[Federal Register Volume 79, Number 11 (Thursday, January 16, 2014)]
[Proposed Rules]
[Pages 3042-3069]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-00649]



[[Page 3041]]

Vol. 79

Thursday,

No. 11

January 16, 2014

Part III





Department of the Treasury





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Internal Revenue Service





26 CFR Part 1





Disallowance of Partnership Loss Transfers, Mandatory Basis 
Adjustments, Basis Reduction in Stock of a Corporate Partner, 
Modification of Basis Allocation Rules for Substituted Basis 
Transactions, Miscellaneous Provisions; Proposed Rule

  Federal Register / Vol. 79 , No. 11 / Thursday, January 16, 2014 / 
Proposed Rules  

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-144468-05]
RIN 1545-BE98


Disallowance of Partnership Loss Transfers, Mandatory Basis 
Adjustments, Basis Reduction in Stock of a Corporate Partner, 
Modification of Basis Allocation Rules for Substituted Basis 
Transactions, Miscellaneous Provisions

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: The proposed regulations provide guidance on certain 
provisions of the American Jobs Creation Act of 2004 and conform the 
regulations to statutory changes in the Taxpayer Relief Act of 1997. 
The proposed regulations also modify the basis allocation rules to 
prevent certain unintended consequences of the current basis allocation 
rules for substituted basis transactions. Finally, the proposed 
regulations provide additional guidance on allocations resulting from 
revaluations of partnership property. The proposed regulations affect 
partnerships and their partners. This document also contains a notice 
of a public hearing on these proposed regulations.

DATES: Comments must be received by April 16, 2014. Requests to speak 
and outlines of the topics to be discussed at the public hearing 
scheduled for April 30, 2014, at 10 a.m., must be received by April 16, 
2014.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-144468-05), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
144468-05), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC. Alternatively, taxpayers may submit 
comments electronically via the Federal eRulemaking Portal at 
www.regulations.gov (IRS REG-144468-05).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Wendy Kribell or Benjamin Weaver at (202) 317-6850; concerning 
submissions of comments, the hearing, and/or to be placed on the 
building access list to attend the hearing, Oluwafunmilayo (Funmi) 
Taylor, (202) 317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent 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, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by March 17, 2014. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collections of information in the proposed regulations are in 
proposed Sec. Sec.  1.704-3(f), 1.734-1(d), 1.743-1(k), and 1.743-1(n). 
This information will be used by the IRS to assure compliance with 
certain provisions of the American Jobs Creation Act of 2004. The 
collections of information are either required to obtain a benefit or 
are mandatory. The likely respondents are individuals and partnerships.
    The burden for the collection of information in Sec.  1.704-3(f) is 
as follows:
    Estimated total annual reporting burden: 324,850 hours.
    Estimated average annual burden per respondent: 2 hours.
    Estimated number of respondents: 162,425.
    Estimated annual frequency of responses: On occasion.
    The burden for the collection of information in Sec.  1.734-1(d) is 
as follows:
    Estimated total annual reporting burden: 1,650 hours.
    Estimated average annual burden per respondent: 3 hours.
    Estimated number of respondents: 550.
    Estimated annual frequency of responses: On occasion.
    The burden for the collection of information in Sec.  1.743-1(k)(1) 
is as follows:
    Estimated total annual reporting burden: 1,650 hours.
    Estimated average annual burden per respondent: 3 hours.
    Estimated number of respondents: 550.
    Estimated annual frequency of responses: On occasion.
    The burden for the collection of information in Sec.  1.743-1(k)(2) 
is as follows:
    Estimated total annual reporting burden: 550 hours.
    Estimated average annual burden per respondent: 1 hour.
    Estimated number of respondents: 550.
    Estimated annual frequency of responses: On occasion.
    The burden for the collection of information in Sec.  1.743-
1(n)(10) is as follows:
    Estimated total annual reporting burden: 3,600.
    Estimated average annual burden per respondent: 1 hour.
    Estimated number of respondents: 3,600.
    Estimated annual frequency of responses: Various.
    The burden for the collection of information in Sec.  1.743-
1(n)(11) is as follows:
    Estimated total annual reporting burden: 2,700.
    Estimated average annual burden per respondent: 1.5 hours.
    Estimated number of respondents: 1,800.
    Estimated annual frequency of responses: On occasion
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection 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 section 6103.

Background

1. Contributions of Built-in Loss Property

    Under section 721(a) of the Internal Revenue Code (the Code), if a 
partner contributes property in exchange for a partnership interest, 
neither the partners

[[Page 3043]]

nor the partnership recognize gain or loss. Section 722 provides that 
when a partner contributes property to a partnership, the basis in the 
partnership interest received equals the adjusted basis of the 
contributed property. Similarly, under section 723, the partnership's 
adjusted basis in the contributed property equals the contributing 
partner's adjusted basis in the property. Section 704(c)(1)(A) requires 
the partnership to allocate items of partnership income, gain, loss, 
and deduction with respect to contributed property among the partners 
so as to take into account any built-in gain or built-in loss in the 
contributed property. This rule is intended to prevent the transfer of 
built-in gain or built-in loss from the contributing partner to other 
partners. If a partner contributes built-in gain or built-in loss 
property to a partnership and later transfers the interest in the 
partnership, Sec.  1.704-3(a)(7) provides that the built-in gain or 
built-in loss must be allocated to the transferee as it would have been 
allocated to the transferor.
    Section 833(a) of the American Jobs Creation Act of 2004, Public 
Law 108-357, 118 Stat. 1418 (the AJCA) added section 704(c)(1)(C) to 
the Code for contributions of built-in loss property to partnerships 
after October 22, 2004. In general, section 704(c)(1)(C) provides that 
a partner's built-in loss may only be taken into account in determining 
the contributing partner's share of partnership items. Prior to the 
AJCA, a contributing partner could transfer losses to a transferee 
partner or other partners when the contributing partner was no longer a 
partner in the partnership. See H. R. Rep. 108-548 at 282 (2004) (House 
Committee Report) and H.R. Rep. 108-755 at 622 (2004) (Conference 
Report). Thus, Congress enacted section 704(c)(1)(C) to prevent the 
inappropriate transfer of built-in losses to partners other than the 
contributing partner. See House Committee Report, at 283. More 
specifically, Congress enacted section 704(c)(1)(C) to prevent a 
transferee partner from receiving an allocation of the transferor 
partner's share of losses relating to the transferor's contribution of 
built-in loss property and to prevent remaining partners from receiving 
an allocation of a distributee partner's share of losses relating to 
the distributee's contribution of built-in loss property when the 
distributee receives a liquidating distribution. See House Committee 
Report, at 282 and Conference Report, at 621-622. To that end, section 
704(c)(1)(C) provides that if property contributed to a partnership has 
a built-in loss, (i) such built-in loss shall be taken into account 
only in determining the amount of items allocated to the contributing 
partner; and (ii) except as provided by regulations, in determining the 
amount of items allocated to other partners, the basis of the 
contributed property in the hands of the partnership is equal to its 
fair market value at the time of the contribution. For purposes of 
section 704(c)(1)(C), the term built-in loss means the excess of the 
adjusted basis of the property (determined without regard to section 
704(c)(1)(C)(ii)) over its fair market value at the time of 
contribution.

2. Mandatory Basis Adjustment Provisions

a. Overview
    The mandatory basis adjustment provisions in section 833(b) and (c) 
of the AJCA reflect Congress' belief that the ``electivity of 
partnership basis adjustments upon transfers and distributions leads to 
anomalous tax results, causes inaccurate income measurement, and gives 
rise to opportunities for tax sheltering.'' See S. Rep. 108-192 at 189 
(2003) (Grassley Report). Specifically, Congress was concerned that the 
optional basis adjustment regime permitted partners to duplicate losses 
and inappropriately transfer losses among partners. Id. According to 
the legislative history, Congress intended these amendments to prevent 
the inappropriate transfer of losses among partners, while preserving 
the simplification aspects of the existing partnership rules for 
transactions involving smaller amounts (as described in this preamble, 
a $250,000 threshold). See House Committee Report, at 283. Thus, 
section 743 and section 734 were amended as described in sections 2.b. 
and 2.c. of the background section of this preamble.
b. Section 743 Substantial Built-In Loss Provisions
i. In General
    Before the enactment of the AJCA, under section 743(a), upon the 
transfer of a partnership interest by sale or exchange or upon the 
death of a partner, a partnership was not required to adjust the basis 
of partnership property unless the partnership had a section 754 
election in effect. If the partnership had a section 754 election in 
effect at the time of a transfer, section 743(b) required the 
partnership to increase or decrease the adjusted basis of the 
partnership property to take into account the difference between the 
transferee's proportionate share of the adjusted basis of the 
partnership property and the transferee's basis in its partnership 
interest.
    As amended by the AJCA, section 743(a) and (b) require a 
partnership to adjust the basis of partnership property upon a sale or 
exchange of an interest in the partnership or upon the death of a 
partner if there is a section 754 election in effect, or, for transfers 
after October 22, 2004, if the partnership has a substantial built-in 
loss immediately after the transfer (regardless of whether the 
partnership has a section 754 election in effect). Section 743(d)(1) 
provides that, for purposes of section 743, a partnership has a 
substantial built-in loss if the partnership's adjusted basis in the 
partnership property exceeds the fair market value of the property by 
more than $250,000. Section 743(d)(2) provides that the Secretary shall 
prescribe such regulations as may be appropriate to carry out the 
purposes of section 743(d)(1), including regulations aggregating 
related partnerships and disregarding property acquired by the 
partnership in an attempt to avoid such purposes.
ii. Electing Investment Partnerships
    Section 833(b) of the AJCA also added section 743(e) to the Code, 
which provides alternative rules for electing investment partnerships 
(EIPs). According to the legislative history, Congress was aware that 
mandating section 743(b) adjustments would impose administrative 
difficulties on certain types of investment partnerships that are 
engaged in investment activities and that typically did not make 
section 754 elections prior to the AJCA, even when the adjustments to 
the bases of partnership property would be upward adjustments. See 
House Committee Report, at 283. Accordingly, for partnerships that meet 
the requirements of an EIP in section 743(e)(6) and that elect to apply 
the provisions of section 743(e), section 743(e)(1) provides that for 
purposes of section 743, an EIP shall not be treated as having a 
substantial built-in loss with respect to any transfer occurring while 
the EIP election is in effect. Instead, section 743(e)(2) provides 
that, in the case of a transfer of an interest in an EIP, the 
transferee's distributive share of losses (without regard to gains) 
from the sale or exchange of partnership property shall not be allowed 
except to the extent that it is established that such losses exceed the 
loss (if any) recognized by the transferor (or any prior transferor to 
the extent not fully offset by a prior disallowance under section 
743(e)(2)) on the transfer of the partnership

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interest. Section 743(e)(3) further provides that losses disallowed 
under section 743(e)(2) shall not decrease the transferee's basis in 
the partnership interest. In the case of partnership property that has 
a built-in loss at the time of the transfer, the loss disallowance 
rules in section 743(e)(2) and (e)(3) approximate the effect of a basis 
adjustment and prevent the transferee from taking into account an 
allocation of the preexisting built-in loss (and the corresponding 
basis reduction) without requiring the partnership to adjust the bases 
of all partnership property. In addition, section 743(e)(5) provides 
that in the case of a transferee whose basis in distributed partnership 
property is reduced under section 732(a)(2), the amount of the loss 
recognized by the transferor on the transfer that is taken into account 
under section 743(e)(2) shall be reduced by the amount of such basis 
reduction.
    Section 743(e)(6) defines an electing investment partnership as any 
partnership if (A) the partnership makes an election to have section 
743(e) apply; (B) the partnership would be an investment company under 
section 3(a)(1)(A) of the Investment Company Act of 1940 but for an 
exemption under paragraph (1) or (7) of section 3(c) of the Act; (C) 
the partnership has never been engaged in a trade or business; (D) 
substantially all of the assets of the partnership are held for 
investment; (E) at least 95 percent of the assets contributed to the 
partnership consist of money; (F) no assets contributed to the 
partnership had an adjusted basis in excess of fair market value at the 
time of contribution; (G) all partnership interests are issued pursuant 
to a private offering before the date that is 24 months after the date 
of the first capital contribution to the partnership; (H) the 
partnership agreement has substantive restrictions on each partner's 
ability to cause a redemption of the partner's interest; and (I) the 
partnership agreement provides for a term that is not in excess of 15 
years. The flush language of section 743(e)(6) provides that the EIP 
election, once made, shall be irrevocable except with the consent of 
the Secretary. Section 833(d) of the AJCA provides a transition rule 
with respect to section 743(e)(6)(H) and (I) for partnerships eligible 
to make an election to be an EIP that were in existence on June 4, 
2004. For those partnerships, section 743(e)(6)(H) does not apply and 
the term in section 743(e)(6)(I) is 20 years.
    According to the legislative history, Congress expected EIPs to 
include venture capital funds, buyout funds, and funds of funds. See 
Conference Report, at 626. The legislative history further indicates 
that, with respect to the requirement in section 743(e)(6)(G), Congress 
intended that ``dry'' closings in which partnership interests are 
issued without the contribution of capital not start the running of the 
24-month period. Id. Furthermore, with respect to the requirement in 
section 743(e)(6)(H), Congress provided illustrative examples of 
substantive restrictions: a violation of Federal or State law (such as 
ERISA or the Bank Holding Company Act) or an imposition of the Federal 
excise tax on, or a change in the Federal tax-exempt status of, a tax-
exempt partner. Id.
    Section 743(e)(4) also provides that section 743(e) shall be 
applied without regard to any termination of a partnership under 
section 708(b)(1)(B). Finally, section 743(e)(7) provides that the 
Secretary shall prescribe such regulations as may be appropriate to 
carry out the purposes of section 743(e), including regulations for 
applying section 743(e) to tiered partnerships.
    Section 833(b) of the AJCA prescribed certain reporting 
requirements for EIPs by adding section 6031(f) to the Code. Section 
6031(f) provides that in the case of an EIP, the information required 
under section 6031(b) (relating to furnishing copies of returns of 
partnership income to partners) to be furnished to a partner to whom 
section 743(e)(2) applies shall include information as is necessary to 
enable the partner to compute the amount of losses disallowed under 
section 743(e).
    On April 1, 2005, the Treasury Department and the IRS issued Notice 
2005-32 (2005-1 CB 895), which provides, in part, interim procedures 
and reporting requirements for EIPs; interim procedures for transferors 
of EIP interests; and guidance regarding whether a partnership is 
engaged in a trade or business for purposes of section 743(e)(6)(C). 
Public comments on Notice 2005-32 are discussed in Parts 2.a.i and 
2.a.ii of the Explanation of Provisions section of this preamble. See 
Sec.  601.601(d)(2)(ii)(b).
iii. Securitization Partnerships
    Finally, section 833 of the AJCA added section 743(f) to the Code, 
which provides an exception from the mandatory basis adjustment 
provisions in section 743(a) and (b) for securitization partnerships. 
Section 743(f)(1) states that for purposes of section 743, a 
securitization partnership shall not be treated as having a substantial 
built-in loss with respect to any transfer. Section 743(f)(2) provides 
that the term securitization partnership means a partnership the sole 
business activity of which is to issue securities that provide for a 
fixed principal (or similar) amount and that are primarily serviced by 
the cash flows of a discrete pool (either fixed or revolving) of 
receivables or other financial assets that by their terms convert into 
cash in a finite period, but only if the sponsor of the pool reasonably 
believes that the receivables and other financial assets comprising the 
pool are not acquired so as to be disposed of. For purposes of the 
``reasonable belief'' standard, the legislative history indicates that 
Congress intended rules similar to the rules in Sec.  1.860G-2(a)(3) 
(relating to a reasonable belief safe harbor for obligations 
principally secured by an interest in real property) to apply. See 
Conference Report, at 627. Furthermore, Congress did not intend for the 
mandatory basis adjustment rules to be avoided by securitization 
partnerships through dispositions of pool assets. Id. Finally, the 
legislative history states that if a partnership ceases to meet the 
qualifications of a securitization partnership, the mandatory basis 
adjustment provisions apply to the first transfer thereafter and to 
each subsequent transfer. Id.
c. Section 734 Substantial Basis Reduction Provisions
    Section 734(b) requires a partnership to increase or decrease the 
adjusted basis of partnership property to take into account any gain or 
loss recognized to the distributee and the difference between the 
partnership's and the distributee's bases in distributed property. 
Similar to section 743, prior to the AJCA, section 734(a) did not 
require a partnership to adjust the basis of partnership property upon 
a distribution of partnership property to a partner unless the 
partnership had a section 754 election in effect.
    Consistent with the amendments to section 743, section 833(c) of 
the AJCA amended section 734(a) and (b) to require a partnership to 
adjust the basis of partnership property upon a distribution of 
partnership property to a partner if there is a section 754 election in 
effect or, for distributions occurring after October 22, 2004, if there 
is a substantial basis reduction with respect to the distribution. 
Section 734(d)(1) provides that for purposes of section 734, there is a 
substantial basis reduction with respect to a distribution if the sum 
of the amounts described in section 734(b)(2)(A) and 734(b)(2)(B) 
exceeds $250,000. The amount described in section 734(b)(2)(A) is the 
amount of loss recognized to the distributee partner with respect to 
the distribution under section 731(a)(2). The amount described in 
section

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734(b)(2)(B) is, in the case of distributed property to which section 
732(b) applies, the excess of the basis of the distributed property to 
the distributee, as determined under section 732, over the adjusted 
basis of the distributed property to the partnership immediately before 
the distribution (as adjusted by section 732(d)). Section 734(d)(2) 
provides regulatory authority for the Secretary to carry out the 
purposes of section 734(d) by cross-reference to section 743(d)(2). 
Section 743(d)(2) is discussed in Part 2.b.i of the Background section 
of this preamble.
    As with section 743(b) adjustments, section 734(e) provides an 
exception to the mandatory basis adjustment provisions in section 734 
for securitization partnerships. A securitization partnership (which is 
defined by reference to section 743(f)) is not treated as having a 
substantial basis reduction with respect to any distribution of 
property to a partner. See Part 2.b.iii of the Background section of 
this preamble for the definition of securitization partnership in 
section 743(f). Like the rules under section 743, the mandatory basis 
adjustment provisions under section 734 will apply with respect to the 
first distribution that occurs after the partnership ceases to meet the 
definition of a securitization partnership and to each subsequent 
distribution.
d. Interim Reporting Requirements for Mandatory Basis Adjustments
    The Treasury Department and the IRS issued general interim 
procedures for mandatory basis adjustments under sections 734 and 743. 
These interim procedures, which are described in Notice 2005-32, state 
that until further guidance is provided, partnerships required to 
reduce the bases of partnership properties under the substantial basis 
reduction provisions in section 734 must comply with Sec.  1.734-1(d) 
as if an election under section 754 were in effect at the time of the 
relevant distribution. Similarly, partnerships that are required to 
reduce the bases of partnership properties under the substantial built-
in loss provisions in section 743 must comply with Sec.  1.743-1(k)(1), 
(3), (4), and (5) as if an election under section 754 were in effect at 
the time of the relevant transfer. Furthermore, a transferee of an 
interest in a partnership that is required to reduce the bases of 
partnership properties under the substantial built-in loss provisions 
must comply with Sec.  1.743-1(k)(2) as if an election under section 
754 were in effect at the time of the relevant transfer.

