) The provisions of this paragraph (b)(4) are illustrated by the 
following example:

    Example. (i) A and B are equal partners in personal service 
partnership PRS. As a result of B's death, B's partnership interest 
is transferred to T when PRS's balance sheet (reflecting a cash 
receipts and disbursements method of accounting) is as follows:

------------------------------------------------------------------------
                                                      Assets
                                         -------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
Capital Asset...........................          $2,000          $5,000
Unrealized Receivables..................               0          15,000
                                         -------------------------------
    Total...............................           2,000          20,000
------------------------------------------------------------------------


------------------------------------------------------------------------
                                              Liabilities and Capital
                                         -------------------------------
                                           Adjusted per     Fair market
                                               books           value
------------------------------------------------------------------------
Capital:
    A...................................           1,000          10,000
    B...................................           1,000          10,000
                                         -------------------------------
        Total...........................           2,000          20,000
------------------------------------------------------------------------

    (ii) None of the assets owned by PRS is section 704(c) property, 
and the capital asset is nondepreciable. The fair market value of 
T's partnership interest on the applicable date of valuation set 
forth in section 1014 is $10,000. Of this amount, $2,500 is

[[Page 69919]]

attributable to T's share of the partnership's capital asset, and 
$7,500 is attributable to T's 50% share of the partnership's 
unrealized receivables. The partnership's unrealized receivables 
represent income in respect of a decedent. Accordingly, under 
section 1014(c), T's basis in its partnership interest is not 
adjusted for that portion of the interest which is attributable to 
the unrealized receivables. Therefore, T's basis in its partnership 
interest is $2,500.
    (iii) At the time of the transfer, B's share of the 
partnership's basis in partnership assets is $1,000. Accordingly, T 
receives a $1,500 basis adjustment under section 743(b). Under this 
paragraph (b)(4), the entire basis adjustment is allocated to the 
partnership's capital asset.

    (5) Transferred basis exchanges--(i) In general. This paragraph 
(b)(5) applies to basis adjustments under section 743(b) which result 
from exchanges in which the transferee's basis in the interest is 
determined in whole or in part by reference to the transferor's basis 
in the interest. For example, this paragraph applies if a partnership 
interest is contributed to a corporation in a transaction to which 
section 351 applies or to a partnership in a transaction to which 
section 721(a) applies.
    (ii) Allocations between classes of property. If the total amount 
of the basis adjustment under section 743(b) is zero, then no 
adjustment to the basis of partnership property will be made under this 
paragraph (b)(5). If there is an increase in basis to be allocated to 
partnership assets, such increase must be allocated to capital gain 
property or ordinary income property, respectively, only if the total 
amount of gain or loss (including any remedial allocations under 
Sec. 1.704-3(d)) that would be allocated to the transferee (to the 
extent attributable to the acquired partnership interest) from the 
hypothetical sale of all such property would result in a net gain or 
net income, as the case may be, to the transferee. Where, under the 
preceding sentence, an increase in basis may be allocated to both 
capital gain assets and ordinary income assets, the increase shall be 
allocated to each class in proportion to the net gain or net income, 
respectively, which would be allocated to the transferee from the sale 
of all assets in each class. If there is a decrease in basis to be 
allocated to partnership assets, such decrease must be allocated to 
capital gain property or ordinary income property, respectively, only 
if the total amount of gain or loss (including any remedial allocations 
under Sec. 1.704-3(d)) that would be allocated to the transferee (to 
the extent attributable to the acquired partnership interest) from the 
hypothetical sale of all such property would result in a net loss to 
the transferee. Where, under the preceding sentence, a decrease in 
basis may be allocated to both capital gain assets and ordinary income 
assets, the decrease shall be allocated to each class in proportion to 
the net loss which would be allocated to the transferee from the sale 
of all assets in each class.
    (iii) Allocations within the classes--(A) Increases. If there is an 
increase in basis to be allocated within a class, the increase must be 
allocated first to properties with unrealized appreciation in 
proportion to the transferee's share of the respective amounts of 
unrealized appreciation before such increase (but only to the extent of 
the transferee's share of each property's unrealized appreciation). Any 
remaining increase must be allocated among the properties within the 
class in proportion to the transferee's share of the amount that would 
be realized by the partnership upon the hypothetical sale of each asset 
in the class.
    (B) Decreases. If there is a decrease in basis to be allocated 
within a class, the decrease must be allocated first to properties with 
unrealized depreciation in proportion to the transferee's shares of the 
respective amounts of unrealized depreciation before such decrease (but 
only to the extent of the transferee's share of each property's 
unrealized depreciation). Any remaining decrease must be allocated 
among the properties within the class in proportion to the transferee's 
shares of their adjusted bases (as adjusted under the preceding 
sentence).
    (C) Limitation in decrease of basis. Where, as the result of a 
transaction to which this paragraph (b)(5) applies, a decrease in basis 
must be allocated to capital gain assets, ordinary income assets, or 
both, and the amount of the decrease otherwise allocable to a 
particular class exceeds the transferee's share of the adjusted basis 
to the partnership of all depreciated assets in that class, the 
transferee's negative basis adjustment is limited to the transferee's 
share of the partnership's adjusted basis in all depreciated assets in 
that class.
    (D) Carryover adjustment. Where a transferee's negative basis 
adjustment under section 743(b) cannot be allocated to any asset, 
because the adjustment exceeds the transferee's share of the adjusted 
basis to the partnership of all depreciated assets in a particular 
class, the adjustment is made when the partnership subsequently 
acquires property of a like character to which an adjustment can be 
made.
    (iv) Examples. The provisions of this paragraph (b)(5) are 
illustrated by the following examples:

    Example 1. A is a member of partnership LTP, which has made an 
election under section 754. The three partners in LTP have equal 
interests in capital and profits. Solely in exchange for a 
partnership interest in UTP, A contributes its interest in LTP to 
UTP in a transaction described in section 721. At the time of the 
transfer, A's basis in its partnership interest ($5,000) equals its 
share of inside basis (also $5,000). Under section 723, UTP's basis 
in its interest in LTP is $5,000. LTP's only two assets on the date 
of contribution are inventory with a basis of $5,000 and a fair 
market value of $7,500, and a nondepreciable capital asset with a 
basis of $10,000 and a fair market value of $7,500. The amount of 
the basis adjustment under section 743(b) to partnership property is 
$0 ($5,000, UTP's basis in its interest in LTP, minus $5,000, UTP's 
share of LTP's basis in partnership assets). Because UTP acquired 
its interest in LTP in a transferred basis exchange, and the total 
amount of the basis adjustment under section 743(b) is zero, UTP 
receives no special basis adjustments under section 743(b) with 
respect to the partnership property of LTP.
    Example 2. (i) A purchases a partnership interest in LTP at a 
time when an election under section 754 is not in effect. The three 
partners in LTP have equal interests in capital and profits. During 
a later year for which LTP has an election under section 754 in 
effect, and in a transaction that is unrelated to A's purchase of 
the LTP interest, A contributes its interest in LTP to UTP in a 
transaction described in section 721 (solely in exchange for a 
partnership interest in UTP). At the time of the transfer, A's 
adjusted basis in its interest in LTP is $20,433. Under section 721, 
A recognizes no gain or loss as a result of the contribution of its 
partnership interest to UTP. Under section 723, UTP's basis in its 
partnership interest in LTP is $20,433. The balance sheet of LTP on 
the date of the contribution shows the following:

------------------------------------------------------------------------
                                                      Assets
                                         -------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
Cash....................................          $5,000          $5,000
Accounts receivable.....................          10,000          10,000
Inventory...............................          20,000          21,000

[[Page 69920]]