3. Section 755 Rules for Allocation of Basis

a. Section 755(c)
    If section 734(a) requires a basis adjustment (either because the 
partnership has a section 754 election in effect or because there is a 
substantial basis reduction with respect to the distribution), section 
734(b) provides that the partnership increases or decreases the basis 
of partnership property by any gain or loss recognized by the 
distributee and the difference (if any) between the partnership's and 
the distributee's adjusted bases in the distributed property. Section 
755(a) generally provides that any increase or decrease in the adjusted 
basis of partnership property under section 734(b) shall be allocated 
in a manner that: (1) reduces the difference between the fair market 
value and the adjusted basis of partnership properties, or (2) in any 
other manner permitted by regulations. Generally, section 755(b) 
requires a partnership to allocate increases or decreases in the 
adjusted basis of partnership property arising from the distribution of 
property to property of a like character to the property distributed 
(either to (1) capital assets and property described in section 
1231(b), or (2) any other property).
    According to the Joint Committee on Taxation's (the JCT's) 
investigative report of Enron Corporation (See Joint Committee on 
Taxation, Report of Investigation of Enron Corporation and Related 
Entities Regarding Federal Tax and Compensation Issues, and Policy 
Recommendations, JCS-3-03 (February 2003) (JCT Enron Report)), 
taxpayers were engaging in transactions to achieve unintended tax 
results through the interaction of these partnership basis adjustment 
rules and the rules in section 1032 protecting a corporation from 
recognizing gain on its stock. Section 1032(a) provides that no gain or 
loss is recognized to a corporation on the receipt of money or other 
property in exchange for stock of the corporation. In particular, the 
JCT Enron Report describes Enron Corporation's Project Condor as 
structured to take advantage of the interaction between sections 754 
and 1032 by increasing the basis of depreciable assets under section 
732 while decreasing the basis under section 734(b) of preferred stock 
of a corporate partner held by the partnership. The step down in the 
basis of the corporate partner's preferred stock had no ultimate tax 
effect because the corporate partner could avoid recognizing the gain 
in the stock through section 1032, which prevents a corporation from 
recognizing gain on the sale of its stock. The transaction thus 
duplicated tax deductions at no economic cost. See Grassley Report, at 
127 and House Committee Report, at 287. The JCT expressed specific 
concern about the exclusion of gain under section 1032 following a 
negative basis adjustment under section 734(b) to stock of a corporate 
partner. JCT Enron Report, at 220-21. Therefore, the JCT recommended 
that the partnership basis rules preclude an increase in basis to an 
asset if the offsetting basis reduction would be allocated to stock of 
a partner (or related party). Id. at 221.
    In response to these recommendations, section 834(a) of the AJCA 
enacted section 755(c), which provides that in making an allocation 
under section 755(a) of any decrease in the adjusted basis of 
partnership property under section 734(b)--(1) no allocation may be 
made to stock in a corporation (or any person related (within the 
meaning of sections 267(b) and 707(b)(1)) to such corporation) that is 
a partner in the partnership, and (2) any amount not allocable to stock 
by reason of section 755(c)(1) shall be allocated under section 755(a) 
to other partnership property. The flush language of section 755(c) 
further provides that a partnership recognizes gain to the extent that 
the amount required to be allocated under section 755(c)(2) to other 
partnership property exceeds the aggregate adjusted basis of such other 
property immediately before the required allocation.
b. Basis Adjustment Allocation Rules for Substituted Basis Transactions
    A basis adjustment under section 743(a) is determined in accordance 
with section 743(b). The partnership must allocate any increase or 
decrease in the adjusted basis of partnership property required under 
section 743(b) under the rules of section 755. Section 1.755-1(b)(5) 
provides additional guidance on how to allocate basis adjustments under 
section 743(b) that result from substituted basis transactions, which 
are defined as exchanges in which the transferee's basis in the 
partnership interest is determined in whole or in part by reference to 
the transferor's basis in that interest. For exchanges on or after June 
9, 2003, Sec.  1.755-1(b)(5) also applies to basis adjustments that 
result from exchanges in which the transferee's basis in the 
partnership interest is determined by reference to other property held 
at any time by the transferee.
    Generally, Sec.  1.755-1(b)(5)(ii) provides that if there is an 
increase in basis to be allocated to partnership assets, the increase 
must be allocated to capital

[[Page 3046]]

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. Similarly, if there 
is a decrease in basis to be allocated to partnership assets, Sec.  
1.755-1(b)(5)(ii) generally provides that the 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. Thus, whether or not a basis 
adjustment resulting from a substituted basis transaction can be 
allocated to partnership property depends on whether the transferee 
partner would be allocated a net gain or net income, in the case of a 
positive basis adjustment, or net loss, in the case of a negative basis 
adjustment.
    Section 1.755-1(b)(5)(iii) provides rules for allocating increases 
or decreases in basis within the classes of property. Of note, in the 
case of a decrease, Sec.  1.755-1(b)(5)(iii)(B) states that 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 the 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) 
(subject to a limitation in decrease of basis in Sec.  1.755-
1(b)(5)(iii)(C) and a carryover rule in Sec.  1.755-1(b)(5)(iii)(D)).
    In addition, Sec.  1.743-1(f) provides that, when there has been 
more than one transfer of a partnership interest, a partnership 
determines a transferee's basis adjustment without regard to any prior 
transferee's basis adjustment. Accordingly, if a partner acquires its 
partnership interest in a transaction other than a substituted basis 
transaction and then subsequently transfers its interest in a 
substituted basis transaction, the transferee's basis adjustment may 
shift among partnership assets.

4. Miscellaneous Provisions

a. Section 704(c) Allocations
    Property contributed to a partnership by a partner is section 
704(c) property if, at the time of contribution, the property has a 
built-in gain or built-in loss (``forward section 704(c) gain or 
loss''). Section 704(c)(1)(A) requires a partnership to allocate 
income, gain, loss, and deduction so as to take into account the built-
in gain or built-in loss. For this purpose, Sec.  1.704-3(a)(3)(ii) 
provides that a built-in gain or built-in loss is generally the 
difference between the property's book value and the contributing 
partner's adjusted tax basis upon contribution (reduced by decreases in 
the difference between the property's book value and adjusted tax 
basis). Section 1.704-3(a)(6)(i) provides that the principles of 
section 704(c) also apply to allocations with respect to property for 
which differences between book value and adjusted tax basis are created 
when a partnership revalues property pursuant to Sec.  1.704-
1(b)(2)(iv)(f) (``reverse section 704(c) allocations''). Partnerships 
are not required to use the same allocation method for forward and 
reverse section 704(c) allocations, but the allocation method (or 
combination of methods) must be reasonable. See Sec. Sec.  1.704-
3(a)(6)(i) and 1.704-3(a)(10)(i). Section 1.704-3(a)(10)(i) provides 
that an allocation method is not reasonable if the contribution or 
revaluation event and the corresponding allocation are made with a view 
to shifting the tax consequences of built-in gain or built-in loss 
among the partners in a manner that substantially reduces the present 
value of the partners' aggregate tax liability.
    On August 12, 2009, the Treasury Department and the IRS published 
Notice 2009-70, 2009-2 CB 255, which requested comments on the proper 
application of the rules relating to the creation and maintenance of 
forward and multiple reverse section 704(c) allocations (referred to as 
``section 704(c) layers'' in this preamble). Specifically, Notice 2009-
70 requested comments on, among other things, whether taxpayers should 
net reverse section 704(c) allocations against existing section 704(c) 
layers or maintain separate section 704(c) layers if the section 704(c) 
layers offset one another; how partnerships should allocate tax 
depreciation, depletion, amortization, and gain or loss between 
multiple section 704(c) layers (including any offsetting section 704(c) 
layers); and whether there are other issues relating to section 704(c) 
layers. Public comments on Notice 2009-70 are discussed in Part 4.a of 
the Explanation of Provisions section of this preamble. See Sec.  
601.601(d)(2)(ii)(b).
b. Extension of Time Period for Taxing Precontribution Gain
    The Taxpayer Relief Act of 1997 (Pub. Law 105-34, 111 Stat. 788) 
extended the time period in sections 704(c)(1)(B) and 737(b)(1) for 
taxing precontribution gain for property contributed to a partnership 
after June 8, 1997, from five years to seven years (the rule does not, 
however, apply to any property contributed pursuant to a written 
binding contract in effect on June 8, 1997, and at all times thereafter 
before such contribution if such contract provides for the contribution 
of a fixed amount of property). The regulations under sections 704, 
737, and 1502 have not been revised to reflect this statutory change.

Explanation of Provisions

1. Contributions of Built-in Loss Property

a. Overview
    Section 704(c)(1)(C)(i) provides that if property contributed to a 
partnership has a built-in loss (``section 704(c)(1)(C) property''), 
such built-in loss shall be taken into account only in determining the 
amount of items allocated to the contributing partner (``section 
704(c)(1)(C) partner''). Section 704(c)(1)(C)(ii) further provides 
that, except as provided by regulations, in determining the amount of 
items allocated to other partners, the basis of the contributed 
property in the hands of the partnership is equal to its fair market 
value at the time of the contribution. For purposes of section 
704(c)(1)(C), the term built-in loss means the excess of the adjusted 
basis of the section 704(c)(1)(C) property (determined without regard 
to section 704(c)(1)(C)(ii)) over its fair market value at the time of 
contribution.
    The Treasury Department and the IRS believe additional guidance is 
needed with respect to the application of section 704(c)(1)(C). 
Accordingly, the proposed regulations provide rules regarding: (1) the 
scope of section 704(c)(1)(C); (2) the effect of the built-in loss; (3) 
distributions by partnerships holding section 704(c)(1)(C) property; 
(4) transfers of a section 704(c)(1)(C) partner's partnership interest; 
(5) transfers of section 704(c)(1)(C) property; and (6) reporting 
requirements.
b. Scope of Section 704(c)(1)(C)
    The proposed regulations define section 704(c)(1)(C) property as 
section

[[Page 3047]]

704(c) property with a built-in loss at the time of contribution. Thus, 
in addition to the rules in the proposed regulations, section 
704(c)(1)(C) property is subject to the existing rules and regulations 
applicable to section 704(c) property generally (see, for example, 
Sec.  1.704-3(a)(9), which provides special rules for tiered 
partnerships), except as provided in the proposed regulations.
    The Treasury Department and the IRS considered whether the 
principles of section 704(c)(1)(C) should apply to reverse section 
704(c) allocations (within the meaning of Sec.  1.704-3(a)(6)(i)). The 
Treasury Department and the IRS concluded that applying the proposed 
regulations to reverse section 704(c) allocations would be difficult 
for taxpayers to comply with and for the IRS to administer. Therefore, 
the proposed regulations do not apply to reverse section 704(c) 
allocations.
    The Treasury Department and the IRS also considered whether section 
704(c)(1)(C) should apply to Sec.  1.752-7 liabilities. Under Sec.  
1.752-7(b)(3)(i), a Sec.  1.752-7 liability is an obligation described 
in Sec.  1.752-1(a)(4)(ii) (generally any fixed or contingent 
obligation to make payment without regard to whether the obligation is 
otherwise taken into account for purposes of Code) to the extent that 
the obligation either is not described in Sec.  1.752-1(a)(4)(i) or the 
amount of the obligation exceeds the amount taken into account under 
Sec.  1.752-1(a)(4)(i). The preamble to the final regulations under 
Sec.  1.752-7, published on May 26, 2005, acknowledges that the rules 
in section 704(c)(1)(C) and the rules under Sec.  1.752-7 are similar. 
See TD 9207, 70 FR 30334. The preamble explains that it is possible to 
view the contribution of property with an adjusted tax basis equal to 
the fair market value of the property, determined without regard to any 
Sec.  1.752-7 liabilities, as built-in loss property after the Sec.  
1.752-7 liability is taken into account (when the Sec.  1.752-7 
liability is related to the contributed property). However, the 
preamble further provides that Sec.  1.752-7 shall be applied without 
regard to the amendments made by the AJCA, unless future guidance 
provides to the contrary. The Treasury Department and the IRS believe 
the rules regarding Sec.  1.752-7 liabilities adequately address the 
issues posed by Sec.  1.752-7 liabilities and, thus, the proposed 
regulations provide that section 704(c)(1)(C) property does not include 
a Sec.  1.752-7 liability.
c. Effect of Section 704(c)(1)(C) Basis Adjustment
    The legislative history indicates that Congress intended the built-
in loss attributable to section 704(c)(1)(C) property to be for the 
benefit of the contributing partner only. Conceptually, the built-in 
loss is similar to a section 743(b) adjustment, which is an adjustment 
to the basis of partnership property solely with respect to the 
transferee partner. The current regulations under section 743 provide 
detailed rules regarding accounting for, maintenance of, recovery of, 
and transfers of assets with, section 743(b) adjustments. The Treasury 
Department and the IRS believe it is appropriate that the proposed 
regulations provide rules similar to those applicable to positive basis 
adjustments under section 743(b). The Treasury Department and the IRS 
believe that this approach simplifies the application and 
administration of section 704(c)(1)(C) and provides a framework of 
rules familiar to partners, partnerships, and the IRS. Even though the 
proposed regulations generally adopt the approach taken with respect to 
section 743(b) adjustments, the Treasury Department and the IRS believe 
that some of the rules governing section 743(b) adjustments should not 
apply with respect to a built-in loss and that additional rules are 
necessary for section 704(c)(1)(C). Thus, the proposed regulations 
import and specifically apply certain concepts contained in the section 
743 regulations to section 704(c)(1)(C), as opposed to simply providing 
that principles similar to those contained in the regulations under 
section 743 apply to section 704(c)(1)(C) by cross-reference. The 
following discussion describes both the substantive rules applied under 
section 704(c)(1)(C) and, where applicable, how those rules differ from 
their counterparts under section 743(b).
    The proposed regulations create the concept of a section 
704(c)(1)(C) basis adjustment. The section 704(c)(1)(C) basis 
adjustment is initially equal to the built-in loss associated with the 
section 704(c)(1)(C) property at the contribution and then is adjusted 
in accordance with the proposed regulations. For example, if A 
contributes, in a section 721 transaction, property with a fair market 
value of $6,000 and an adjusted basis of $11,000 to a partnership, the 
partnership's basis in the property is $6,000, A's basis in its 
partnership interest is $11,000, and A has a section 704(c)(1)(C) basis 
adjustment of $5,000. Similar to basis adjustments under section 
743(b), a section 704(c)(1)(C) basis adjustment is unique to the 
section 704(c)(1)(C) partner and does not affect the basis of 
partnership property or the partnership's computation of any item under 
section 703. The rules regarding the effect of the section 704(c)(1)(C) 
basis adjustment are similar to the rules for section 743(b) 
adjustments in Sec. Sec.  1.743-1(j)(1) through (j)(3), including: (1) 
the effect of the section 704(c)(1)(C) basis adjustment on the basis of 
partnership property; (2) the computation and allocation of the 
partnership's items of income, deduction, gain, or loss; (3) 
adjustments to the partners' capital accounts; (4) adjustments to the 
section 704(c)(1)(C) partner's distributive share; and (5) the 
determination of a section 704(c)(1)(C) partner's income, gain, or loss 
from the sale or exchange of section 704(c)(1)(C) property. The 
Treasury Department and the IRS believe the rule regarding recovery of 
the section 704(c)(1)(C) basis adjustment should be consistent with the 
rule regarding recovery of the adjusted tax basis in the property that 
is not subject to section 704(c)(1)(C). Thus, for property eligible for 
cost recovery, the proposed regulations provide that, regarding the 
effect of the basis adjustment in determining items of deduction, if 
section 704(c)(1)(C) property is subject to amortization under section 
197, depreciation under section 168, or other cost recovery in the 
hands of the section 704(c)(1)(C) partner, the section 704(c)(1)(C) 
basis adjustment associated with the property is recovered in 
accordance with section 197(f)(2), section 168(i)(7), or other 
applicable Code sections. Similar to section 743, the proposed 
regulations further provide that the amount of any section 704(c)(1)(C) 
basis adjustment that is recovered by the section 704(c)(1)(C) partner 
in any year is added to the section 704(c)(1)(C) partner's distributive 
share of the partnership's depreciation or amortization deductions for 
the year. The section 704(c)(1)(C) basis adjustment is adjusted under 
section 1016(a)(2) to reflect the recovery of the section 704(c)(1)(C) 
basis adjustment.
d. Distribution by Partnership Holding Section 704(c)(1)(C) Property
    The proposed regulations provide guidance on current distributions 
of section 704(c)(1)(C) property to the section 704(c)(1)(C) partner; 
distributions of section 704(c)(1)(C) property to another partner; and 
liquidating distributions to a section 704(c)(1)(C) partner. The 
Treasury Department and the IRS believe it is appropriate to apply 
principles similar to section 743 to simplify the administration of 
section 704(c)(1)(C)

[[Page 3048]]

for partners, partnerships, and the IRS. Thus, the proposed regulations 
generally provide rules similar to those for section 743(b) 
adjustments.
i. Current Distribution of Section 704(c)(1)(C) Property to Section 
704(c)(1)(C) Partner
    Under the proposed regulations, the adjusted partnership basis of 
section 704(c)(1)(C) property distributed to the section 704(c)(1)(C) 
partner includes the section 704(c)(1)(C) basis adjustment for purposes 
of determining the amount of any adjustment under section 734. However, 
the proposed regulations provide that section 704(c)(1)(C) basis 
adjustments are not taken into account in making allocations under 
Sec.  1.755-1(c).
ii. Distribution of Section 704(c)(1)(C) Property to Another Partner
    Under the proposed regulations, if a partner receives a 
distribution of property in which another partner has a section 
704(c)(1)(C) basis adjustment, the distributee partner does not take 
the section 704(c)(1)(C) basis adjustment into account under section 
732. However, the Treasury Department and the IRS request comments on 
whether a section 704(c)(1)(C) adjustment to distributed stock should 
be taken into account for purposes of section 732(f) notwithstanding 
the general rule that section 704(c)(1)(C) adjustments are not taken 
into account under section 732.
    Upon the distribution of section 704(c)(1)(C) property to another 
partner, the section 704(c)(1)(C) partner reallocates its section 
704(c)(1)(C) basis adjustment relating to the distributed property 
among the remaining items of partnership property under Sec.  1.755-
1(c), which is similar to the rule in Sec.  1.743-1(g)(2)(ii) for 
reallocating section 743(b) adjustments. This rule allocates the basis 
adjustment to partnership property without regard to the section 
704(c)(1)(C) partner's allocable share of income, gain, or loss in each 
partnership asset. The Treasury Department and the IRS request comments 
on whether the reallocations of section 704(c)(1)(C) basis adjustments 
and section 743(b) basis adjustments should instead be made under the 
principles of Sec.  1.755-1(b)(5)(iii) to take into account the 
partner's allocable share of income, gain, or loss from each 
partnership asset.
    The proposed regulations further provide that if section 
704(c)(1)(B) applies to treat the section 704(c)(1)(C) partner as 
recognizing loss on the sale of the distributed property, the section 
704(c)(1)(C) basis adjustment is taken into account in determining the 
amount of loss. Accordingly, when the section 704(c)(1)(C) property is 
distributed to a partner other than the contributing partner within 
seven years of its contribution to the partnership, the loss will be 
taken into account by the contributing partner. The Treasury Department 
and the IRS considered extending the seven-year period so that the loss 
will be taken into account by the contributing partner on any 
distribution of section 704(c)(1)(C) property to a partner other than 
the contributing partner. The Treasury Department and the IRS do not 
adopt this approach in the proposed regulations because it would be 
inconsistent with section 704(c)(1)(B) generally and would be more 
difficult to administer.
iii. Distribution in Complete Liquidation of a Section 704(c)(1)(C) 
Partner's Interest
    The proposed regulations provide that if a section 704(c)(1)(C) 
partner receives a distribution of property (whether or not the 
property is section 704(c)(1)(C) 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 section 704(c)(1)(C) partner's section 704(c)(1)(C) basis 
adjustment for the property in which the section 704(c)(1)(C) partner 
relinquished an interest (if any) by reason of the liquidation. For 
purposes of determining the redeemed section 704(c)(1)(C) partner's 
basis in distributed property under section 732, the partnership 
reallocates any section 704(c)(1)(C) basis adjustment from section 
704(c)(1)(C) property retained by the partnership to distributed 
properties of like character under the principles of Sec.  1.755-
1(c)(i), after applying sections 704(c)(1)(B) and 737. If section 
704(c)(1)(C) property is retained by the partnership, and no property 
of like character is distributed, then that property's section 
704(c)(1)(C) basis adjustment is not reallocated to the distributed 
property for purposes of applying section 732.
    If any section 704(c)(1)(C) basis adjustment is not reallocated to 
the distributed property in connection with the distribution, then that 
remaining section 704(c)(1)(C) basis adjustment shall be treated as a 
positive section 734(b) adjustment. If the distribution also gives rise 
to a negative section 734(b) adjustment, then the negative section 
734(b) adjustment and the section 704(c)(1)(C) basis adjustment 
reallocation are netted together, and the net amount is allocated under 
Sec.  1.755-1(c). If the partnership does not have a section 754 
election in effect at the time of the liquidating distribution, the 
partnership shall be treated as having made a section 754 election 
solely for purposes of computing any negative section 734(b) adjustment 
that would arise from the distribution.
e. Transfer of Section 704(c)(1)(C) Partner's Partnership Interest
i. In General
    Under section 722, a section 704(c)(1)(C) partner's basis in its 
partnership interest fully reflects the built-in loss portion of the 
basis of the contributed property and the built-in loss generally is 
taken into account by the section 704(c)(1)(C) partner upon disposition 
of the partnership interest. Therefore, in accordance with section 
704(c)(1)(C)'s overall policy objective of preventing the inappropriate 
transfer of built-in losses through partnerships, the proposed 
regulations provide that the transferee of a section 704(c)(1)(C) 
partner's partnership interest generally does not succeed to the 
section 704(c)(1)(C) partner's section 704(c)(1)(C) basis adjustment. 
Instead, the share of the section 704(c)(1)(C) basis adjustment 
attributable to the interest transferred is eliminated. For example, if 
a section 704(c)(1)(C) partner sells 20 percent of its interest in a 
partnership, the partner recognizes its outside loss with respect to 
that 20 percent but 20 percent of the partner's section 704(c)(1)(C) 
basis adjustment for each section 704(c)(1)(C) property contributed by 
the partner is eliminated. The transferor remains a section 
704(c)(1)(C) partner with respect to any remaining section 704(c)(1)(C) 
basis adjustments. The proposed regulations provide exceptions to this 
general rule for nonrecognition transactions, which are discussed in 
Part 1.e.ii of the Explanation of Provisions section of this preamble.
ii. Nonrecognition Transactions
    Under the proposed regulations, the general rule that a section 
704(c)(1)(C) basis adjustment is not transferred with the related 
partnership interest does not apply to the extent a section 
704(c)(1)(C) partner transfers its partnership interest in a 
nonrecognition transaction, with certain exceptions. The legislative 
history notes that Congress intended to treat a corporation succeeding 
to the attributes of a contributing corporate partner under section 381 
in the same manner as the contributing partner. See Conference Report, 
at 623 n. 546. The Treasury Department and the IRS considered whether 
similar successor rules should apply in other

[[Page 3049]]

nonrecognition transactions. Some of the considerations included: (1) 
providing consistent results regardless of the order in which a 
transaction occurs; (2) ensuring that built-in losses are not 
duplicated; (3) preventing the shifting of basis to other assets; (4) 
recognizing that other provisions in subchapter K (for example, section 
743(b)) already apply to prevent many of the potential abuses; and (5) 
providing administrable rules for partners, partnerships, and the IRS. 
The Treasury Department and the IRS concluded that these considerations 
and the policy rationale underlying the successor rule for section 381 
transactions in the legislative history weigh in favor of applying 
similar successor rules to other nonrecognition transactions, including 
section 721 transactions, section 351 transactions, and distributions 
governed by section 731. Thus, when the partnership interest is 
transferred in one of these nonrecognition transactions, the transferee 
generally succeeds to the transferor's section 704(c)(1)(C) basis 
adjustments attributable to the interest transferred and is treated as 
the section 704(c)(1)(C) partner with respect to such interest. If the 
nonrecognition transaction is described in section 168(i)(7)(B), then 
the rules in section 168(i)(7)(A) apply with respect to the 
transferor's cost recovery deductions under section 168 with respect to 
the section 704(c)(1)(C) basis adjustment. The proposed regulations 
further provide that if gain or loss is recognized in the transaction, 
appropriate adjustments must be made to the section 704(c)(1)(C) basis 
adjustment.
    The Treasury Department and the IRS believe that a section 743(b) 
adjustment generally will prevent inappropriate duplication of loss 
when a partnership has a section 754 election in effect or a 
substantial built-in loss with respect to the transfer. (See Part 
2.a.i. of the Explanation of Provisions section of this preamble for 
rules regarding substantial built-in loss transactions). To the extent 
that the transferee partner's basis in the transferred partnership 
interest does not reflect a built-in loss, a section 743(b) adjustment 
should require the partnership to reduce the basis of its properties to 
reflect the elimination of the built-in loss. The Treasury Department 
and the IRS believe that the amount of the section 704(c)(1)(C) 
adjustment and any negative 743(b) adjustment should be netted for this 
purpose. The Treasury Department and the IRS believe that similar 
treatment is appropriate when a partnership does not have a section 754 
election in effect at the time of transfer to prevent duplication of 
the built-in loss. Therefore, regardless of whether a section 754 
election is in effect or a substantial built-in loss exists with 
respect to a transfer, the proposed regulations provide that the 
transferee partner succeeds to the transferor's section 704(c)(1)(C) 
basis adjustment, as reduced by the amount of any negative section 
743(b) adjustment that would be allocated to the section 704(c)(1)(C) 
property if the partnership had a section 754 election in effect at the 
time of the transfer.
    The proposed regulations also provide that the general rule 
regarding nonrecognition transactions does not apply to the transfer of 
all or a portion of a section 704(c)(1)(C) partner's partnership 
interest by gift because the gift recipient does not fit within 
Congress's notion of a successor as described in the legislative 
history. See Conference Report, at 623 n. 546. Thus, the general 
transfer rule applies instead, and the section 704(c)(1)(C) basis 
adjustment is eliminated.
f. Transfers of Section 704(c)(1)(C) Property
    The proposed regulations also provide guidance on the treatment of 
the section 704(c)(1)(C) partner and the section 704(c)(1)(C) basis 
adjustment when the partnership transfers section 704(c)(1)(C) 
property. Consistent with the rules under section 743, a section 
704(c)(1)(C) partner's section 704(c)(1)(C) basis adjustment is 
generally taken into account in determining the section 704(c)(1)(C) 
partner's income, gain, loss, or deduction from the sale or exchange of 
section 704(c)(1)(C) property.
    With certain exceptions, if section 704(c)(1)(C) property is 
transferred in a nonrecognition transaction, the proposed regulations 
provide that the section 704(c)(1)(C) partner retains the section 
704(c)(1)(C) basis adjustment in the replacement property (in the case 
of a section 1031 transaction), in stock (in the case of a section 351 
transaction), in a lower-tier partnership interest (in the case of a 
section 721 transaction), or in the same property held by a new 
partnership (in the case of a section 708(b)(1)(B) technical 
termination). The proposed regulations also provide additional rules 
for section 721 and section 351 transactions, which are described in 
the following sections.
i. Contribution of Section 704(c)(1)(C) Property Under Section 721
    The proposed regulations provide rules for when, after a section 
704(c)(1)(C) partner contributes section 704(c)(1)(C) property to an 
upper-tier partnership, the upper-tier partnership contributes the 
property to a lower-tier partnership in a transaction described in 
section 721(a). The proposed regulations ensure that the section 
704(c)(1)(C) adjustment amount is ultimately tracked back to the 
initial contributing partner, similar to the rules for section 721 
contributions of property in which a partner has a section 743(b) 
adjustment.
    In particular, the proposed regulations provide that the interest 
in the lower-tier partnership received by the upper-tier partnership is 
treated as the section 704(c)(1)(C) property with the same section 
704(c)(1)(C) basis adjustment as the contributed property. The lower-
tier partnership determines its basis in the contributed property by 
excluding the existing section 704(c)(1)(C) basis adjustment. However, 
the lower-tier partnership also succeeds to the upper-tier 
partnership's section 704(c)(1)(C) basis adjustment. The portion of the 
upper-tier partnership's basis in its interest in the lower-tier 
partnership attributable to the section 704(c)(1)(C) basis adjustment 
must be segregated and allocated solely to the section 704(c)(1)(C) 
partner for whom the initial section 704(c)(1)(C) basis adjustment was 
made. Similarly, the section 704(c)(1)(C) basis adjustment to which the 
lower-tier partnership succeeds must be segregated and allocated solely 
to the upper-tier partnership, and the section 704(c)(1)(C) partner for 
whom the initial section 704(c)(1)(C) basis adjustment was made. If 
gain or loss is recognized on the transaction, appropriate adjustments 
must be made to the section 704(c)(1)(C) basis adjustment.
    The proposed regulations provide that to the extent that any 
section 704(c)(1)(C) basis adjustment in a tiered partnership is 
recovered (for example, by sale or depreciation of the property), or is 
otherwise reduced, upper or lower partnerships in the tiered structure 
must make conforming reductions to related section 704(c)(1)(C) basis 
adjustments to prevent duplication of loss.
    The proposed regulations recognize that the contribution from the 
upper-tier partnership to the lower-tier partnership will give rise to 
an additional section 704(c)(1)(C) basis adjustment if the value of the 
property has fallen below its common basis to the upper-tier 
partnership; this additional section 704(c)(1)(C) adjustment will be 
allocated among the partners of the upper-tier partnership in a manner 
that reflects their relative shares of that loss.

[[Page 3050]]

ii. Transfer of Section 704(c)(1)(C) Property in a Section 351 
Transaction
    The transfer of the section 704(c)(1)(C) property by a partnership 
to a corporation in a section 351 transaction severs the contributing 
partner's connection with the section 704(c)(1)(C) property at the 
partnership level. The section 704(c)(1)(C) partner, now an indirect 
shareholder of the corporation, no longer has a section 704(c)(1)(C) 
basis adjustment with respect to the property. The proposed regulations 
provide that if, in an exchange described in section 351, a partnership 
transfers section 704(c)(1)(C) property to a corporation, the stock the 
partnership receives in the exchange is treated, solely with respect to 
the section 704(c)(1)(C) partner, as section 704(c)(1)(C) property that 
generally has the same section 704(c)(1)(C) basis adjustment as the 
section 704(c)(1)(C) property transferred to the corporation (reduced 
by any portion of the section 704(c)(1)(C) basis adjustment that 
reduced the partner's share of any gain on the transaction). The 
transferee corporation's adjusted basis in the transferred property is 
determined under section 362 (including by applying section 362(e)), 
taking into account any section 704(c)(1)(C) basis adjustments in the 
transferred property. However, the proposed regulations provide that, 
if a partnership recognizes gain on the transfer, the partnership's 
gain is determined without regard to any section 704(c)(1)(C) basis 
adjustment, but the section 704(c)(1)(C) partner's gain does take into 
account the section 704(c)(1)(C) basis adjustment. See Sec.  1.362-
4(e)(1) for additional rules regarding the application of section 
362(e) to transfers by partnerships.
iii. Partnership Technical Terminations
    The proposed regulations provide that a partner with a section 
704(c)(1)(C) basis adjustment in section 704(c)(1)(C) property held by 
a partnership that terminates under section 708(b)(1)(B) will continue 
to have the same section 704(c)(1)(C) basis adjustment with respect to 
section 704(c)(1)(C) property deemed contributed by the terminated 
partnership to the new partnership under Sec.  1.708-1(b)(4). In 
addition, the deemed contribution of property by a terminated 
partnership to a new partnership is not subject to the proposed 
regulations and does not create a section 704(c)(1)(C) basis 
adjustment.
iv. Miscellaneous Provisions
    The proposed regulations also provide additional rules for like-
kind exchanges of section 704(c)(1)(C) property, dispositions of 
section 704(c)(1)(C) property in installment sales, and contributed 
contracts.
g. Reporting Requirements Under Section 704(c)(1)(C)
    The proposed regulations prescribe certain reporting requirements 
for section 704(c)(1)(C) basis adjustments that are similar to the 
requirements for section 743(b) adjustments. Specifically, the proposed 
regulations provide that a partnership that owns property for which 
there is a section 704(c)(1)(C) basis adjustment must attach a 
statement to the partnership return for the year of the contribution of 
the section 704(c)(1)(C) property setting forth the name and taxpayer 
identification number of the section 704(c)(1)(C) partner as well as 
the section 704(c)(1)(C) basis adjustment and the section 704(c)(1)(C) 
property to which the adjustment relates.

2. Mandatory Basis Adjustment Provisions

a. Section 743 Substantial Built-In Loss Provisions
i. General Provisions
    The proposed regulations generally restate the statutory language 
in section 743(a) and (b) regarding substantial built-in losses, but 
provide additional guidance in several areas. The proposed regulations 
clarify that, if a partnership has a substantial built-in loss 
immediately after the transfer of a partnership interest, the 
partnership is treated as having a section 754 election in effect for 
the taxable year in which the transfer occurs, but only with respect to 
that transfer (unless another transaction is also subject to the 
mandatory basis adjustment provisions of sections 734 or 743).
    The proposed regulations also provide that in determining whether 
there is a substantial built-in loss, section 743(b) adjustments and 
section 704(c)(1)(C) basis adjustments (except the transferee's section 
743(b) adjustments and section 704(c)(1)(C) basis adjustments, if any) 
are disregarded.
    The proposed regulations also provide special rules for determining 
fair market value in the case of a tiered partnership. The Treasury 
Department and the IRS are aware that there is some uncertainty as to 
how to determine the fair market value of a lower-tier partnership 
interest for purposes of determining whether the partnership has a 
substantial built-in loss in its assets when the upper-tier partnership 
is allocated a share of the lower-tier partnership's liabilities under 
section 752. The Treasury Department and the IRS believe it is 
appropriate for this purpose to gross up the fair market value of the 
lower-tier partnership interest by the upper-tier partnership's 
allocated share of liabilities; otherwise, the regulations could 
inappropriately treat a lower-tier partnership interest as a loss 
asset. Thus, under the proposed regulations, the fair market value of a 
lower-tier partnership interest (solely for purposes of computing the 
upper-tier partnership's basis adjustment under section 743(b)) is 
equal to the sum of: (i) the amount of cash that the upper-tier 
partnership would receive if the lower-tier partnership sold all of its 
property for cash to an unrelated person for an amount equal to the 
fair market value of such property, satisfied all of its liabilities, 
and liquidated; and (ii) the upper-tier partnership's share of the 
lower-tier partnership's liabilities (as determined under section 752 
and the regulations).
    In addition, the proposed regulations provide special rules for 
basis adjustments with respect to tiered partnerships. Under the 
authority granted by section 743(d)(2), the proposed regulations 
provide that if a partner transfers an interest in an upper-tier 
partnership that holds a direct or indirect interest in a lower-tier 
partnership, and the upper-tier partnership has a substantial built-in 
loss with respect to the transfer, each lower-tier partnership is 
treated, solely with respect to the transfer, as if it had made a 
section 754 election for the taxable year of the transfer. The Treasury 
Department and the IRS are aware of the practical and administrative 
difficulties associated with requiring a lower-tier partnership that 
has not elected under section 754 to adjust the basis of its assets in 
connection with the transfer of an interest in an upper-tier 
partnership. Comments are requested on the scope of this rule and on 
measures to ease administrative burdens while still accomplishing the 
objective of the statute.
    These proposed regulations also provide guidance on the application 
of section 743(b) adjustments in tiered partnership situations 
generally. Consistent with Rev. Rul. 87-115, 1987-2 CB 163, the 
proposed regulations provide that if an interest in an upper-tier 
partnership that holds an interest in a lower-tier partnership is 
transferred by sale or exchange or upon the death of a partner, and the 
upper-tier partnership and the lower-tier partnership both have 
elections in effect under section 754, then an interest in the lower-
tier partnership will be deemed to have been transferred by sale or 
exchange or

[[Page 3051]]

upon the death of a partner, as the case may be. The amount of the 
interest in the lower-tier partnership deemed to have been transferred 
is the portion of the upper-tier partnership's interest in the lower-
tier partnership that is attributable to the interest in the upper-tier 
partnership being transferred. Accordingly, to the extent the adjusted 
basis of the upper-tier partnership's interest in a lower-tier 
partnership is adjusted, the lower-tier partnership must adjust the 
basis of its properties.
    Section 743(e)(7) provides that the Secretary may prescribe 
regulations for applying the EIP rules to tiered partnerships, and the 
legislative history makes clear that Congress did not intend for EIPs 
to avoid the mandatory basis adjustment provisions through the use of 
tiered partnerships. See Conference Report, at 627. The Treasury 
Department and the IRS believe that the same concerns exist for tiered 
EIPs as exist for all other partnerships subject to the mandatory basis 
adjustment provisions. Accordingly, the proposed regulations do not 
include specific rules for tiered EIPs beyond the rules governing all 
tiered partnerships.
    The proposed regulations provide anti-abuse rules. The purpose of 
the amendments to section 743 is to prevent a partner that purchases an 
interest in a partnership with an existing built-in loss and no 
election under section 754 in effect from being allocated a share of 
the loss when the partnership disposes of the property or takes cost 
recovery deductions with respect to the property. Accordingly, 
consistent with the purpose of the amendments and the specific grant of 
regulatory authority in section 743(d)(2), the proposed regulations 
provide that the provisions of section 743 and the regulations 
thereunder regarding substantial built-in loss transactions must be 
applied in a manner consistent with the purpose of such provisions and 
the substance of the transaction. Thus, if a principal purpose of a 
transaction is to avoid the application of the substantial built-in 
loss rules with respect to a transfer, the Commissioner can recast the 
transaction for Federal income tax purposes as appropriate to achieve 
tax results that are consistent with the purpose of the provisions. 
Whether a tax result is inconsistent with the purpose of the 
substantial built-in loss provisions is determined based on all the 
facts and circumstances. For example, under the proposed regulations, 
property held by related partnerships may be aggregated and a 
contribution of property to a partnership may be disregarded in 
applying the substantial built-in loss provisions in section 743 and 
the regulations thereunder if the property was transferred with a 
principal purpose of avoiding the application of such provisions.
    Finally, the proposed regulations clarify that a partnership that 
has a substantial built-in loss immediately following the transfer of a 
partnership interest must comply with certain provisions of Sec.  
1.743-1(k). In this case, the partnership must attach a statement of 
adjustments to its partnership return as if an election under section 
754 were in effect at the time of the transfer solely with respect to 
the transfer for which there is a substantial built-in loss.
    One commenter on the Notice requested that the Treasury Department 
and the IRS provide a de minimis exception for the substantial built-in 
loss provisions for transfers of small interests (subject to an annual 
limit on aggregate transfers during a taxable year). The substantial 
built-in loss provisions are intended to prevent the inappropriate 
shifting of losses among partners, and neither the legislative history 
nor the statute suggests that Congress intended to limit the scope of 
the rule to the transfer of large interests. Accordingly, the Treasury 
Department and the IRS decline to provide an exception to the 
substantial built-in loss rules based on the size of the interest 
transferred. The Treasury Department and the IRS will continue to 
study, and request comments on, whether a rule is warranted that 
excludes de minimis basis adjustments from the mandatory adjustment 
provisions.
ii. EIPs
    The proposed regulations generally adopt the statutory language in 
section 743(e) and the provisions in the Notice. The Notice requested 
comments on certain aspects of the interim procedures for EIPs, and the 
Treasury Department and the IRS received comments in response to that 
request, which are described in this section.
    The Notice detailed reporting requirements for transferors of EIP 
interests so that transferees could comply with the loss limitation 
rule in section 743(e)(2). The proposed regulations clarify that the 
reporting requirements with respect to transferors of an interest in an 
EIP described in the Notice do not apply if the transferor recognizes 
gain on the transfer and no prior transferor recognized a loss on any 
transfer. The Treasury Department and the IRS do not believe reporting 
is necessary in this limited circumstance because the transferee should 
not be subject to the loss limitation rule of section 743(e)(2).
    In regard to the requirement in section 743(e)(6)(I) that the 
partnership agreement provide for a term that is not in excess of 15 
years, one commenter requested that regulations provide that a 
partnership may still qualify as an EIP even if the partnership's 
initial term is greater than 15 years, particularly in cases in which 
the amount of the partnership's equity investment in the remaining 
assets is small (for example, 25 percent of the total committed 
capital). However, Congress considered the circumstances in which it 
would be appropriate to provide an extension of the term and 
specifically provided an exception to the 15-year requirement for EIPs 
in existence on June 4, 2004. Accordingly, the Treasury Department and 
the IRS decline to adopt this comment in the proposed regulations.
    The Notice also provides guidance on whether a partnership has ever 
been engaged in a trade or business for purposes of section 
743(e)(6)(C). The Notice provides that until further guidance is 
issued, an upper-tier partnership will not be treated as engaged in the 
trade or business of a lower-tier partnership if, at all times during 
the period in which the upper-tier partnership owns an interest in the 
lower-tier partnership, the adjusted basis of its interest in the 
lower-tier partnership is less than 25 percent of the total capital 
that is required to be contributed to the upper-tier partnership by its 
partners during the entire term of the upper-tier partnership (the 
``25% Rule''). The Notice specifically requests comments on rules that 
would be appropriate for future guidance in determining whether an 
upper-tier partnership is treated as engaged in a trade or business 
that is conducted by a lower-tier partnership. One commenter requested 
that the Treasury Department and the IRS confirm whether the 25% Rule 
is a safe harbor or whether a violation of the 25% Rule disqualifies a 
partnership from being an EIP. This commenter also requested that the 
Treasury Department and the IRS clarify the 25% Rule in the case of 
borrowing. The commenter noted that lower-tier partnership interests 
are often acquired with capital contributions and the proceeds of 
borrowing. Therefore, the commenter requested that any safe harbor take 
into account leverage. This commenter further suggested that rules 
similar to the rules in Sec.  1.731-2(e)(3) (providing circumstances in 
which a partnership would not be treated as engaged in a trade or 
business for purposes of section 731(c)(3)(C)) should apply for 
purposes of section 743(e)(6)(C). Finally, the