 
Nondepreciable capital asset............          20,000          40,000
                                         -------------------------------
    Total...............................          55,000          76,000
------------------------------------------------------------------------


------------------------------------------------------------------------
                                              Liabilities and Capital
                                         -------------------------------
                                           Adjusted per     Fair market
                                               books           value
------------------------------------------------------------------------
Liabilities.............................         $10,000         $10,000
Capital:
    A...................................          15,000          22,000
    B...................................          15,000          22,000
    C...................................          15,000          22,000
                                         -------------------------------
        Total...........................          55,000          76,000
------------------------------------------------------------------------

    (ii) The amount of the basis adjustment under section 743(b) is 
the difference between the basis of UTP's interest in LTP and UTP's 
share of the adjusted basis to LTP of partnership property. UTP's 
interest in the previously taxed capital of LTP is $15,000 ($22,000, 
the amount of cash UTP would receive if LTP liquidated immediately 
after the hypothetical transaction, decreased by $7,000, the amount 
of tax gain allocated to UTP from the hypothetical transaction). 
UTP's share of the adjusted basis to LTP of partnership property is 
$18,333 ($15,000 share of previously taxed capital, plus $3,333 
share of LTP's liabilities). The amount of the basis adjustment 
under section 743(b) to partnership property therefore, is $2,100 
($20,433 minus $18,333).
    (iii) The total amount of gain that would be allocated to UTP 
from the hypothetical sale of capital gain property is $6,666.67 
(one-third of the excess of the fair market value of LTP's 
nondepreciable capital asset, $40,000, over its basis, $20,000). The 
total amount of gain that would be allocated to UTP from the 
hypothetical sale of ordinary income property is $333.33 (one-third 
of the excess of the fair market value of LTP's inventory, $21,000, 
over its basis, $20,000). Under paragraph (b)(5), LTP must allocate 
$2,000 ($6,666.67 divided by $7,000 times $2,100) of UTP's basis 
adjustment to the nondepreciable capital asset. LTP must allocate 
$100 ($333.33 divided by $7,000 times $2,100) of UTP's basis 
adjustment to the inventory.

    (c) Adjustments under section 734(b)--(1) Allocations between 
classes of property--(i) General rule. Where there is a distribution of 
partnership property resulting in an adjustment to the basis of 
undistributed partnership property under section 734(b)(1)(B) or 
(b)(2)(B), the adjustment must be allocated to remaining partnership 
property of a character similar to that of the distributed property 
with respect to which the adjustment arose. Thus, when the 
partnership's adjusted basis of distributed capital gain property 
immediately prior to distribution exceeds the basis of the property to 
the distributee partner (as determined under section 732), the basis of 
the undistributed capital gain property remaining in the partnership is 
increased by an amount equal to the excess. Conversely, when the basis 
to the distributee partner (as determined under section 732) of 
distributed capital gain property exceeds the partnership's adjusted 
basis of such property immediately prior to the distribution, the basis 
of the undistributed capital gain property remaining in the partnership 
is decreased by an amount equal to such excess. Similarly, where there 
is a distribution of ordinary income property, and the basis of the 
property to the distributee partner (as determined under section 732) 
is not the same as the partnership's adjusted basis of the property 
immediately prior to distribution, the adjustment is made only to 
undistributed property of the same class remaining in the partnership.
    (ii) Special rule. Where there is a distribution resulting in an 
adjustment under section 734(b)(1)(A) or (b)(2)(A) to the basis of 
undistributed partnership property, the adjustment is allocated only to 
capital gain property.
    (2) Allocations within the classes--(i) Increases. If there is an 
increase in basis to be allocated within a class, the increase must be 
allocated first to properties with unrealized appreciation in 
proportion to their respective amounts of unrealized appreciation 
before such increase (but only to the extent of each property's 
unrealized appreciation). Any remaining increase must be allocated 
among the properties within the class in proportion to their fair 
market values.
    (ii) Decreases. If there is a decrease in basis to be allocated 
within a class, the decrease must be allocated first to properties with 
unrealized depreciation in proportion to their respective amounts of 
unrealized depreciation before such decrease (but only to the extent of 
each property's unrealized depreciation). Any remaining decrease must 
be allocated among the properties within the class in proportion to 
their adjusted bases (as adjusted under the preceding sentence).
    (3) Limitation in decrease of basis. Where a decrease in the basis 
of partnership assets is required under section 734(b)(2) and the 
amount of the decrease exceeds the adjusted basis to the partnership of 
property of the required character, the basis of such property is 
reduced to zero (but not below zero).
    (4) Carryover adjustment. Where, in the case of a distribution, an 
increase or a decrease in the basis of undistributed property cannot be 
made because the partnership owns no property of the character required 
to be adjusted, or because the basis of all the property of a like 
character has been reduced to zero, the adjustment is made when the 
partnership subsequently acquires property of a like character to which 
an adjustment can be made.
    (5) Example. The following example illustrates this paragraph (c):