[[Page 3052]]

commenter requested that the Treasury Department and the IRS provide 
additional safe harbors (for example, where the upper-tier partnership 
is organized for investment services and the partners and managers of 
the upper-tier partnership do not engage in the day-to-day operations 
of the lower-tier partnership's trade or business activity, but 
partners and/or managers are on the board of directors of the lower-
tier partnership).
    The Treasury Department and the IRS view the 25% Rule as a bright-
line rule. Therefore, a failure to meet the 25% Rule will mean that the 
partnership fails to qualify as an EIP. The Treasury Department and the 
IRS agree that the rules in Sec.  1.731-2(e)(3) should apply for 
purposes of section 743(e)(6)(C). Therefore, the proposed regulations 
provide a safe harbor by cross-referencing those rules. Under the 
proposed regulations, if a partnership would not be treated as engaged 
in a trade or business under Sec.  1.731-2(e)(3) for purposes of 
section 731(c)(3)(C), the partnership also will not be treated as 
engaged in a trade or business for purposes of section 743(e)(6)(C). 
The Treasury Department and the IRS believe the 25% Rule and the cross-
reference to Sec.  1.731-2(e)(3) provide appropriate guidance under 
section 743(e)(6)(C) and therefore the proposed regulations do not 
provide any additional safe harbors. The Treasury Department and the 
IRS are continuing to study the extent to which borrowing should be 
taken into account in applying the 25% Rule and therefore request 
comments on appropriate rules.
    A commenter also requested additional guidance regarding section 
743(e)(6)(H), which provides that one of the eligibility requirements 
for an EIP is that the partnership agreement have substantive 
restrictions on each partner's ability to cause a redemption of the 
partner's interest. The proposed regulations follow the examples in the 
legislative history and provide that substantive restrictions for 
purposes of section 743(e)(7)(H) include cases in which a redemption is 
permitted under a partnership agreement only if the redemption is 
necessary to avoid a violation of state, federal, or local laws (such 
as ERISA or the Bank Holding Company Act) or the imposition of a 
federal excise tax on, or a change in the federal tax-exempt status of, 
a tax-exempt partner. See Conference Report at 626. The Treasury 
Department and the IRS request comments on other restrictions that 
could be considered substantive restrictions on a partner's ability to 
cause a redemption of the partner's interest for purposes of section 
743(e)(6)(H).
    The proposed regulations provide that the EIP election must be made 
on a timely filed original return, including extensions. One commenter 
requested relief for certain instances in which the partnership fails 
to make a valid EIP election. The commenter requested relief when: (1) 
A partnership makes an EIP election, but did not qualify to make the 
election; (2) the partnership attempts to make an EIP election, but it 
is defective; or (3) the partnership makes an EIP election, but fails 
to continue to qualify. In each case, the commenter believes that the 
Treasury Department and the IRS should treat the partnership as an EIP 
if: (a) Its failure to qualify or the defect was inadvertent; (b) the 
partners and the partnership consistently treated the partnership as an 
EIP; (c) steps were taken to cure the defect in a reasonable period of 
time; and (d) the partners and the EIP agree to make any necessary 
adjustments. The Treasury Department and the IRS do not adopt this 
comment in the proposed regulations because there are existing 
procedures for situations in which a regulatory election is defective.
    The Treasury Department and the IRS request comments on appropriate 
rules for situations in which a partnership that has elected to be an 
EIP fails to qualify in a particular year, but then qualifies again in 
a future year. The Treasury Department and the IRS also request 
comments on the circumstances in which a qualifying partnership that 
has revoked an EIP election should be permitted to reelect and the 
rules and procedures that should apply to the reelection.
iii. Securitization Partnerships
    The proposed regulations generally restate the statutory provisions 
relating to the exception from the substantial built-in loss provisions 
for securitization partnerships.
b. Section 734 Substantial Basis Reduction Provisions
i. General Provisions
    The proposed regulations generally follow the statutory provisions 
regarding substantial basis reductions. Questions have been raised 
whether the $250,000 threshold in section 734(d)(1) applies to a 
partnership's aggregate distributions for a taxable year. The Treasury 
Department and the IRS believe that the better interpretation of 
section 734(a), (b), and (d) is that the threshold applies separately 
with respect to each distributee because: (1) Both section 734(a) and 
(b) refer to a distribution of property to ``a partner;'' and (2) 
section 734(b)(2)(A) and (B), referenced in section 734(d), refer to 
the ``distributee partner'' or the ``distributee.'' These references 
indicate that the substantial built-in loss provisions apply to each 
partner-distributee separately, but with respect to the entire 
distribution made to the distributee. That is, where multiple 
properties are distributed to a partner-distributee, the $250,000 
threshold is determined by reference to all properties distributed to 
the partner-distributee as part of the same distribution.
    The proposed regulations also provide additional guidance in 
several areas. The proposed regulations provide that if there is a 
substantial basis reduction, the partnership is treated as having an 
election under section 754 in effect for the taxable year in which the 
distribution occurs, but solely for the distribution to which the 
substantial basis reduction relates (unless another transaction is 
subject to the mandatory basis adjustment provisions of sections 734 or 
743). For example, if a partnership without a section 754 election in 
effect has a substantial basis reduction with respect to a 
distribution, and a partner in the partnership in that same year 
transfers a partnership interest (and the partnership does not have a 
substantial built-in loss immediately after the transfer), the 
partnership will be treated as having a section 754 election in effect 
for the distribution but not the transfer.
    The same issues exist in the context of section 734(b) adjustments 
and tiered partnerships as exist with respect to section 743(b) 
adjustments and tiered partnerships. Thus, the proposed regulations 
also provide guidance for substantial basis reductions in tiered 
partnership arrangements. Under the proposed regulations, if there is a 
substantial basis reduction with respect to a distribution by an upper-
tier partnership that (either directly or indirectly through one or 
more partnerships) holds an interest in a lower-tier partnership, each 
lower-tier partnership is treated, solely with respect to the 
distribution, as if it had made an election under section 754 for the 
taxable year in which the distribution occurs.
    These proposed regulations also provide guidance on the application 
of section 734(b) adjustments in tiered partnership situations 
generally. Consistent with Rev. Rul. 92-15, 1992-1 CB 215, if an upper-
tier partnership makes an adjustment under section 734(b) to the basis 
of an interest it holds in a lower-tier partnership that has an

[[Page 3053]]

election under section 754 in effect, the lower-tier partnership must 
make adjustments to the upper-tier partnership's share of the lower-
tier partnership's assets. The amount of the lower-tier partnership's 
adjustment is equal to the adjustment made by the upper-tier 
partnership to the basis of its interest in the lower-tier partnership. 
The lower-tier partnership's adjustment to the upper-tier partnership's 
share of its assets is for the upper-tier partnership only and does not 
affect the basis in the lower-tier partnership's property for the other 
partners of the lower-tier partnership.
    The Treasury Department and the IRS are aware of the practical and 
administrative difficulties associated with the requirement that a 
lower-tier partnership adjust the basis of its assets with respect to 
adjustments under both section 734 and section 743 and request comments 
on the scope of this rule and measures to ease the administrative 
burden while still accomplishing the objective of the statute.
    The proposed regulations also update Sec.  1.734-1(d) to clarify 
that its reporting requirements apply if there is a substantial basis 
reduction with respect to a distribution. In this case, the provisions 
of Sec.  1.734-1(d) apply solely with respect to the distribution to 
which the substantial basis reduction relates as if an election under 
section 754 were in effect at the time of the transfer.
ii. Securitization Partnerships
    The proposed regulations generally restate the statutory provisions 
relating to the exception from the substantial basis reduction 
provisions for securitization partnerships.

3. Section 755 Basis Allocation Rules

a. Section 755(c)
    The proposed regulations generally restate the statutory provisions 
of section 755(c) and provide rules applicable to an allocation of a 
downward adjustment in the basis of partnership property under sections 
734(b) and 755(a). As discussed in Part 3 of the Background section of 
this preamble, Congress enacted section 755(c) in response to the JCT's 
investigation of Enron Corporation. In addressing transactions among 
related parties, the JCT Enron Report specifically provides that:

    Partnership allocations between members of the same affiliated 
group (and, in general, related parties) may not have the same 
economic consequences as allocations between unrelated partners. As 
a result, related partners can use the partnership allocation rules 
inappropriately to shift basis among assets . . . The Joint 
Committee staff recommends that . . . the partnership basis rules 
should be altered to preclude an increase in basis to an asset if 
the offsetting basis reduction would be allocated to stock of a 
partner (or related party).

    JCT Enron Report, at 29-30. The proposed regulations provide that 
in making an allocation under section 755(a) of any decrease in the 
adjusted basis of partnership property under section 734(b), no 
allocation may be made to stock in a corporation (or any person related 
(within the meaning of sections 267(b) or 707(b)(1)) to such 
corporation) that is a partner in the partnership. Given Congress's 
intent to prevent taxpayers from shifting tax gain to stock of a 
corporate partner or corporation related to a corporate partner, the 
Treasury Department and the IRS believe it is appropriate to interpret 
section 755(c) to apply broadly to related persons under either section 
267(b) or section 707(b)(1). See Grassley Report, at 127 and House 
Committee Report, at 287. If section 755(c) only applied to persons 
treated as related within the meaning of both section 267(b) and 
section 707(b)(1), then the provision would apply in very limited 
circumstances, significantly restricting the scope of section 755(c).
b. Modification of Basis Allocation Rules for Substituted Basis 
Transactions
    The Treasury Department and the IRS are aware that the current 
basis allocation rules for substituted basis transactions can result in 
unintended consequences, particularly with regard to the ``net gain'' 
and ``net loss'' requirement in Sec.  1.755-1(b)(5)(ii). The net gain 
or net loss requirement in Sec.  1.755-1(b)(5)(ii) may, in certain 
situations, cause a partnership to be unable to properly adjust the 
basis of partnership property with respect to a transferee partner. For 
example, when there is an increase in basis to be allocated to 
partnership assets and the property of the partnership does not have 
overall unrealized net gain or net income, the basis increase cannot be 
allocated under Sec.  1.755-1(b)(5). Conversely, if there is a decrease 
in basis to be allocated to partnership assets and the property of the 
partnership does not have overall unrealized net loss, the basis 
decrease cannot be allocated under Sec.  1.755-1(b)(5). The Treasury 
Department and the IRS believe this result is inappropriate. 
Accordingly, the Treasury Department and the IRS propose to amend the 
current regulations as described in this preamble.
i. Allocations Between Classes of Property
    The proposed regulations provide that if there is an increase in 
basis to be allocated to partnership assets under Sec.  1.755-1(b)(5), 
the increase must be allocated between capital gain property and 
ordinary income property in proportion to, and to the extent of, gross 
gain or gross income (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 property in each class. The proposed 
regulations further provide that any remaining increase must be 
allocated between the classes in proportion to the fair market value of 
all property in each class.
    If there is a decrease in basis to be allocated to partnership 
assets under Sec.  1.755-1(b)(5), the proposed regulations provide that 
the decrease must be allocated between capital gain property and 
ordinary income property in proportion to, and to the extent of, the 
gross 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 
property in each class. Any remaining decrease must be allocated 
between the classes in proportion to the transferee's shares of the 
adjusted bases of all property in each class (as adjusted under the 
preceding sentence). Thus, the proposed regulations remove the 
requirements that (1) there be an overall net gain or net income in 
partnership property for an increase in basis to be allocated to a 
particular class of property; and (2) there be an overall net loss in 
partnership property for a decrease in basis to be allocated to a 
particular class of property.
ii. Allocations Within Classes of Property
    The Treasury Department and the IRS are aware that there is 
uncertainty regarding whether the transferee's shares of unrealized 
appreciation and depreciation described in Sec.  1.755-1(b)(5)(iii)(A) 
and (B) include only amounts attributable to the acquired partnership 
interest. The proposed regulations clarify that the transferee's shares 
of the items are limited to the amounts attributable to the acquired 
partnership interest.
    In addition, Sec.  1.755-1(b)(5)(iii)(C) has a limitation that 
provides that a transferee's negative basis adjustment is limited to 
the transferee's share of the partnership's adjusted basis in all

[[Page 3054]]

depreciated assets in that class. By focusing on the transferee's share 
of adjusted basis with respect to only depreciated assets in the class, 
as opposed to all assets in the class, this rule subjects more of the 
negative basis adjustment to the carryover rules in Sec.  1.755-
1(b)(5)(iii)(D). The Treasury Department and the IRS believe this 
result is inappropriate. Accordingly, the proposed regulations provide 
that if a decrease in basis must be allocated to partnership property 
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 assets in that class, the basis of the property is 
reduced to zero (but not below zero). Therefore, under the proposed 
regulations, the negative basis adjustment is no longer limited to the 
transferee's share of the partnership's adjusted basis in all 
depreciated assets in a class.
c. Succeeding to Transferor's Basis Adjustment
    The proposed regulations amend the regulations under section 743 to 
provide an exception to the rule that a transferee's basis adjustment 
is determined without regard to any prior transferee's basis 
adjustment. The Treasury Department and the IRS believe that this rule 
can lead to inappropriate results when the transferor transfers its 
partnership interest in a substituted basis transaction (within the 
meaning of Sec.  1.755-1(b)(5)) and the transferor had a basis 
adjustment under section 743(b) attributable to the transferred 
interest that was allocated pursuant to Sec.  1.755-1(b)(2) through 
(b)(4). Under the current regulations, the transferee does not succeed 
to the transferor's section 743(b) adjustment but, rather, is entitled 
to a new section 743(b) adjustment that is allocated under a different 
set of rules, which may result in the inappropriate shifting of basis 
among the partnership's assets. The proposed regulations provide that 
the transferee in a substituted basis transaction succeeds to that 
portion of the transferor's basis adjustment attributable to the 
transferred partnership interest and that the adjustment is taken into 
account in determining the transferee's share of the adjusted basis to 
the partnership for purposes of Sec. Sec.  1.743-1(b) and 1.755-
1(b)(5).

4. Miscellaneous Provisions

a. Special Rules for Forward and Reverse Section 704(c) Allocations
    One commenter on Notice 2009-70 noted that the definitions of the 
terms ``built-in gain'' and ``built-in loss'' in Sec.  1.704-
3(a)(3)(ii) imply that section 704(c) layers with ``different signs'' 
should be netted against each other because the regulations provide 
that built-in gain or built-in loss is reduced by differences in the 
property's adjusted tax basis and book value.
    In response to this comment, the proposed regulations provide that 
built-in gain and built-in loss do not take into account any decreases 
or increases, as the case may be, to the property's book value pursuant 
to a revaluation of partnership property under Sec.  1.704-
1(b)(2)(iv)(f). Thus, for example, under the proposed regulations, 
reverse section 704(c) allocations do not reduce forward section 704(c) 
gain or loss.
    The Treasury Department and the IRS also received several comments 
regarding the proper treatment of section 704(c) layers, suggesting one 
of two approaches. Under the layering approach, a partnership would 
create and maintain multiple section 704(c) layers for the property. 
Under the netting approach, a partnership would net multiple section 
704(c) layers for the property and therefore each section 704(c) 
property would have one section 704(c) layer. One commenter recommended 
that the layering approach be the default rule, but that certain 
partnerships should be permitted to adopt a netting approach depending 
on the value of the partnership's assets. This commenter believed that 
the layering approach is more appropriate because the netting approach 
can result in distortions when partnerships use the traditional method 
of allocating section 704(c) amounts and the ceiling rule is 
implicated. The commenter also argued that the layering approach better 
maintains the economic expectations of the partners and is generally 
more consistent with the policy underlying section 704(c). However, 
this commenter also acknowledged that the netting approach is simpler 
to apply, and that in many cases both approaches will reach the same 
result. Another commenter suggested that partnerships be given the 
option of using either the layering approach or the netting approach. 
According to the commenter, this would allow partnerships to avoid the 
burden and expense of maintaining section 704(c) layers, particularly 
when maintaining section 704(c) layers is unnecessary.
    The proposed regulations do not permit taxpayers to use a netting 
approach because a netting approach could lead to distortions. The 
Treasury Department and the IRS understand, however, that maintaining 
section 704(c) layers may result in additional administrative burdens 
and, therefore, request comments on when it is appropriate for 
partnerships to use a netting approach (for example, small 
partnerships).
    One commenter noted that guidance was necessary with respect to how 
to allocate tax items among multiple section 704(c) layers. This 
commenter suggested three methods for allocating tax items: (1) 
Allocate tax items to the oldest layer first; (2) allocate tax items to 
the newest section 704(c) layers first; and (3) allocate tax items 
among the section 704(c) layers pro rata based on the amount of each 
layer. The commenter suggested that the Treasury Department and the IRS 
provide a default rule that would allocate to the oldest section 704(c) 
layers first, but permit partnerships to elect any reasonable method 
(such as the three methods described).
    The Treasury Department and the IRS agree that partnerships should 
be permitted to use any reasonable method in allocating tax items. The 
Treasury Department and the IRS decline to adopt a default rule for 
allocating tax items because no single method is more appropriate than 
other methods. Therefore, the proposed regulations provide that a 
partnership may use any reasonable method to allocate items of income, 
gain, loss, and deduction associated with an item of property among the 
property's forward and reverse section 704(c) layers subject to the 
anti-abuse rule in Sec.  1.704-3(a)(10). The partnership's choice of 
method is also subject to Sec.  1.704-3(a)(2), which provides that a 
partnership may use different methods with respect to different items 
of contributed property, provided that the partnership and the partners 
consistently apply a single reasonable method for each item of 
contributed property and that the overall method or combination of 
methods is reasonable based on the facts and circumstances and 
consistent with the purpose of section 704(c). The Treasury Department 
and the IRS are considering providing examples of reasonable methods in 
future guidance and therefore request comments on these and other 
methods for allocating tax items.
b. Extension of Time Period for Taxing Precontribution Gain
    The proposed regulations amend various provisions in Sec. Sec.  
1.704-4, 1.737-1, and 1.1502-13 to reflect the amendments to sections 
704(c)(1)(B) and 737(b)(1) that lengthen the period of time for taxing 
precontribution gain from five years to seven years. The

[[Page 3055]]

proposed regulations also clarify how partners determine the seven-year 
period. Specifically, the proposed regulations provide that the seven-
year period begins on, and includes, the date of contribution, and ends 
on, and includes, the last date that is within seven years of the 
contribution.

Proposed Effective Date

    These regulations are generally proposed to apply to partnership 
contributions and transactions occurring on or after the date final 
regulations are published in the Federal Register. The proposed 
regulations under Sec.  1.755-1(b)(5) will apply to transfers of 
partnership interests occurring on or after January 16, 2014. No 
inference is intended as to the tax consequences of transactions 
occurring before the effective date of these regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866, as supplemented by Executive Order 13563. Therefore, a 
regulatory assessment is not required. It has also been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
does not apply to these regulations. It is hereby certified that the 
collection of information in this notice of proposed rulemaking will 
not have a significant economic impact on a substantial number of small 
entities within the meaning of section 601(6) of the Regulatory 
Flexibility Act (5 U.S.C. chapter 6). The Treasury Department and the 
IRS believe that the economic impact on small entities as a result of 
the collection of information in this notice of proposed rulemaking 
will not be significant. The small entities subject to the collection 
are business entities formed as partnerships that: (1) Receive a 
contribution of built-in loss property; (2) are required to make a 
mandatory basis adjustment under section 734 or section 743; and/or (3) 
are eligible for, and elect to apply, the electing investment 
partnership provisions in section 743(e). In the case of the 
contribution of built-in loss property, the partnership is required to 
provide a statement in the year of contribution setting forth basic 
information that the partnership will need in order to properly apply 
the rules. Similarly, in the case of the mandatory basis adjustment 
provisions, the partnership will already have the information subject 
to the collection in order to comply with the rules. In the case of 
EIPs, the collections are either one-time (election) or annual (annual 
statement). The collection only applies if the partnership elects to be 
an EIP. Furthermore, the proposed regulations provide the specific 
language for the annual statement. Finally, the collection regarding 
the mandatory basis adjustment provisions and the EIP rules have been 
in effect since 2005, as required by Notice 2005-32, and the Treasury 
Department and the IRS have not received comments that the collections 
have a significant economic impact. For these reasons, the Treasury 
Department and the IRS do not believe that the collection of 
information in this notice of proposed rulemaking has a significant 
economic impact. Pursuant to section 7805(f) of the Code, this notice 
of proposed rulemaking will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business.

Comments and Public Hearing

    Before the proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The Treasury Department and the IRS request comments on all 
aspects of the proposed rules. All comments will be available for 
public inspection and copying.
    A public hearing has been scheduled for April 30, 2014 beginning at 
10:00 a.m. in the Auditorium, Internal Revenue Building, 1111 
Constitution Avenue NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble. April 16, 2014.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments by April 16, 2014, and an outline of the topics to be 
discussed and the time to be devoted to each topic (signed original and 
eight (8) copies) by April 16, 2014. A period of 10 minutes will be 
allotted to each person for making comments. An agenda showing the 
scheduling of the speakers will be prepared after the deadline for 
receiving outlines has passed. Copies of the agenda will be available 
free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are Wendy L. Kribell and 
Benjamin H. Weaver, Office of the Associate Chief Counsel (Passthroughs 
& Special Industries). However, other personnel from the Treasury 
Department and the IRS participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR Part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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

0
Par. 2. Section 1.704-3 is amended by:
0
1. Revising paragraph (a)(3)(ii).
0
2. Adding paragraph (a)(3)(iii).
0
3. Revising paragraph (a)(6)(i).
0
4. Adding paragraph (a)(6)(iii).
0
5. Adding paragraph (a)(6)(iv).
0
6. Revising paragraph (a)(7).
0
7. Revising the first sentence in paragraph (a)(10) by removing the 
word ``allocation'' before the word ``method''.
0
8. Redesignating paragraph (f) as paragraph (g).
0
9. Adding a new paragraph (f).
0
10. Adding a sentence at the end of newly redesignated paragraph (g).
    The revisions and additions read as follows.


Sec.  1.704-3  Contributed property.