    Example. (i) A, B, and C form equal partnership PRS. A 
contributes $50,000 and Asset 1, capital gain property with a fair 
market value of $50,000 and an adjusted tax basis of $25,000. B and 
C each contributes $100,000. PRS uses the cash to purchase Assets 2, 
3, 4, 5, and 6. Assets 4, 5, and 6 are the only assets held by the 
partnership which are subject to section 751. The partnership has an 
election in effect under section 754. After seven years, the 
adjusted basis and fair market value of PRS's assets are as follows:

[[Page 69921]]



------------------------------------------------------------------------
                                                      Assets
                                         -------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
Capital Gain Property:
    Asset 1.............................        $ 25,000        $ 75,000
    Asset 2.............................         100,000         117,500
    Asset 3.............................          50,000          60,000
Ordinary Income Property:
    Asset 4.............................        $ 40,000        $ 45,000
    Asset 5.............................          50,000          60,000
    Asset 6.............................          10,000           2,500
                                         -------------------------------
      Total.............................         275,000         360,000
------------------------------------------------------------------------

    (ii) Allocation between classes. Assume that PRS distributes 
Assets 3 and 5 to A in complete liquidation of A's interest in the 
partnership. A's basis in the partnership interest was $75,000. The 
partnership's basis in Assets 3 and 5 was $50,000 each. A's $75,000 
basis in its partnership interest is allocated between Assets 3 and 
5 under sections 732(b) and (c). A will, therefore, have a basis of 
$25,000 in Asset 3 (capital gain property), and a basis of $50,000 
in Asset 5 (section 751 property). The distribution results in a 
$25,000 increase in the basis of capital gain property. There is no 
change in the basis of ordinary income property.
    (iii) Allocation within class. The amount of the basis increase 
to capital gain property is $25,000 and must be allocated among the 
remaining capital gain assets in proportion to the difference 
between the fair market value and basis of each. The fair market 
value of Asset 1 exceeds its basis by $50,000. The fair market value 
of Asset 2 exceeds its basis by $17,500. Therefore, the basis of 
Asset 1 will be increased by $18,519 ($25,000, multiplied by 
$50,000, divided by $67,500), and the basis of Asset 2 will be 
increased by $6,481 ($25,000 multiplied by $17,500, divided by 
$67,500).

    (d) Effective date. This section applies to transfers of 
partnership interests and distributions of property from a partnership 
that occur on or after December 15, 1999.
    Par. 9. Section 1.1017-1 is amended by:
    1. Revising paragraph (g)(2)(iv).
    2. Adding paragraph (g)(2)(v).
    The addition and revision read as follows:


Sec. 1.1017-1  Basis reductions following a discharge of indebtedness.