    (a) * * *
    (3) * * *
    (ii) Built-in gain and built-in loss. The built-in gain on section 
704(c) property is the excess of the property's book value over the 
contributing partner's adjusted tax basis upon contribution. The built-
in gain is thereafter reduced by decreases in the difference between 
the property's book value and adjusted tax basis (other than decreases 
to the property's book value pursuant to Sec.  1.704-1(b)(2)(iv)(f)). 
The built-in loss on section 704(c) property is the excess of the 
contributing partner's adjusted tax basis over the property's book 
value upon contribution. The built-in loss is thereafter reduced by 
decreases in the difference between the property's adjusted tax basis 
and book value (other than increases to the property's book

[[Page 3056]]

value pursuant to Sec.  1.704-1(b)(2)(iv)(f)). For purposes of 
paragraph (a)(6)(iii) and (iv) of this section, a built-in gain or 
built-in loss referred to in this paragraph shall be referred to as a 
forward section 704(c) allocation. See Sec.  1.460-4(k)(3)(v)(A) for a 
rule relating to the amount of built-in income or built-in loss 
attributable to a contract accounted for under a long-term contract 
method of accounting.
    (iii) Effective/applicability date. The provisions of paragraph 
(a)(3)(ii) of this section apply to partnership contributions and 
transactions occurring on or after the date of publication of the 
Treasury decision adopting these rules as final regulations in the 
Federal Register. * * *
* * * * *
    (6) (i) Revaluations under section 704(b). The principles of this 
section apply with respect to property for which differences between 
book value and adjusted tax basis are created when a partnership 
revalues partnership property pursuant to section 1.704-1(b)(2)(iv)(f) 
(reverse section 704(c) allocations). Each such revaluation creates a 
separate amount of built-in gain or built-in loss, as the case may be 
(a section 704(c) layer), that must be tracked separately from built-in 
gain or built-in loss arising from contribution (a forward section 
704(c) layer) and any other revaluation (a reverse section 704(c) 
layer). For instance, one section 704(c) layer with respect to a 
particular property may be of built-in gain, and another section 704(c) 
layer with respect to the same property may be of built-in loss.
* * * * *
    (iii) Allocation method. A partnership may use any reasonable 
method to allocate the items of income, gain, loss, and deduction 
associated with an item of property among the property's forward and 
reverse section 704(c) layers.
    (iv) Effective/applicability date. The provisions of paragraph 
(a)(6)(iii) of this section apply to partnership contributions and 
transactions occurring on or after the date of publication of the 
Treasury decision adopting these rules as final regulations in the 
Federal Register.
* * * * *
    (7) Transfers of a partnership interest. If a contributing partner 
transfers a partnership interest, built-in gain must be allocated to 
the transferee partner as it would have been allocated to the 
transferor partner. If the contributing partner transfers a portion of 
the partnership interest, the share of built-in gain proportionate to 
the interest transferred must be allocated to the transferee partner. 
Rules for the allocation of built-in loss are provided in paragraph (f) 
of this section.
* * * * *
    (f) Special rules for built-in loss property--(1) General 
principles--(i) Contributing partner. If a partner contributes section 
704(c)(1)(C) property (as defined in paragraph (f)(2)(i) of this 
section) to a partnership, the excess of the adjusted basis of the 
section 704(c)(1)(C) property (determined without regard to paragraph 
(f)(1)(ii) of this section) over its fair market value immediately 
before the contribution will be taken into account only in determining 
the amount of items allocated to the section 704(c)(1)(C) partner (as 
defined in paragraph (f)(2)(ii) of this section) that contributed such 
section 704(c)(1)(C) property.
    (ii) Non-contributing partners. In determining the amount of items 
allocated to partners other than the section 704(c)(1)(C) partner, the 
initial basis of section 704(c)(1)(C) property in the hands of the 
partnership is equal to the property's fair market value at the time of 
contribution.
    (2) Definitions. For purposes of this section--
    (i) Section 704(c)(1)(C) property. The term section 704(c)(1)(C) 
property means section 704(c) property (as defined in paragraph 
(a)(3)(i) of this section) with a built-in loss at the time of 
contribution. Section 704(c)(1)(C) property does not include a Sec.  
1.752-7 liability (within the meaning of Sec.  1.752-7(b)(3)) or 
property for which differences between book value and adjusted tax 
basis are created when a partnership revalues property pursuant to 
Sec.  1.704-1(b)(2)(iv)(f).
    (ii) Section 704(c)(1)(C) partner. The term section 704(c)(1)(C) 
partner means a partner that contributes section 704(c)(1)(C) property 
to a partnership.
    (iii) Section 704(c)(1)(C) basis adjustment. A property's section 
704(c)(1)(C) basis adjustment is initially equal to the excess of the 
adjusted basis of section 704(c)(1)(C) property (determined without 
regard to paragraph (f)(1)(ii) of this section) over its fair market 
value immediately before the contribution, and is subsequently adjusted 
for the recovery of the section 704(c)(1)(C) basis adjustment under 
paragraph (f)(3)(ii)(D) of this section.
    (3) Operational rules--(i) In general. Except as provided in this 
section, section 704(c)(1)(C) property is subject to the rules and 
regulations applicable to section 704(c) property. See, for example, 
Sec.  1.704-3(a)(9).
    (ii) Effect of section 704(c)(1)(C) basis adjustment--(A) In 
general. The section 704(c)(1)(C) basis adjustment is an adjustment to 
the basis of partnership property with respect to the section 
704(c)(1)(C) partner only. A section 704(c)(1)(C) basis adjustment 
amount is excluded from the partnership's basis of section 704(c)(1)(C) 
property. Thus, for purposes of calculating income, deduction, gain, 
and loss, the section 704(c)(1)(C) partner will have a special basis 
for section 704(c)(1)(C) property in which the partner has a section 
704(c)(1)(C) basis adjustment. The section 704(c)(1)(C) basis 
adjustment has no effect on the partnership's computation of any item 
under section 703.
    (B) Computation of section 704(c)(1)(C) 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 section 704(c)(1)(C) partner, in accordance 
with section 704, and adjusts the partners' capital accounts 
accordingly. The partnership then adjusts the section 704(c)(1)(C) 
partner's distributive share of the items of partnership income, 
deduction, gain, or loss in accordance with paragraphs (f)(3)(ii)(C) 
and (D) of this section, to reflect the effects of the section 
704(c)(1)(C) partner's section 704(c)(1)(C) basis adjustment. These 
adjustments to the section 704(c)(1)(C) partner's distributive share 
must be reflected on Schedules K and K-1 of the partnership's return 
(Form 1065). The adjustments to the section 704(c)(1)(C) partner's 
distributive shares do not affect the section 704(c)(1)(C) partner's 
capital account.
    (C) Effect of section 704(c)(1)(C) basis adjustment in determining 
items of income, gain, or loss. The amount of a section 704(c)(1)(C) 
partner's income, gain, or loss from the sale or exchange of 
partnership property in which the section 704(c)(1)(C) partner has a 
section 704(c)(1)(C) basis adjustment is equal to the section 
704(c)(1)(C) partner's share of the partnership's gain or loss from the 
sale of the property (including any remedial allocations under Sec.  
1.704-3(d)), minus the section 704(c)(1)(C) partner's section 
704(c)(1)(C) basis adjustment for the partnership property.
    (D) Effect of section 704(c)(1)(C) basis adjustment in determining 
items of deduction--(1) In general. If section 704(c)(1)(C) property is 
subject to amortization under section 197, depreciation under section 
168, or other cost recovery in the hands of the section 704(c)(1)(C) 
partner, the section

[[Page 3057]]

704(c)(1)(C) basis adjustment associated with the property is recovered 
in accordance with section 197(f)(2), section 168(i)(7), or another 
applicable Internal Revenue Code section. The amount of any section 
704(c)(1)(C) basis adjustment that is recovered by the section 
704(c)(1)(C) partner in any year is added to the section 704(c)(1)(C) 
partner'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 section 
704(c)(1)(C) basis adjustment.

    (2) Example.  A contributes Property, with an adjusted basis of 
$12,000 and a fair market value of $5,000 on January 1 of the year 
of contribution, and B contributes $5,000 to PRS, a partnership. 
Prior to the contribution, A depreciates Property under section 168 
over 10 years using the straight-line method and the half-year 
convention. On the contribution date, Property has 7.5 years 
remaining in its recovery period. Property is section 704(c)(1)(C) 
property, and A's section 704(c)(1)(C) basis adjustment is $7,000. 
PRS's basis in Property is $5,000 (fair market value) and, in 
accordance with section 168(i)(7), the depreciation is $667 per year 
($5,000 divided by 7.5 years), which is shared equally between A and 
B. A's $7,000 section 704(c)(1)(C) basis adjustment is subject to 
depreciation of $933 per year in accordance with section 168(i)(7) 
($7,000 divided by 7.5 years), which is taken into account by A.

    (iii) Transfer of section 704(c)(1)(C) partner's partnership 
interest--(A) General rule. Except as provided in paragraph 
(f)(3)(iii)(B) of this section, if a section 704(c)(1)(C) partner 
transfers its partnership interest, the portion of the section 
704(c)(1)(C) basis adjustment attributable to the interest transferred 
is eliminated and the transferee is not treated as the section 
704(c)(1)(C) partner with respect to the interest transferred. The 
transferor remains the section 704(c)(1)(C) partner with respect to any 
remaining section 704(c)(1)(C) basis adjustment.
    (B) Special rules--(1) General rule for transfer of partnership 
interest in nonrecognition transaction. Except as provided in paragraph 
(f)(3)(iii)(B)(2) of this section, paragraph (f)(3)(iii)(A) of this 
section does not apply to the extent a section 704(c)(1)(C) partner 
transfers its partnership interest in a nonrecognition transaction. 
Instead, the transferee of all or a portion of a section 704(c)(1)(C) 
partner's partnership interest succeeds to the transferor's section 
704(c)(1)(C) basis adjustments in an amount attributable to the 
interest transferred and the transferee will be treated as the section 
704(c)(1)(C) partner with respect to the transferred interest. 
Regardless of whether a section 754 election is in effect or a 
substantial built-in loss exists with respect to the transfer, the 
amount of any section 704(c)(1)(C) basis adjustment with respect to 
section 704(c)(1)(C) property to which the transferee succeeds shall be 
decreased by the amount of the negative section 743(b) adjustment that 
would be allocated to the section 704(c)(1)(C) property pursuant to the 
provisions of Sec.  1.755-1 if the partnership had a section 754 
election in effect upon the transfer. If the nonrecognition transaction 
is described in section 168(i)(7)(B), then the rules in section 
168(i)(7)(A) apply with respect to transferor's cost recovery 
deductions under section 168. If gain or loss is recognized on the 
transaction, appropriate adjustments must be made to the section 
704(c)(1)(C) basis adjustment.
    (2) Exception for gifts. Paragraph (f)(3)(iii)(B)(1) of this 
section does not apply to the transfer of all or a portion of a section 
704(c)(1)(C) partner's partnership interest by gift.
    (C) Examples. The following examples illustrate the principles of 
this paragraph (f)(3)(iii)--

    Example 1. Sale of entire partnership interest. In Year 1, A 
contributes non-depreciable Property, with an adjusted basis of 
$11,000 and a fair market value of $5,000, and B and C each 
contribute $5,000 cash to PRS, a partnership. PRS's basis in 
Property is $5,000, and A's section 704(c)(1)(C) basis adjustment in 
Property is $6,000. In Year 3, Property's fair market value is 
unchanged and A's section 704(c)(1)(C) basis adjustment remains 
$6,000. D purchases A's interest in PRS for its fair market value of 
$5,000. PRS does not have a section 754 election in effect in Year 
3. A recognizes a loss of $6,000 on the sale, which equals the 
excess of its basis in PRS ($11,000) over the amount realized on the 
sale ($5,000). Pursuant to paragraph (f)(3)(iii)(A) of this section, 
D does not succeed to A's section 704(c)(1)(C) basis adjustment, 
which is eliminated upon the sale.
    Example 2. Sale of portion of partnership interest. Assume the 
same facts as Example 1 except that D purchases 50 percent of A's 
interest in PRS for its fair market value of $2,500. A recognizes a 
loss of $3,000 on the sale, which equals the excess of its basis in 
the 50 percent interest in PRS ($5,500) over the amount realized on 
the sale ($2,500). Pursuant to paragraph (f)(3)(iii)(A) of this 
section, D does not succeed to A's section 704(c)(1)(C) basis 
adjustment, and A's section 704(c)(1)(C) basis adjustment is reduced 
to $3,000 upon the sale.
    Example 3. Section 721 transaction--(i) Assume the same facts as 
Example 1 except that instead of selling its interest in PRS to D in 
Year 3, A contributes its interest in PRS to UTP, a partnership, in 
exchange for a 50 percent interest in UTP. Following the 
contribution, UTP's basis in PRS is $5,000 plus a $6,000 section 
704(c)(1)(C) basis adjustment solely allocable to A. Under the facts 
of this example, UTP's share of basis in PRS property is the same.
    (ii) Under paragraph (f)(3)(iii)(B)(1) of this section, UTP 
succeeds to A's $6,000 section 704(c)(1)(C) basis adjustment in 
Property. PRS does not have a section 754 election in effect and 
does not have a substantial built-in loss (within the meaning of 
Sec.  1.743-1(a)(2)(i)) with respect to the transfer. Paragraph 
(f)(3)(iii)(B)(1) of this section requires PRS to reduce the amount 
of the section 704(c)(1)(C) basis adjustment by the amount of the 
negative section 743(b) adjustment that would be allocated to 
Property if PRS had an election under section 754 in effect. Because 
UTP's basis in PRS equals UTP's share of basis in PRS property, no 
negative section 743(b) adjustment would result from the transfer. 
Accordingly, UTP's section 704(c)(1)(C) basis adjustment in Property 
is $6,000. Pursuant to paragraph (a)(9) of this section, UTP must 
allocate its distributive share of PRS's items with respect to the 
section 704(c)(1)(C) basis adjustment solely to A.
    (iii) In Year 3, PRS sells Property for its fair market value of 
$5,000. PRS realizes no gain or loss on the sale. Pursuant to 
paragraph (f)(3)(ii)(C) of this section, PRS reduces UTP's allocable 
gain from the sale of Property ($0) by the amount of UTP's section 
704(c)(1)(C) basis adjustment for Property ($6,000). Thus, UTP is 
allocated a $6,000 loss. Pursuant to paragraph (a)(9) of this 
section, UTP must allocate the $6,000 loss with respect to the 
section 704(c)(1)(C) basis adjustment to A. A's basis in UTP 
decreases from $11,000 to $5,000 and its section 704(c)(1)(C) basis 
adjustment in UTP is eliminated.
    Example 4. Interaction with section 362(e)(2)(A)--(i) Assume the 
same facts as Example 1 except that instead of selling its interest 
in PRS to D in Year 3, A contributes its interest in PRS to Y Corp, 
a corporation, in a transfer described in section 351. PRS has a 
section 754 election in effect. A's basis in its Y Corp stock is 
$11,000 under section 358.
    (ii) A and Y Corp do not elect to apply the provisions of 
section 362(e)(2)(C). Therefore, section 362(e)(2)(A) will apply 
because Y Corp's basis in PRS ($11,000) would exceed the fair market 
value of PRS ($5,000) immediately after the transaction. Thus, 
pursuant to section 362(e)(2)(B), Y Corp's basis in PRS will be 
$5,000. Y Corp succeeds to A's $6,000 section 704(c)(1)(C) basis 
adjustment in Property pursuant to paragraph (f)(3)(iii)(B)(1) of 
this section. Pursuant to Sec.  1.743-1, Y Corp's section 743(b) 
adjustment is ($6,000), or the difference between Y Corp's basis in 
PRS of $5,000 and Y Corp's share of the adjusted basis of PRS's 
property of $11,000 (which is Y Corp's cash on liquidation of 
$5,000, increased by the $6,000 tax loss that would be allocated to 
Y Corp upon a hypothetical transaction). The ($6,000) section 743(b) 
adjustment will be allocated to PRS's property in accordance with 
section 755 and the regulations thereunder.
    Example 5. Gift of partnership interest. Assume the same facts 
as Example 1 except that instead of selling its PRS interest to D in 
Year 3, A makes a gift of its PRS interest

[[Page 3058]]

to D. Pursuant to paragraph (f)(3)(iii)(B)(2) of this section, D 
does not succeed to any of A's section 704(c)(1)(C) basis adjustment 
in Property. The $6,000 section 704(c)(1)(C) basis adjustment is 
eliminated upon the gift.

    (iv) Transfer of section 704(c)(1)(C) property by partnership--(A) 
Like-kind exchange--(1) General rule. If a partnership disposes of 
section 704(c)(1)(C) property in a like-kind exchange described in 
section 1031 and the regulations thereunder, the substituted basis 
property (as defined in section 7701(a)(42)) received by the 
partnership is treated, solely with respect to the section 704(c)(1)(C) 
partner, as section 704(c)(1)(C) property with the same section 
704(c)(1)(C) basis adjustment as the section 704(c)(1)(C) property 
disposed of by the partnership (with appropriate adjustments for any 
portion of the section 704(c)(1)(C) basis adjustment taken into account 
in determining the section 704(c)(1)(C) partner's gain or loss 
recognized on the transfer).

    (2) Example. A contributes Property 1 with an adjusted basis of 
$12,000 and a fair market value of $10,000 and B contributes $10,000 
cash to PRS, a partnership. A has a $2,000 section 704(c)(1)(C) 
basis adjustment in Property 1, and PRS has an adjusted basis in 
Property 1 of $10,000, or its fair market value. PRS subsequently 
engages in a like-kind exchange under section 1031 of Property 1 
when the fair market value of Property 1 is $13,000 and receives 
Property 2 with a fair market value of $12,000 and $1,000 cash in 
exchange. PRS's gain on the transaction is $3,000 ($13,000 minus 
PRS's $10,000 adjusted basis) but is recognized only to the extent 
of the cash received of $1,000, of which $500 is allocable to A. As 
provided in paragraph (f)(3)(iv)(A)(1) of this section, Property 2 
is treated as section 704(c)(1)(C) property with respect to A and 
has the same section 704(c)(1)(C) basis adjustment as Property 1. 
Because PRS recognized gain on the transaction, A must use $500 of 
its section 704(c)(1)(C) basis adjustment to reduce A's gain to $0. 
Therefore, A's $2,000 section 704(c)(1)(C) basis adjustment is 
reduced to $1,500.

    (B) Contribution of 704(c)(1)(C) property in section 721 
transaction--(1) In general. The rules set forth in this paragraph 
(f)(3)(iv)(B) apply if a section 704(c)(1)(C) partner contributes 
section 704(c)(1)(C) property to an upper-tier partnership, and that 
upper-tier partnership subsequently contributes the section 
704(c)(1)(C) property to a lower-tier partnership in a transaction 
described in section 721(a) (whether as part of a single transaction or 
as separate transactions). The interest in the lower-tier partnership 
received by the upper-tier partnership is treated as the section 
704(c)(1)(C) property with the same section 704(c)(1)(C) basis 
adjustment as the contributed property. The lower-tier partnership 
determines its basis in the contributed property by excluding the 
existing section 704(c)(1)(C) basis adjustment under the principles of 
paragraph (f)(3)(ii)(A) of this section. However, the lower-tier 
partnership also succeeds to the upper-tier partnership's section 
704(c)(1)(C) basis adjustment. The portion of the upper-tier 
partnership's basis in its interest in the lower-tier partnership 
attributable to the section 704(c)(1)(C) basis adjustment must be 
segregated and allocated solely to the section 704(c)(1)(C) partner for 
whom the initial section 704(c)(1)(C) basis adjustment was made. 
Similarly, the section 704(c)(1)(C) basis adjustment to which the 
lower-tier partnership succeeds must be segregated and allocated solely 
to the upper-tier partnership, and the section 704(c)(1)(C) partner for 
whom the initial section 704(c)(1)(C) basis adjustment was made. If 
gain or loss is recognized on the transaction, appropriate adjustments 
must be made to the section 704(c)(1)(C) basis adjustment.
    (2) Special rules. (a) To the extent that any section 704(c)(1)(C) 
basis adjustment in a tiered partnership is recovered under paragraphs 
(f)(3)(ii)(C) or (D) of this section, or is otherwise reduced, upper- 
or lower-tier partnerships in the tiered structure must make conforming 
reductions to related section 704(c)(1)(C) basis adjustments to prevent 
duplication of loss.
    (b) Section 704(c)(1)(C) property that is contributed by an upper-
tier partnership to a lower-tier partnership will have an additional 
section 704(c)(1)(C) basis adjustment if the value of the section 
704(c)(1)(C) property is less than its tax basis (as adjusted under 
paragraph (f)(3)(ii) of this section) at the time of the transfer to 
the lower-tier partnership. Any additional section 704(c)(1)(C) basis 
adjustment determined under this paragraph will be allocated among the 
partners of the upper-tier partnership in a manner that reflects their 
relative shares of that loss.

     (3) Example 1-- (i) In Year 1, A contributes Property with an 
adjusted basis of $11,000 and a fair market value of $5,000, and B 
contributes $5,000 cash to UTP, a partnership. Later in Year 1, when 
Property's basis has not changed, and Property is worth at least 
$5,000, UTP contributes Property to LTP in a section 721 transaction 
for a 50-percent interest in LTP. In Year 2, LTP sells Property for 
its fair market value of $29,000.
    (ii) A has a $6,000 section 704(c)(1)(C) basis adjustment in 
Property. After the section 721 transaction, A's section 
704(c)(1)(C) basis adjustment in Property becomes A's section 
704(c)(1)(C) adjustment in UTP's interest in LTP. UTP has a section 
704(c)(1)(C) adjustment in Property in the amount of A's section 
704(c)(1)(C) adjustment in Property. This section 704(c)(1)(C) 
adjustment must be segregated and allocated solely to A. UTP's basis 
in its interest in LTP is determined without reference to the 
section 704(c)(1)(C) adjustment. Thus, UTP's basis in LTP is $5,000. 
LTP's basis in Property is determined without reference to the 
section 704(c)(1)(C) basis adjustment; therefore, LTP's basis in 
Property is $5,000.
    (iii) Upon the sale of Property, LTP realizes a gain of $24,000 
($29,000 fair market value minus $5,000 adjusted basis). UTP's 
allocable share of the $24,000 gain from the sale of Property by LTP 
is $12,000, reduced by UTP's $6,000 section 704(c)(1)(C) basis 
adjustment in Property. Because UTP's section 704(c)(1)(C) basis 
adjustment must be segregated and allocated solely to A, UTP 
allocates the $12,000 of gain equally between A and B, but allocates 
the recovery of the $6,000 section 704(c)(1)(C) basis adjustment to 
A. Therefore, pursuant to paragraph (f)(3)(ii)(C) of this section, A 
recognizes no gain or loss on the sale (A's $6,000 share of UTP's 
gain minus the $6,000 section 704(c)(1)(C) basis adjustment). 
Because UTP's section 704(c)(1)(C) adjustment in Property is used, 
A's section 704(c)(1)(C) basis adjustment in UTP's interest in LTP 
is reduced to $0 to prevent duplication of loss pursuant to 
paragraph (f)(3)(iv)(B)(2)(a) of this section.
    Example 2-- Assume the same facts as Example 1, except that in 
Year 2, UTP sells its entire interest in LTP to D for its fair 
market value of $17,000. UTP recognizes a $12,000 gain on the sale, 
which equals the excess of UTP's amount realized on the sale 
($17,000) over UTP's basis in LTP ($5,000). UTP allocates the 
$12,000 gain equally to A and B. However, A's $6,000 section 
704(c)(1)(C) adjustment in UTP's interest in LTP offsets A's share 
of the gain. Therefore, A recognizes no gain or loss on the sale. D 
does not receive any of UTP's section 704(c)(1)(C) basis adjustment 
in Property, which is eliminated upon the sale.
    Example 3-- (i) Assume the same facts as Example 1, except that 
at the time UTP contributes Property to LTP, the fair market value 
of Property has fallen to $2,000. In Year 2, LTP sells Property for 
its fair market value of $2,000.
    (ii) A has a $6,000 section 704(c)(1)(C) basis adjustment in 
Property. After the section 721 transaction, pursuant to paragraph 
(f)(3)(iv)(B)(1) of this section, A's section 704(c)(1)(C) basis 
adjustment in Property becomes A's section 704(c)(1)(C) adjustment 
in UTP's interest in LTP. Pursuant to paragraph (f)(3)(iv)(B)(1) of 
this section, UTP has a section 704(c)(1)(C) adjustment in Property 
in the amount of A's section 704(c)(1)(C) adjustment in Property. 
This section 704(c)(1)(C) adjustment must be segregated and 
allocated solely to A. Because UTP's basis in Property ($5,000) 
exceeds the fair market value of Property ($2,000) by $3,000 at the 
time of UTP's contribution to LTP, UTP has an additional section 
704(c)(1)(C) adjustment of $3,000 in Property pursuant to paragraph 
(f)(3)(iv)(B)(2)(b) of this section. Partners A and B share equally 
in this $3,000 section 704(c)(1)(C)

[[Page 3059]]

adjustment. UTP's basis in its interest in LTP is determined without 
reference to A's section 704(c)(1)(C) adjustment. Thus, UTP's basis 
in LTP is $5,000. Pursuant to paragraph (f)(3)(iv)(B)(1) of this 
section, LTP's basis in Property is determined without reference to 
either section 704(c)(1)(C) basis adjustment; therefore, LTP's basis 
in Property is $2,000.
    (iii) Upon the sale of Property, LTP recognizes no gain or loss 
($2,000 sales price minus $2,000 adjusted basis). However, the sale 
of Property triggers UTP's two separate section 704(c)(1)(C) basis 
adjustments. First, UTP applies the $3,000 section 704(c)(1)(C) 
adjustment attributable to the built-in loss in Property arising 
after A contributed Property to UTP. This results in an allocation 
of ($1,500) of loss to each of A and B. Next, UTP applies the $6,000 
section 704(c)(1)(C) basis adjustment attributable to A's initial 
contribution of Property to UTP, resulting in an additional ($6,000) 
of loss allocated to A. Thus, the sale of Property by LTP results in 
A recognizing ($7,500) of loss, and B recognizing ($1,500) of loss. 
Pursuant to paragraph (f)(3)(iv)(B)(2)(a) of this section, because 
UTP's section 704(c)(1)(C) adjustment in Property is used, A's 
section 704(c)(1)(C) basis adjustment in UTP's interest in LTP is 
reduced to $0 to prevent duplication of loss.

    (C) Section 351 transactions--(1) Basis in transferred property. A 
corporation's adjusted basis in property transferred to the corporation 
by a partnership in a transaction described in section 351 is 
determined under section 362 (including for purposes of applying 
section 362(e)) by taking into account any section 704(c)(1)(C) basis 
adjustment for the property (other than any portion of a section 
704(c)(1)(C) basis adjustment that reduces a partner's gain under 
paragraph (f)(3)(iv)(C)(2) of this section).
    (2) Partnership gain. The amount of gain, if any, recognized by the 
partnership on the transfer of property by the partnership to a 
corporation in a transfer described in section 351 is determined 
without regard to any section 704(c)(1)(C) basis adjustment for the 
transferred property. The amount of gain, if any, recognized by the 
partnership on the transfer that is allocated to the section 
704(c)(1)(C) partner is adjusted to reflect the partner's section 
704(c)(1)(C) basis adjustment in the transferred property.
    (3) Basis in stock. The partnership's adjusted basis in stock 
received from a corporation in a transfer described in section 351 is 
determined without regard to the section 704(c)(1)(C) basis adjustment 
in property transferred to the corporation in the section 351 exchange. 
A partner with a section 704(c)(1)(C) 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 section 704(c)(1)(C) basis adjustment in 
the transferred property, reduced by any portion of the section 
704(c)(1)(C) basis adjustment that reduced the partner's gain under 
paragraph (f)(3)(iv)(C)(2) of this section.
    (4) Example. The following example illustrates the provisions of 
this paragraph (f)(3)(iv)(C).

    Example. Section 351 transaction --(i) In Year 1, A contributes 
$10,000 cash and B contributes Property with an adjusted basis of 
$18,000 and a fair market value of $10,000 to PRS, a partnership. 
PRS takes Property with a basis of $10,000. B's section 704(c)(1)(C) 
basis adjustment for Property is $8,000. PRS contributes Property to 
Y Corp in a section 351 transaction. Under section 362(e)(2)(A), Y 
Corp takes a $10,000 basis in Property. PRS's basis in its Y Corp 
stock is $10,000 under section 358. Pursuant to paragraph 
(f)(3)(iv)(C)(3) of this section, B has a section 704(c)(1)(C) basis 
adjustment of $8,000 in the Y Corp stock received by PRS in the 
section 351 exchange.
    (ii) In Year 2, Y Corp sells Property for its fair market value 
of $10,000. Y Corp recognizes no gain or loss on the sale of 
Property. Pursuant to paragraph (f)(3)(iv)(C)(1) of this section, B 
does not take into account its section 704(c)(1)(C) basis adjustment 
upon the sale by Y Corp of Property. Instead, B will take the 
section 704(c)(1)(C) basis adjustment into account when PRS disposes 
of the Y Corp stock.

    (D) Section 708(b)(1)(B) transactions--(1) In general. A partner 
with a section 704(c)(1)(C) basis adjustment in section 704(c)(1)(C) 
property held by a partnership that terminates under section 
708(b)(1)(B) will continue to have the same section 704(c)(1)(C) basis 
adjustment for section 704(c)(1)(C) property deemed contributed by the 
terminated partnership to the new partnership under Sec.  1.708-
1(b)(4). In addition, the deemed contribution of property by a 
terminated partnership to a new partnership is not subject to this 
section and does not create a section 704(c)(1)(C) basis adjustment.

    (2) Example. A contributes Property with an adjusted basis of 
$11,000 and a fair market value of $5,000 and B contributes $5,000 
cash to PRS, a partnership. B sells its entire interest in PRS to C 
for its fair market value of $5,000, which terminates PRS under 
section 708(b)(1)(B). Under Sec.  1.708-1(b)(4), PRS is deemed to 
contribute all of its assets and liabilities to a new partnership 
(New PRS) in exchange for an interest in New PRS. Immediately 
thereafter, PRS is deemed to distribute its interest in New PRS 
equally to A and C in complete liquidation of PRS. New PRS takes 
Property with a basis of $5,000 and A retains its $6,000 section 
704(c)(1)(C) basis adjustment related to Property inside New PRS.

    (E) Disposition in an installment sale. If a partnership disposes 
of section 704(c)(1)(C) property in an installment sale (as defined in 
section 453(b)), the installment obligation received by the partnership 
is treated as the section 704(c)(1)(C) property with the same section 
704(c)(1)(C) basis adjustment as the section 704(c)(1)(C) property 
disposed of by the partnership (with appropriate adjustments for any 
gain recognized on the installment sale).
    (F) Contributed contracts. If a partner contributes to a 
partnership a contract that is section 704(c)(1)(C) property, and the 
partnership subsequently acquires property pursuant to the contract in 
a transaction in which less than all of the loss is recognized, then 
the acquired property is treated as section 704(c)(1)(C) property with 
the same section 704(c)(1)(C) basis adjustment as the contract (with 
appropriate adjustments for any gain or loss recognized on the 
acquisition). For this purpose, the term contract includes, but is not 
limited to, options, forward contracts, and futures contracts.
    (v) Distributions--(A) Current distribution of section 704(c)(1)(C) 
property to section 704(c)(1)(C) partner. If a partnership distributes 
property to a partner and the partner has a section 704(c)(1)(C) basis 
adjustment for the property, the section 704(c)(1)(C) basis adjustment 
is taken into account under section 732. See Sec.  1.732-2(a). For 
certain adjustments to the basis of remaining partnership property 
after the distribution of section 704(c)(1)(C) property to the section 
704(c)(1)(C) partner, see Sec.  1.734-2(c).
    (B) Distribution of section 704(c)(1)(C) property to another 
partner. If a partner receives a distribution of property in which 
another partner has a section 704(c)(1)(C) basis adjustment, the 
distributee does not take the section 704(c)(1)(C) basis adjustment 
into account under section 732. If section 704(c)(1)(B) applies to 
treat the section 704(c)(1)(C) partner as recognizing loss on the sale 
of the distributed property, the section 704(c)(1)(C) basis adjustment 
is taken into account in determining the amount of the loss. A section 
704(c)(1)(C) partner with a section 704(c)(1)(C) basis adjustment in 
the distributed property that is not taken into account as described in 
the prior sentence reallocates the section 704(c)(1)(C) basis 
adjustment among the remaining items of partnership property under 
Sec.  1.755-1(c).
    (C) Distributions in complete liquidation of a section 704(c)(1)(C) 
partner's interest. If a section 704(c)(1)(C) partner receives a 
distribution of property (whether or not

[[Page 3060]]

the partner has a section 704(c)(1)(C) basis adjustment in the 
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 section 704(c)(1)(C) 
partner's section 704(c)(1)(C) basis adjustment for the property in 
which the section 704(c)(1)(C) partner relinquished an interest. For 
purposes of determining the section 704(c)(1)(C) partner's basis in 
distributed property under section 732, the partnership reallocates any 
section 704(c)(1)(C) basis adjustment from section 704(c)(1)(C) 
property retained by the partnership to distributed properties of like 
character under the principles of Sec.  1.755-1(c)(i), after applying 
sections 704(c)(1)(B) and 737. If section 704(c)(1)(C) property is 
retained by the partnership, and no property of like character is 
distributed, then that property's section 704(c)(1)(C) basis adjustment 
is not reallocated to the distributed property for purposes of applying 
section 732. See Sec.  1.734-2(c)(2) for rules regarding the treatment 
of any section 704(c)(1)(C) adjustment that is not fully utilized by 
the section 704(c)(1)(C) partner.
    (D) Examples. The following examples illustrate the principles of 
this paragraph (f)(3)(v).

    Example 1. Current distribution of section 704(c)(1)(C) property 
to section 704(c)(1)(C) partner--(i) A contributes Property 1 with 
an adjusted basis of $15,000 and a fair market value of $10,000 and 
Property 2 with an adjusted basis of $5,000 and a fair market value 
of $20,000 and B contributes $30,000 cash to PRS, a partnership. 
Property 1 and Property 2 are both capital assets. When Property 1 
has a fair market value of $12,000, and neither A nor B's basis in 
PRS has changed, PRS distributes Property 1 to A in a current 
distribution.
    (ii) Property 1 has an adjusted basis to PRS of $10,000, and A 
has a section 704(c)(1)(C) basis adjustment of $5,000 in Property 1. 
Pursuant to Sec.  1.732-2(c) and paragraph (f)(3)(v)(A) of this 
section, for purposes of section 732(a)(1), the adjusted basis of 
Property 1 to PRS immediately before the distribution is $15,000 
(PRS's $10,000 adjusted basis increased by A's $5,000 section 
704(c)(1)(C) basis adjustment for Property 1) and, therefore. A 
takes a $15,000 adjusted basis in Property 1 upon the distribution. 
Accordingly, no adjustment is required to PRS's property under 
section 734.
    Example 2. Current distribution of section 704(c)(1)(C) property 
to another partner. Assume the same facts as Example 1 except PRS 
distributes Property 1 to B in a distribution to which section 
704(c)(1)(B) does not apply. B does not take any portion of A's 
section 704(c)(1)(C) basis adjustment into account. Accordingly, 
pursuant to Sec.  1.732-1(a) and paragraph (f)(3)(v)(B) of this 
section, for purposes of section 732(a)(1), the adjusted basis of 
Property 1 to PRS immediately before the distribution is $10,000 
and, therefore, B takes a $10,000 adjusted basis in Property 1 upon 
the distribution. Accordingly, no adjustment is required to PRS's 
property under section 734. A's section 704(c)(1)(C) basis 
adjustment in Property 1 is reallocated to Property 2 in accordance 
with Sec.  1.755-1(c).
    Example 3. (i) Liquidating distribution to section 704(c)(1)(C) 
partner. In Year 1, A contributes Property 1 with an adjusted basis 
of $15,000 and a fair market value of $10,000 and Property 2 with an 
adjusted basis of $5,000 and a fair market value of $20,000 and B 
and C each contribute $30,000 cash to PRS, a partnership. Property 1 
and Property 2 are both capital assets. In a later year, when the 
fair market value of Property 2 is still $20,000, and no partner's 
basis in PRS has changed, PRS distributes Property 2 and $10,000 to 
A in complete liquidation of A's partnership interest in a 
distribution to which section 737 does not apply. PRS has a section 
754 election in effect for the year of the distribution.
    (ii) Property 2 has an adjusted basis to PRS of $5,000, and A 
has a section 704(c)(1)(C) basis adjustment of $5,000 in Property 1. 
Pursuant to Sec.  1.732-2(c) and paragraph (f)(3)(v)(C) of this 
section, for purposes of section 732(b), the adjusted basis of 
Property 2 to PRS immediately before the distribution is $10,000 
(PRS's $5,000 adjusted basis in Property 2 increased by A's $5,000 
section 704(c)(1)(C) basis adjustment for Property 1), and A's 
adjusted basis in Property 2 upon the distribution is $10,000 (A's 
$20,000 basis in PRS minus the $10,000 cash distributed). Therefore, 
no adjustment is required to PRS's property under section 734.

    (vi) Returns. A partnership that owns property with a section 
704(c)(1)(C) basis adjustment must attach a statement to the 
partnership return for the year of the contribution setting forth the 
name and taxpayer identification number of the section 704(c)(1)(C) 
partner as well as the section 704(c)(1)(C) basis adjustment and the 
section 704(c)(1)(C) property to which the adjustment relates.
    (g) * * *. The provisions of paragraph (f) of this section apply to 
partnership contributions occurring on or after the date of publication 
of the Treasury decision adopting these rules as final regulations in 
the Federal Register.
0
Par. 3. Section 1.704-4 is amended as follows:
0
1. In paragraph (a)(1), by removing ``five years'' and adding in its 
place ``seven years''.
0
2. In paragraph (a)(4) by removing ``five-year'' and adding in its 
place ``seven-year'' each time it appears.
0
3. By revising paragraph (a)(4)(i).
0
4. In paragraph (f)(2), Examples 1 and 2, by removing the phrase 
``five-year'' and adding in its place ``seven-year'' each time it 
appears and removing ``2000'' and adding in its place ``2002'' each 
time it appears.
0
5. By adding a sentence to the end of paragraph (g).
    The revision and addition read as follows:


Sec.  1.704-4  Distribution of contributed property.

    (a) * * *
    (4) Determination of seven-year period--(i) General rule. The 
seven-year period specified in paragraph (a)(1) of this section begins 
on, and includes, the date of contribution and ends on, and includes, 
the last date that is within seven years of the contribution. For 
example, if a partner contributes section 704(c) property to a 
partnership on May 15, 2016, the seven-year period with respect to the 
section 704(c) property ends on, and includes, May 14, 2023.
* * * * *
    (g) * * * The provisions of this section relating to the seven-year 
period for determining the applicability of section 704(c)(1)(B) are 
applicable for partnership contributions occurring on or after the date 
of publication of the Treasury decision adopting these rules as final 
regulations in the Federal Register.
0
Par. 4. Section 1.732-2 is amended by:
0
1. Redesignating paragraph (b) introductory text as (b)(1) introductory 
text and revising it.
0
2. Adding paragraph (b)(2.
0
3. Redesignating paragraph (c) as paragraph (d).
0
4. Adding a new paragraph (c).
    The revisions and addition reads as follows:


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

* * * * *
    (b) Adjustments under section 743(b)--(1) In general. In the case 
of a distribution of property to a partner who acquired any part of its 
interest in a transfer, if there was an election under section 754 in 
effect with respect to the transfer, or if the partnership had a 
substantial built-in loss (as defined in Sec.  1.743-1(a)(2)(i)) 
immediately after the transfer, then, for purposes of section 732 
(other than subsection (d) thereof), the adjusted partnership basis of 
the distributed property shall take into account, in addition to any 
adjustments under section 734(b), the transferee's special basis 
adjustment for the distributed property under section 743(b). The 
application of this paragraph may be illustrated by the following 
example:
* * * * *
    (2) Effective/applicability date. Paragraph (b)(1) of this section 
relating to substantial built-in losses is

[[Page 3061]]

applicable for partnership distributions occurring on or after the date 
of publication of the Treasury decision adopting these rules as final 
regulations in the Federal Register.
    (c) Adjustments under section 704(c)(1)(C)--(1) In general. In the 
case of a distribution of property to a section 704(c)(1)(C) partner 
(as defined in Sec.  1.704-3(f)(2)(ii)), for purposes of section 732 
(other than subsection (d) thereof), the adjusted partnership basis of 
the distributed property shall take into account, in addition to any 
adjustments under section 734(b), the distributee's section 
704(c)(1)(C) basis adjustment (if any) for the distributed property.
    (2) Effective/applicability date. Paragraph (c)(1) of this section 
is applicable for partnership distributions occurring on or after the 
date of publication of the Treasury decision adopting these rules as 
final regulations in the Federal Register.
* * * * *
0
Par. 5. Section 1.734-1 is amended by:
0
1. Revising the section heading.
0
2. Revising paragraph (a).
0
3. Revising paragraph (b)(2)(i).
0
4. Adding Example 3 following paragraph (b)(2)(ii).
0
5. Adding a sentence at the end of paragraph (d).
0
6. Adding paragraphs (f), (g), and (h).
    The revisions and additions read as follows:


Sec.  1.734-1  Adjustment to basis of undistributed partnership 
property where partnership has a section 754 election or there is a 
substantial basis reduction with respect to a distribution.