* * * * *
    (g) * * *
    (2) * * *
    (iv) Partner's share of partnership basis--(A) In general. For 
purposes of this paragraph (g), a partner's proportionate share of the 
partnership's basis in depreciable property (or depreciable real 
property) is equal to the sum of--
    (1) The partner's section 743(b) basis adjustments to items of 
partnership depreciable property (or depreciable real property); and
    (2) The common basis depreciation deductions (but not including 
remedial allocations of depreciation deductions under Sec. 1.704-3(d)) 
that, under the terms of the partnership agreement effective for the 
taxable year in which the discharge of indebtedness occurs, are 
reasonably expected to be allocated to the partner over the property's 
remaining useful life. The assumptions made by a partnership in 
determining the reasonably expected allocation of depreciation 
deductions must be consistent for each partner. For example, a 
partnership may not treat the same depreciation deductions as being 
reasonably expected by more than one partner.
    (B) Effective date. This paragraph (g)(2)(iv) applies to elections 
made under sections 108(b)(5) and 108(c) on or after December 15, 1999.
    (v) Treatment of basis reduction--(A) Basis adjustment. The amount 
of the reduction to the basis of depreciable partnership property 
constitutes an adjustment to the basis of partnership property with 
respect to the partner only. No adjustment is made to the common basis 
of partnership property. Thus, for purposes of income, deduction, gain, 
loss, and distribution, the partner will have a special basis for those 
partnership properties the bases of which are adjusted under section 
1017 and this section.
    (B) Recovery of adjustments to basis of partnership property. 
Adjustments to the basis of partnership property under this section are 
recovered in the manner described in Sec. 1.743-1.
    (C) Effect of basis reduction. Adjustments to the basis of 
partnership property under this section are treated in the same manner 
and have the same effect as an adjustment to the basis of partnership 
property under section 743(b). The following example illustrates this 
paragraph (g)(2)(v):

    Example. (i) A, B, and C are equal partners in partnership PRS, 
which owns (among other things) Asset 1, an item of depreciable 
property with a basis of $30,000. A's basis in its partnership 
interest is $20,000. Under the terms of the partnership agreement, 
A's share of the depreciation deductions from Asset 1 over its 
remaining useful life will be $10,000. Under section 1017, A 
requests, and PRS agrees, to decrease the basis of Asset 1 with 
respect to A by $10,000.
    (ii) In the year following the reduction of basis under section 
1017, PRS amends its partnership agreement to provide that items of 
depreciation and loss from Asset 1 will be allocated equally between 
B and C. In that year, A's distributive share of the partnership's 
common basis depreciation deductions from Asset 1 is now $0. Under 
Sec. 1.743-1(j)(4)(ii)(B), the amount of the section 1017 basis 
adjustment that A recovers during the year is $1,000. A will report 
$1,000 of ordinary income because A's distributive share of the 
partnership's common basis depreciation deductions from Asset 1 ($0) 
is insufficient to offset the amount of the section 1017 basis 
adjustment recovered by A during the year ($1,000).
    (iii) In the following year, PRS sells Asset 1 for $15,000 and 
recognizes a $12,000 loss. This loss is allocated equally between B 
and C, and A's share of the loss is $0. Upon the sale of Asset 1, A 
recovers its entire remaining section 1017 basis adjustment 
($9,000). A will report $9,000 of ordinary income.

    (D) Effective date. This paragraph (g)(2)(v) applies to elections 
made under sections 108(b)(5) and 108(c) on or after December 15, 1999.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 10. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 11. In Sec. 602.101, paragraph (b) is amended by revising the 
entries for 1.732-1 and 1.743-1 in the table to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

[[Page 69922]]



------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
 
                  *        *        *        *        *
1.732-1....................................................    1545-0099
                                                               1545-1588
 
                  *        *        *        *        *
1.743-1....................................................    1545-0074
                                                               1545-1588
 
                  *        *        *        *        *
------------------------------------------------------------------------

David A. Mader,
Acting Deputy Commissioner of Internal Revenue.
    Approved November 29, 1999.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 99-32400 Filed 12-14-99; 8:45 am]
BILLING CODE 4830-01-U