    (a) General rule--(1) Adjustments to basis. A partnership shall not 
adjust the basis of partnership property as the result of a 
distribution of property to a partner unless the election provided in 
section 754 (relating to optional adjustment to basis of partnership 
property) is in effect or there is a substantial basis reduction 
(within the meaning of paragraph (a)(2)(i) of this section) with 
respect to the distribution.
    (2) Substantial basis reduction--(i) In general. For purposes of 
this section, there is a substantial basis reduction with respect to a 
distribution of property or properties to a partner if the sum of the 
amounts described in section 734(b)(2)(A) and (b)(2)(B) exceeds 
$250,000. If there is a substantial basis reduction under this section, 
the partnership is treated as having an election under section 754 in 
effect solely for the distribution to which the substantial basis 
reduction relates.
    (ii) Special rules for tiered partnerships. See paragraph (f) of 
this section for special rules regarding tiered partnerships.
    (iii) Special rules for securitization partnerships. See paragraph 
(g) of this section for special rules regarding securitization 
partnerships.
    (b) * * *
    (2) Decrease in basis. (i) When a partnership with a section 754 
election in effect makes a distribution in liquidation of a partner's 
entire interest in the partnership, or when there is a substantial 
basis reduction (within the meaning of paragraph (a)(2)(i) of this 
section), the partnership shall decrease the adjusted basis of the 
remaining partnership property by--
    (ii) * * *

    Example 3 --(i) A, B, and C each contribute $2 million to PRS, a 
partnership. PRS purchases Property 1 and Property 2, both of which 
are capital assets, for $1 million and $5 million respectively. In 
Year 2, the fair market value of Property 1 increases to $3 million 
and the fair market value of Property 2 increases to $6 million. 
Also in Year 2, PRS distributes Property 1 to C in liquidation of 
C's interest in PRS at a time when C's basis in its PRS interest is 
still $2 million. PRS does not have an election under section 754 in 
effect.
    (ii) Under section 732, the basis of Property 1 in the hands of 
C is $2 million. Because the excess of C's adjusted basis in 
Property 1 ($2 million) over PRS's adjusted basis in Property 1 ($1 
million) is $1 million, the amount described in section 734(b)(2)(B) 
($1 million) exceeds $250,000, and therefore, there is a substantial 
basis reduction with respect to the distribution. Accordingly, 
pursuant to paragraph (a)(2)(i) of this section, PRS is treated as 
having a section 754 election in effect in Year 2 and must reduce 
its basis in Property 2 in accordance with paragraph (b)(2)(i) of 
this section.
* * * * *
    (d) * * * A partnership required to adjust the basis of partnership 
property following the distribution of property because there is a 
substantial basis reduction (within the meaning of paragraph (a)(2)(i) 
of this section) with respect to the distribution is subject to, and 
required to comply with, the provisions of this paragraph (d) solely 
with respect to the distribution to which the substantial basis 
reduction relates.
* * * * *
    (f) Adjustments with respect to tiered partnerships--(1) In 
general. If an upper-tier partnership makes an adjustment under 
paragraph (b) of this section to the basis of an interest it holds in a 
lower-tier partnership that has an election under section 754 in 
effect, the lower-tier partnership must make adjustments under 
paragraph (b) of this section to the upper-tier partnership's share of 
the lower-tier partnership's assets. The amount of the lower-tier 
partnership's adjustment is equal to the adjustment made by the upper-
tier partnership to the basis of its interest in the lower-tier 
partnership. The lower-tier partnership's adjustment to the upper-tier 
partnership's share of its assets is for the upper-tier partnership 
only and does not affect the basis in the lower-tier partnership's 
property for the other partners of the lower-tier partnership. 
Additionally, if there is a substantial basis reduction (within the 
meaning of paragraph (a)(2)(i) of this section) with respect to a 
distribution by an upper-tier partnership that (either directly or 
indirectly through one or more partnerships) holds an interest in a 
lower-tier partnership, each lower-tier partnership is treated, solely 
with respect to the distribution, as if it had made an election under 
section 754 for the taxable year in which the distribution occurs. For 
additional examples of the application of the principles of this 
paragraph (f)(1), see Revenue Ruling 92-15, 1992-1 CB 215. See Sec.  
601.601(d)(2)(ii)(b)

    (2) Example --(i) Facts. A, B, and C are equal partners in UTP, 
a partnership. Each partner's interest in UTP has an adjusted basis 
and fair market value of $3 million. UTP owns two capital assets 
with the following adjusted bases and fair market values:

 
                              Adjusted basis         Fair market value
 
Property 1.............  $2.2 million...........  $3 million.
Property 2.............  $2.8 million...........  $3 million.
 

    UTP also owns a 50 percent interest in LTP, a partnership. UTP's 
interest in LTP has an adjusted basis of $4 million and a fair 
market value of $3 million. LTP owns one asset, Property 3, a 
capital asset, which has an adjusted basis of $8 million and a fair 
market value of $6 million. Neither UTP nor LTP has an election 
under section 754 in effect.
    (ii) Liquidating distribution to A of Property 1. UTP 
distributes Property 1 to A in complete liquidation of A's interest 
in UTP. Under section 732(b), the adjusted basis of Property 1 to A 
is $3 million. Therefore, there is a substantial basis reduction 
with respect to the distribution to A because the sum of the amounts 
described in section 734(b)(2)(A) ($0) and section 734(b)(2)(B) (the 
excess of $3 million over $2.2 million, or $800,000) exceeds 
$250,000. Therefore, pursuant to paragraph (b)(2) of this section, 
UTP must decrease the basis of its property by $800,000. Under Sec.  
1.755-1(c), UTP must decrease the adjusted basis of its 50 percent 
interest in LTP by $800,000. Likewise, pursuant to paragraph (f)(1) 
of this section, LTP must decrease its basis in UTP's share of 
Property 3 by $800,000 in accordance with Sec.  1.755-1(c).

    (g) Securitization partnerships. A securitization partnership (as 
defined in Sec.  1.743-1(o)(2)) shall not be treated as

[[Page 3062]]

having a substantial basis reduction with respect to any distribution 
of property to a partner.
    (h) Effective/applicability date. The rules relating to substantial 
basis reductions in paragraphs (a) and (b) of this section and 
paragraphs (f) and (g) of this section apply to partnership 
distributions occurring on or after the date of publication of the 
Treasury decision adopting these rules as final regulations in the 
Federal Register.
0
Par. 6. Section 1.734-2 is amended by revising the section heading and 
adding paragraph (c) to read as follows:


Sec.  1.734-2  Adjustment after distribution to transferee partner or 
section 704(c)(1)(C) partner.

* * * * *
    (c)(1) Section 704(c)(1)(C) basis adjustments will be taken into 
account in determining the basis adjustment under section 734(b). 
However, section 704(c)(1)(C) basis adjustments, other than a section 
704(c)(1)(C) basis adjustment applied as an adjustment to the basis of 
partnership property pursuant to paragraph (c)(2) of this section, will 
not be taken into account in making allocations under Sec.  1.755-1(c).
    (2) Liquidating distributions. If a section 704(c)(1)(C) partner 
receives a distribution of property (including money) in liquidation of 
its entire partnership interest, the section 704(c)(1)(C) partner's 
section 704(c)(1)(C) basis adjustments that are treated as basis in the 
distributed property pursuant to section 732 will be taken into account 
in determining the basis adjustment under section 734(b), regardless of 
whether the distributed property is section 704(c)(1)(C) property. If 
any section 704(c)(1)(C) basis adjustment cannot be reallocated to 
distributed property in connection with the distribution, then that 
remaining section 704(c)(1)(C) basis adjustment shall be treated as a 
positive section 734(b) adjustment. If the distribution also gives rise 
to a negative section 734(b) adjustment without regard to the section 
704(c)(1)(C) basis adjustment reallocation, then the negative section 
734(b) adjustment and the section 704(c)(1)(C) basis adjustment 
reallocation are netted together, and the net amount is allocated under 
Sec.  1.755-1(c). If the partnership does not have a section 754 
election in effect at the time of the liquidating distribution, the 
partnership shall be treated as having made a section 754 election 
solely for purposes of computing any negative section 734(b) adjustment 
that would arise from the distribution.
    (3) The following examples illustrate the provisions of this 
paragraph (c).

    Example 1 --(i) In Year 1, A contributes $5,000 cash and 
Property A, a capital asset, with an adjusted basis of $7,000 and a 
fair market value of $5,000; B contributes $8,000 cash and Property 
B, a capital asset, with an adjusted basis and fair market value of 
$2,000; and C contributes $7,000 cash and Property C, a capital 
asset, with an adjusted basis and fair market value of $3,000 to 
PRS, a partnership. In Year 3, Property B has appreciated in value 
to $8,000. PRS distributes Property B and $4,000 to C in complete 
liquidation of C's interest in PRS at a time when no partner's basis 
in PRS has changed. PRS revalues its property under Sec.  1.704-
1(b)(2)(iv)(f) in connection with the distribution, and makes an 
election under section 754. C recognizes no gain or loss on the 
distribution.
    (ii) C receives Property B with a basis of $6,000 (C's adjusted 
basis in PRS of $10,000 minus the $4,000 cash distributed). Because 
PRS has an election under section 754 in effect, PRS must reduce its 
basis in remaining partnership property under Sec.  1.734-
1(b)(2)(ii) by $4,000 (C's $6,000 basis in Property B minus PRS's 
$2,000 adjusted basis in Property B prior to the distribution. Under 
Sec.  1.755-1(c)(2)(ii), that basis reduction must be allocated 
within a class first to properties with unrealized depreciation in 
proportion to their respective amounts of unrealized depreciation. 
Any remaining decrease must be allocated in proportion to the 
properties' adjusted bases. Because there is no unrealized 
depreciation in either Property A (disregarding A's section 
704(c)(1)(C) basis adjustment) or Property C, the decrease must be 
allocated between the two properties in proportion to their adjusted 
bases, $2,500 ($4,000 multiplied by $5,000 divided by $8,000) to 
Property A and $1,500 ($4,000 multiplied by $3,000 divided by 
$8,000) to Property C.
    (iii) In a subsequent year, PRS sells Property A for its fair 
market value of $7,500 and recognizes $5,000 of gain ($7,500 amount 
realized minus adjusted basis of $2,500). Pursuant to Sec.  1.704-
3(f)(3)(ii)(B), A's $2,500 distributive share of the $5,000 gain 
from the sale of Property A is reduced by A's $2,000 section 
704(c)(1)(C) basis adjustment. Therefore, A recognizes a gain of 
$500 on the sale.
    Example 2 --(i) A contributes Property 1 with an adjusted basis 
of $15,000 and a fair market value of $10,000 and Property 2 with an 
adjusted basis of $15,000 and a fair market value of $20,000, and B 
and C each contribute $30,000 cash to PRS, a partnership. A has a 
section 704(c)(1)(C) basis adjustment of $5,000 with respect to 
Property 1. PRS's adjusted bases in Property 1 and Property 2 are 
$10,000 and $15,000, respectively. When the fair market value of A's 
interest in PRS is still $30,000, and no partner's basis in its PRS 
interest has changed, PRS makes a liquidating distribution to A of 
$30,000 cash, which results in A realizing no gain or loss. PRS has 
an election under section 754 in effect.
    (ii) A is unable to take into account A's section 704(c)(1)(C) 
basis adjustment in Property 1 upon the distribution of the cash as 
described in paragraph (c)(2) of this section because A cannot 
increase the basis of cash under Sec.  1.704-3(f)(v)(C). Thus, A's 
$5,000 section 704(c)(1)(C) basis adjustment is treated as a 
positive section 734(b) adjustment to the partnership's assets 
retained. PRS's $5,000 section 734(b) adjustment will be allocated 
to Property 2, increasing its basis from $15,000 to $20,000 under 
Sec.  1.755-1(c).
    Example 3 --(i) A contributes Property 1 with an adjusted basis 
of $35,000 and a fair market value of $30,000, B contributes 
Property 2 with an adjusted basis and fair market value of $30,000, 
and C contributes $30,000 cash to PRS, a partnership. Property 1 is 
a capital asset, and Property 2 is inventory (as defined in section 
751(d)). PRS's adjusted basis in Property 1 is $30,000 under section 
704(c)(1)(C)(ii), and A has a section 704(c)(1)(C) basis adjustment 
of $5,000 with respect to Property 1. Later, at a time when the 
value and bases of the properties have not changed, PRS distributes 
$30,000 cash to A in complete liquidation of A's interest. A 
recognizes a ($5,000) loss under section 731(a)(2) on the 
distribution. PRS has an election under section 754 in effect.
    (ii) The distribution results in a negative section 734(b) 
adjustment to capital gain property of ($5,000) (the amount of loss 
A recognizes under section 731(a)(2)). Additionally, because A is 
unable to take into account A's section 704(c)(1)(C) basis 
adjustment in Property 1 upon the distribution of the cash, A's 
$5,000 section 704(c)(1)(C) basis adjustment is treated as a 
positive section 734(b) adjustment. Pursuant to paragraph (c)(2) of 
this section, these two adjustments are netted together, resulting 
in no adjustment under section 734(b). Therefore, the partnership's 
basis in Property 1 and Property 2 remains $30,000.
    Example 4 --(i) Assume the same facts as in Example 3 except 
that PRS distributes Property 2 to A in complete liquidation of A's 
interest in a transaction to which section 704(c)(1)(B) and section 
737 do not apply.
    (ii) Pursuant to Sec.  1.704-3(f)(v)(C), A cannot include A's 
section 704(c)(1)(C) basis adjustment in the basis of the 
distributed property, because the section 704(c)(1)(C) property and 
the distributed property are not of like character. Accordingly, the 
basis to A of Property 2 is $30,000. A also recognizes a $5,000 
capital loss under section 731(a)(2), resulting in a ($5,000) basis 
adjustment under section 734(b). Because the section 704(c)(1)(C) 
basis adjustment to Property 1 was not reallocated in connection 
with the distribution, that remaining $5,000 section 704(c)(1)(C) 
basis adjustment is treated as a positive section 734(b) adjustment. 
Pursuant to paragraph (c)(2) of this section, these two adjustments 
are netted together, resulting in no adjustment under section 
734(b). Therefore, the basis of Property 1 remains $30,000.

    (4) Effective/applicability date. This paragraph (c) applies to 
partnership distributions occurring on or after the date of publication 
of the Treasury decision adopting these rules as final regulations in 
the Federal Register.

[[Page 3063]]

0
Par. 7. Section 1.737-1 is amended by revising paragraph (c)(1) and 
adding paragraphs (c)(3) and (4) to read as follows:


Sec.  1.737-1  Recognition of precontribution gain.

* * * * *
    (c) Net precontribution gain--(1) General rule. The distributee 
partner's net precontribution gain is the net gain (if any) that would 
have been recognized by the distributee partner under section 
704(c)(1)(B) and Sec.  1.704-4 if all property that had been 
contributed to the partnership by the distributee partner within seven 
years of the distribution and is held by the partnership immediately 
before the distribution had been distributed by the partnership to 
another partner other than the partner who owns, directly or 
indirectly, more than 50 percent of the capital or profits interest in 
the partnership.
* * * * *
    (3) Determination of seven-year period--(i) General rule. The 
seven-year period specified in paragraph (c)(1) of this section begins 
on, and includes, the date of contribution and ends on, and includes, 
the last date that is within seven years of the contribution. For 
example, if a partner contributes 704(c) property to a partnership on 
May 15, 2016, the seven-year period with respect to the section 704(c) 
property ends on, and includes, May 14, 2023.
    (ii) Section 708(b)(1)(B) terminations. A termination of the 
partnership under section 708(b)(1)(B) does not begin a new seven-year 
period for each partner with respect to built-in gain and built-in loss 
property that the terminated partnership is deemed to contribute to the 
new partnership under Sec.  1.708-1(b)(4). See Sec.  1.704-3(a)(3)(ii) 
for the definitions of built-in gain and built-in loss on section 
704(c) property.
    (4) Effective/applicability date. The provisions of paragraph 
(c)(1) and (3) of this section relating to the seven-year period for 
determining the applicability of section 737(b) apply for partnership 
contributions occurring on or after the date of publication of the 
Treasury decision adopting these rules as final regulations in the 
Federal Register.
* * * * *
0
Par. 8. Section 1.743-1 is amended by:
0
1. Revising the section heading.
0
2. Revising paragraph (a).
0
3. Revising paragraph (b).
0
4. Redesignating paragraph (f) introductory text as paragraph (f)(1) 
introductory text and revising it.
0
5. Adding paragraph (f)(2).
0
6. In paragraph (h)(1), removing ``Sec.  1.708-1(b)(1)(iv)'' and adding 
in its place ``Sec.  1.708-1(b)(4)''.
0
7. Revising paragraph (j)(3)(ii) Example 1.
0
8. Revising paragraph (j)(3)(ii) Example 3.
0
9. Revising paragraph (k)(1)(iii).
0
10. Adding paragraph (k)(2)(iv).
0
11. Redesignating paragraph (l) as paragraph (p).
0
12. Adding a new paragraph (l).
0
13. Adding paragraphs (m), (n), and (o).
0
14. Revising newly redesignated paragraph (p).
    The revisions and additions read as follows:


Sec.  1.743-1  Special rules where partnership has a section 754 
election in effect or has a substantial built-in loss immediately after 
transfer of partnership interest.

    (a) Generally--(1) Adjustment to basis. 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 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, or if the partnership has a substantial built-in loss 
(within the meaning of paragraph (a)(2)(i) of this section) immediately 
after the transfer.
    (2) Substantial built-in loss--(i) In general. A partnership has a 
substantial built-in loss with respect to a transfer of an interest in 
a partnership if the partnership's adjusted basis in partnership 
property exceeds the fair market value of the property (as determined 
in paragraph (a)(2)(iii) of this section) by more than $250,000 
immediately after the transfer.
    (ii) Impact of section 743 basis adjustments and section 
704(c)(1)(C) basis adjustments. For purposes of paragraph (a)(2)(i) of 
this section, any section 743 or section 704(c)(1)(C) basis adjustments 
(as defined in Sec.  1.704-3(f)(2)(iii)) (other than the transferee's 
section 743(b) basis adjustments or section 704(c)(1)(C) basis 
adjustments) to partnership property are disregarded.
    (iii) Determination of fair market value in tiered situation. For 
purposes of paragraph (a)(2)(i) of this section, an upper-tier 
partnership's fair market value in a lower-tier partnership is equal to 
the sum of--
    (A) The amount of cash that the upper-tier partnership would 
receive if the lower-tier partnership sold all of its property for cash 
to an unrelated person for an amount equal to the fair market value of 
such property, satisfied all of its liabilities (other than Sec.  
1.752-7 liabilities), paid an unrelated person to assume all of its 
Sec.  1.752-7 liabilities in a fully taxable, arm's-length transaction, 
and liquidated; and
    (B) The upper-tier partnership's share of the lower-tier 
partnership's liabilities as determined under section 752 and the 
regulations.

    (iv) Example. A and B are equal partners in PRS, a partnership. 
PRS owns Property 1, with an adjusted basis of $3 million and a fair 
market value of $2 million, and Property 2, with an adjusted basis 
of $1 million and a fair market value of $1 million. In Year 2, A 
sells 50 percent of its interest in PRS to C for its fair market 
value of $750,000. PRS does not have section 754 election in effect. 
Under paragraph (a)(2)(i) of this section, PRS has a substantial 
built-in loss because, immediately after the transfer, the adjusted 
basis of PRS's property ($4 million) exceeds the fair market value 
of the property ($3 million) by more than $250,000. Thus, pursuant 
to paragraph (a)(1) of this section, PRS must adjust the bases of 
its properties as if PRS had made a section 754 election for Year 2.

    (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 or that has a substantial built-in loss (within 
the meaning of paragraph (a)(2)(i) of this section) --
* * * * *
    (f) Subsequent transfers--(1) In general. 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 following example illustrates the provisions of this 
paragraph (f)(1):
* * * * *
    (2) Special rules for substituted basis transactions. Where a 
partner had a basis adjustment under section 743(b) allocated pursuant 
to Sec.  1.755-1(b)(2) through (b)(4) that is attributable to an 
interest that is subsequently transferred in a substituted basis 
transaction (within the meaning of Sec.  1.755-1(b)(5)), the provisions 
of paragraph (f)(1) of this section do not apply. Instead, the 
transferee succeeds to that portion of the transferor's basis 
adjustment attributable to the transferred partnership interest. The 
basis adjustment to which the transferee succeeds is taken into account 
for purposes of determining the transferee's share of the adjusted 
basis

[[Page 3064]]

to the partnership of the partnership's property for purposes of 
paragraph (b) of this section and Sec.  1.755-1(b)(5). To the extent a 
transferee would be required to decrease the adjusted basis of an item 
of partnership property pursuant to Sec. Sec.  1.743-1(b)(2) and 1.755-
1(b)(5), the decrease first reduces the positive section 743(b) 
adjustment, if any, that the transferee succeeds to. The following 
example illustrates the provisions of this paragraph (f)(2):

    Example --(i) A and B are partners in LTP, a partnership. A owns 
a 60 percent interest, and B owns a 40 percent interest, in LTP. B 
owns the LTP interest with an adjusted basis of $50 and a fair 
market value of $70. LTP owns two assets: Capital Asset 1 with an 
adjusted basis of $25 and a fair market value of $100, and Capital 
Asset 2 with an adjusted basis of $100 and a fair market value of 
$75. B sells its interest in LTP to UTP. Both LTP and UTP have a 
section 754 election in effect. Pursuant to Sec.  1.755-1(b)(3), 
UTP's $20 section 743(b) adjustment is allocated $30 to Capital 
Asset 1 and ($10) to Capital Asset 2.
    (ii) UTP distributes its LTP interest to C, a partner in UTP, 
when the adjusted bases and fair market values of the LTP interest 
and LTP's assets have not changed. C's adjusted basis in its UTP 
interest at the time of the distribution is $40. Pursuant to 
paragraph (f)(2) of this section, C succeeds to UTP's section 743(b) 
adjustment. Also pursuant to paragraph (f)(2) of this section, the 
section 743(b) adjustment is taken into account in determining C's 
share of the adjusted basis of LTP property. Thus, C also has a $30 
negative section 743(b) adjustment that must be allocated pursuant 
to Sec.  1.755-1(b)(5). That is, C's interest in the partnership's 
previously taxed capital is $70 (C would be entitled to $70 cash on 
liquidation and there is no increase or decrease for tax gain or tax 
loss from the hypothetical transaction, taking into account UTP's 
section 743(b) adjustment to which C succeeds). Pursuant to Sec.  
1.755-1(b)(5)(iii)(B), the $30 negative section 743(b) adjustment 
must be allocated within the capital class first to properties with 
unrealized depreciation in proportion to C's share of the respective 
amounts of unrealized depreciation before the decrease. Taking into 
account UTP's section 743(b) adjustment to which C succeeds, C has 
no share of LTP's unrealized depreciation. Pursuant to Sec.  1.755-
1(b)(5)(iii)(B), any remaining decrease must be allocated among 
Capital Asset 1 and Capital Asset 2 in proportion to C's share of 
their adjusted bases. Taking into account UTP's section 743(b) 
adjustment to which C succeeds, C's share of the adjusted basis in 
Capital Asset 1 is $40 ($10 share of LTP's basis and $30 of UTP's 
section 743(b) adjustment to which C succeeded) and in Capital Asset 
2 is $30 ($40 share of LTP's basis and ($10) of UTP's section 743(b) 
adjustment). Thus, 40/70 of the $30 adjustment, $17.14, is allocated 
to Capital Asset 1 and 30/70 of the $30 adjustment, $12.86, is 
allocated to Capital Asset 2. The decrease allocated to Capital 
Asset 1 first reduces UTP's section 743(b) adjustment to which C 
succeeds. Thus, C has a net section 743(b) adjustment in Capital 
Asset 1 of $12.86 ($30 minus $17.14) and in Capital Asset 2 of 
($22.86) (($10) plus ($12.86)). If Capital Asset 1 is subject to the 
allowance for depreciation or amortization, C's net $12.86 positive 
basis adjustment is recovered pursuant to paragraph (j)(4)(i)(B).
    (iii) If C later transfers its LTP interest to D in a 
transaction that is not a substituted basis transaction within the 
meaning of Sec.  1.755-1(b)(5), under paragraph (f)(1) of this 
section, D does not succeed to any of C's section 743(b) adjustment.
* * * * *
    (j) * * *
    (3) * * *
    (ii) * * *

    Example 1. A and B form equal partnership PRS. A and B each 
contribute $100 cash, and PRS purchases nondepreciable property for 
$200. Later, at a time when the property value has decreased to 
$100, C contributes $50 cash for a 1/3 interest in PRS. Under Sec.  
1.704-1(b)(2)(iv)(f)(5), PRS revalues its property in connection 
with the admission of C, allocating the $100 unrealized loss in the 
property equally between A and B under the partnership agreement, 
which provides for the use of the traditional method under Sec.  
1.704-3(b). A subsequently sells its interest in PRS to T for $50. 
PRS has an election in effect 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 later 
sells the property for $120. PRS recognizes a book gain of $20 
(allocated equally between T, B, and C), and a tax loss of $80. 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 3. A and B form equal partnership PRS. A and B each 
contribute $75 cash. PRS purchases nondepreciable property for $150. 
Later, at a time when the property value has decreased to $100, C 
contributes $50 cash for a 1/3 interest in PRS. Under Sec.  1.704-
1(b)(2)(iv)(f)(5), PRS revalues its property in connection with the 
admission of C. The $50 unrealized loss in the property is allocated 
equally to A and B under the partnership agreement, which provides 
for the use of the remedial allocation method described in Sec.  
1.704-3(d). A subsequently sells its interest in PRS to T for $50. 
PRS has an election in effect under section 754. T receives a 
negative $25 basis adjustment under section 743(b) that, under 
section 755, is allocated to the nondepreciable property. PRS later 
sells the property for $112. PRS recognizes a book gain of $12 
(allocated equally between T, B, and C), and a tax loss of $38 
(allocated equally between T and B). To match its share of book 
gain, C will be allocated $4 of remedial gain, and T and B will each 
be allocated an offsetting $2 remedial loss. T was allocated a total 
of $21 of tax loss with respect to the property. However, because T 
has a negative $25 basis adjustment in the nondepreciable property, 
T recognizes a $4 gain from the partnership's sale of the property.
* * * * *
    (k) * * *
    (1) * * *
    (iii) Rules for substantial built-in loss transactions. A 
partnership required to adjust the basis of partnership property 
following the transfer of an interest in a partnership by sale or 
exchange or on the death of a partner as the result of the partnership 
having a substantial built-in loss (as defined in paragraph (a)(2)(i) 
of this section) immediately after such transfer is subject to, and 
required to comply with, this paragraph (k)(1), and may rely on, and 
must comply with, paragraphs (k)(3), (k)(4), and (k)(5) of this section 
solely with respect to the transfer to which the substantial built-in 
loss relates as if an election under section 754 were in effect at the 
time of the transfer. See paragraph (k)(2) of this section for 
additional rules for transferees and paragraph (n) of this section for 
special reporting rules relating to electing investment partnerships.
    (2) * * *
    (iv) Special rules for transferees subject to the substantial 
built-in loss provisions. The transferee of an interest in a 
partnership that is required to reduce the bases of partnership 
property in accordance with the rules in paragraph (a)(2) of this 
section must comply with this paragraph (k)(2) as if an election under 
section 754 were in effect at the time of the transfer.
    (l) Basis adjustments with respect to tiered partnerships--(1) 
General rule. If an interest in an upper-tier partnership that holds an 
interest in a lower-tier partnership is transferred by sale or exchange 
or upon the death of a partner, and the upper-tier partnership and the 
lower-tier partnership both have elections in effect under section 754, 
then for purposes of section 743(b) and section 754, an interest in the 
lower-tier partnership will be deemed similarly transferred in an 
amount equal to the portion of the upper-tier partnership's interest in 
the lower-tier partnership that is attributable to the interest in the 
upper-tier partnership being transferred. Additionally, if an interest 
in an upper-tier partnership that holds (directly or indirectly through 
one or more partnerships) an interest in a lower-tier partnership is 
transferred by sale or exchange or on the death of a partner, and the 
upper-tier partnership has a substantial built-in loss (within the 
meaning of paragraph (a)(2)(i) of this section) with respect to the 
transfer, each lower-tier partnership is treated, solely with respect 
to the transfer, as if it had made a section 754 election for

[[Page 3065]]

the taxable year of the transfer. For additional examples of the 
application of the principles of this paragraph (l), see Revenue Ruling 
87-115, 1987-2 CB 163. See Sec.  601.601(d)(2)(ii)(b).
    (2) Example. The following example illustrates the principles of 
this paragraph (l).

    Example. A and B are equal partners in UTP, a partnership. UTP 
has no liabilities and owns a 25 percent interest in LTP, a 
partnership. UTP's interest in LTP has a fair market value of 
$100,000 and an adjusted basis of $500,000. LTP has no liabilities 
and owns Land, which has a fair market value of $400,000 and an 
adjusted basis of $2 million. In Year 3, when UTP and LTP do not 
have section 754 elections in effect, B sells 50 percent of its 
interest in UTP to C for its fair market value of $25,000. Because 
the adjusted basis of UTP's interest in LTP ($500,000) exceeds the 
fair market value of UTP's interest in LTP ($100,000) by more than 
$250,000 immediately after the transfer, UTP has a substantial 
built-in loss with respect to the transfer. Thus, pursuant to 
paragraph (l) of this section, UTP must adjust the basis of its 
interest in LTP, and LTP must adjust the basis of Land, as if it had 
made a section 754 election for Year 3.

    (m) Anti-abuse rule for substantial built-in loss transactions. 
Provisions relating to substantial built-in loss transactions in 
paragraph (a) and paragraphs (k), (l), (n), and (o) of this section 
must be applied in a manner consistent with the purposes of these 
paragraphs and the substance of the transaction. Accordingly, if a 
principal purpose of a transaction is to achieve a tax result that is 
inconsistent with the purpose of one or more of these paragraphs, the 
Commissioner may recast the transaction for Federal income tax 
purposes, as appropriate, to achieve tax results that are consistent 
with the purpose of these paragraphs. Whether a tax result is 
inconsistent with the purposes of the provisions is determined based on 
all the facts and circumstances. For example, under the provisions of 
this paragraph (m)--
    (1) Property held by related partnerships may be aggregated if the 
properties were transferred to the related partnerships with a 
principal purpose of avoiding the application of the substantial built-
in loss provisions in section 743 and the regulations; and
    (2) A contribution of property to a partnership may be disregarded 
if the transfer of the property was made with a principal purpose of 
avoiding the application of the substantial built-in loss provisions in 
section 743 and the regulations thereunder.
    (n) Electing investment partnerships--(1) No adjustment of 
partnership basis. For purposes of this section, an electing investment 
partnership (as defined in paragraph (n)(6) of this section) shall not 
be treated as having a substantial built-in loss (within the meaning of 
paragraph (a)(2)(i) of this section) with respect to any transfer 
occurring while the election in paragraph (n)(6)(i) of this section is 
in effect.
    (2) Loss deferral for transferee partner. In the case of a transfer 
of an interest in an electing investment partnership, the transferee 
partner's distributive share of losses (without regard to gains) from 
the sale or exchange of partnership property shall not be allowed 
except to the extent that it is established that such losses exceed the 
loss (if any) recognized by the transferor partner (or by any prior 
transferor to the extent not fully offset by a prior disallowance under 
this paragraph (n)(2)) on the transfer of the partnership interest. If 
an electing investment partnership allocates losses with a different 
character from the sale or exchange of property to the transferee (such 
as ordinary or section 1231 losses and capital losses) and the losses 
allocated to that partner are limited by this paragraph (n)(2), then a 
proportionate amount of the losses disallowed under this paragraph 
(n)(2) shall consist of each loss of a separate character that is 
allocated to the transferee partner.
    (3) No reduction in partnership basis. Losses disallowed under 
paragraph (n)(2) of this section shall not decrease the transferee 
partner's basis in the partnership interest.
    (4) Effect of termination of partnership. This paragraph (n) shall 
be applied without regard to any termination of a partnership under 
section 708(b)(1)(B).
    (5) Certain basis reductions treated as losses. In the case of a 
transferee partner whose basis in property distributed by the 
partnership is reduced under section 732(a)(2), the amount of the loss 
recognized by the transferor on the transfer of the partnership 
interest that is taken into account under paragraph (n)(2) of this 
section shall be reduced by the amount of such basis reduction.
    (6) Electing investment partnership. For purposes of this section, 
the term electing investment partnership means any partnership if--
    (i) The partnership makes an election under paragraph (n)(10) of 
this section to have this paragraph (n) apply;
    (ii) The partnership would be an investment company under section 
3(a)(1)(A) of the Investment Company Act of 1940 but for an exemption 
under paragraph (1) or (7) of section 3(c) of such Act;
    (iii) The partnership has never been engaged in a trade or business 
(see paragraph (n)(7) of this section for additional rules regarding 
this paragraph (n)(6)(iii));
    (iv) Substantially all of the assets of the partnership are held 
for investment;
    (v) At least 95 percent of the assets contributed to the 
partnership consist of money;
    (vi) No assets contributed to the partnership had an adjusted basis 
in excess of fair market value at the time of contribution;
    (vii) All partnership interests of the partnership are issued by 
the partnership pursuant to a private offering before the date that is 
24 months after the date of the first capital contribution to the 
partnership;
    (viii) The partnership agreement of the partnership has substantive 
restrictions on each partner's ability to cause a redemption of the 
partner's interest (see paragraphs (n)(8) and (n)(9) of this section 
for additional rules regarding this paragraph (n)(6)(viii)); and
    (ix) The partnership agreement of the partnership provides for a 
term that is not in excess of 15 years (see paragraph (n)(9) of this 
section for additional rules regarding this paragraph (n)(6)(ix)).
    (7) Trade or business. For purposes of paragraph (n)(6)(iii) of 
this section, whether a partnership is engaged in a trade or business 
is based on the all the facts and circumstances. Notwithstanding the 
prior sentence--
    (i) A partnership will not be treated as engaged in a trade or 
business if, based on all the facts and circumstances, the partnership 
is not engaged in a trade or business under the rules in Sec.  1.731-
2(e)(3).
    (ii) In the case of a tiered partnership arrangement, a partnership 
(upper-tier partnership) will not be treated as engaged in a trade or 
business of a partnership in which it owns an interest (lower-tier 
partnership) if the upper-tier partnership can establish that, at all 
times during the period in which the upper-tier partnership owns an 
interest in the lower-tier partnership, the adjusted basis of its 
interest in the lower-tier partnership is less than 25 percent of the 
total capital that is required to be contributed to the upper-tier 
partnership by its partners during the entire term of the upper-tier 
partnership. Otherwise, the upper-tier partnership will be treated as 
engaged in the trade or business of the lower-tier partnership.
    (8) Substantive restrictions. For purposes of paragraph 
(n)(6)(viii) of this section, substantive restrictions include cases in 
which a redemption is permitted under a partnership agreement only if 
the redemption is

[[Page 3066]]

necessary to avoid a violation of state, federal, or local laws (such 
as ERISA or the Bank Holding Company Act) or the imposition of a 
federal excise tax on, or a change in the federal tax-exempt status of, 
a tax-exempt partner.
    (9) Special rules for partnerships in existence on June 4, 2004. In 
the case of a partnership in existence on June 4, 2004, paragraph 
(n)(6)(viii) of this section will not apply to the partnership and 
paragraph (n)(6)(ix) of this section is applied by substituting ``20 
years'' for ``15 years.''
    (10) Election--(i) Eligibility. A partnership is eligible to make 
the election described in paragraph (n)(6)(i) of this section if the 
partnership meets the definition of an electing investment partnership 
in paragraph (n)(6) of this section and does not have an election under 
section 754 in effect.
    (ii) Manner of making election. A partnership must make the 
election by attaching a written statement to an original return for the 
taxable year for which the election is effective. The original return 
must be filed not later than the time prescribed by Sec.  1.6031(a)-
1(e) of the Procedure and Administration Regulations (including 
extensions) for filing the return for the taxable year for which the 
election is effective. If the partnership is not otherwise required to 
file a partnership return, the election shall be made in accordance 
with the rules in Sec.  1.6031(a)-1(b)(5) of the Procedure and 
Administration Regulations. The statement must--
    (A) Set forth the name, address, and tax identification number of 
the partnership making the election;
    (B) Contain a representation that the partnership is eligible to 
make the election; and
    (C) Contain a declaration that the partnership elects to be treated 
as an electing investment partnership.
    (iii) Effect and duration of election. Once the election is made, 
the election is effective for all transfers during the partnership's 
taxable year for which the election is effective and all succeeding 
taxable years, except as provided in paragraphs (n)(10)(iv) and 
(n)(10)(v) of this section.
    (iv) Termination of election--(A) In general. The election 
terminates if the partnership fails to meet the definition of an 
electing investment partnership. The electing investment partnership's 
election also terminates if the partnership files an election under 
section 754.
    (B) Effect of termination. If the election terminates, the 
partnership will be subject to the substantial built-in loss provisions 
in this section with respect to the first transfer of a partnership 
interest that occurs after the partnership ceases to meet the 
definition of an electing investment partnership (or the first transfer 
that occurs after the effective date of the section 754 election) and 
to each subsequent transfer. In addition, any losses that are 
subsequently allocated to a partner to whom a partnership interest was 
transferred while the election was in effect shall remain subject to 
the rules in paragraph (n)(2) of this section.
    (v) Revocation of election--(A) In general. The election, once 
made, shall be irrevocable except with the consent of the Commissioner. 
The application for consent to revoke the election must be submitted to 
the Internal Revenue Service in the form of a letter ruling request.
    (B) Effect of revocation. If the election is properly revoked, the 
partnership will be subject to the substantial built-in loss provisions 
in this section with respect to the first transfer of a partnership 
interest that occurs after the effective date of the revocation and to 
each subsequent transfer. In addition, any losses that are subsequently 
allocated to a partner to whom a partnership interest was transferred 
while the election was in effect shall remain subject to the rules in 
paragraph (n)(2) of this section.
    (11) Transferor partner required to provide information to 
transferee partner and partnership--(i) In general. Except as provided 
in paragraph (n)(11)(ii) of this section, if an electing investment 
partnership interest is transferred in a sale or exchange or upon the 
death of a partner, the transferor (or, in the case of a partner who 
dies, the partner's executor, personal representative, or other 
successor in interest) must notify the transferee and the partnership 
in writing. If the transferor is a nominee (within the meaning of Sec.  
1.6031(c)-1T), then the nominee, and not the beneficial owner of the 
transferred interest, must supply the information to the transferee and 
the partnership. The notice must be provided within 30 days after the 
date on which the transferor partner (or the executor, personal 
representative, or other successor in interest) receives a Schedule K-1 
from the partnership for the partnership's taxable year in which the 
transfer occurred. The notice must be signed under penalties of 
perjury, must be retained by the transferee and the partnership as long 
as the contents thereof may be material in the administration of any 
internal revenue law, and must include--
    (A) The name, address, and tax identification number of the 
transferor;
    (B) The name, address, and tax identification number of the 
transferee (if ascertainable);
    (C) The name of the electing investment partnership;
    (D) The date of the transfer (and, in the case of the death of a 
partner, the date of the death of the partner);
    (E) The amount of loss, if any, recognized by the transferor on the 
transfer of the interest, together with the computation of the loss;
    (F) The amount of losses, if any, recognized by any prior 
transferors to the extent the losses were subject to disallowance under 
paragraph (n)(2) of this section in the hands of a prior transferee and 
have not been offset by prior loss disallowances under paragraph (n)(2) 
of this section; and
    (G) Any other information necessary for the transferee to compute 
the amount of loss disallowed under paragraph (n)(2) of this section.
    (ii) Exception. The rules of paragraph (n)(11)(i) of this section 
do not apply if the transferor recognizes a gain on the transfer and no 
prior transferor recognized a loss on any transfer.
    (iii) Effect of failure to notify transferee partner. If the 
transferor partner, its legal representative in the case of a transfer 
by death, or the nominee (if the transferor is a nominee) fails to 
provide the transferee partner with the statement, the transferee 
partner must treat all losses allocated from the electing investment 
partnership as disallowed under paragraph (n)(2) of this section unless 
the transferee partner obtains, from the partnership or otherwise, the 
information necessary to determine the proper amount of losses 
disallowed under paragraph (n)(2) of this section. If the transferee 
does not have the information necessary to determine the proper amount 
of losses disallowed under paragraph (n)(2) of this section, but does 
have information sufficient to determine the maximum amount of losses 
that could be disallowed, then the transferee may treat the amount of 
losses disallowed under paragraph (n)(2) of this section as being equal 
to that maximum amount. For example, if the transferee is able to 
ascertain the adjusted basis that a prior transferor had in its 
partnership interest, but is not able to ascertain the amount realized 
by that transferor, the transferee may assume, for purposes of 
calculating the amount of losses disallowed under paragraph (n)(2) of 
this section, that the sales price when the prior transferor sold its 
interest was zero. If, following the filing of a return pursuant to the 
previous sentence, the transferor partner or the partnership provides 
the required

[[Page 3067]]

information to the transferee partner, the transferee partner should 
make appropriate adjustments in an amended return for the year of the 
loss allocation from the partnership in accordance with section 6511 or 
other applicable rules.
    (iv) Additional rules. See paragraph (n)(12)(i) of this section for 
additional reporting requirements when the electing investment 
partnership is not required to file a partnership return.
    (12) Electing investment partnership required to provide 
information to partners--(i) Distributive shares of partnership items. 
An electing investment partnership is required to separately state on 
Schedule K and K-1 of the partnership's return (Form 1065) all 
allocations of losses to all of its partners under Sec.  1.702-
1(a)(8)(ii), including losses that, in the absence of section 743(e), 
could be netted against gains at the partnership level. If a 
partnership's election to be treated as an electing investment 
partnership is terminated or revoked under paragraphs (n)(10)(iv) or 
(n)(10)(v) of this section, the partnership must continue to state such 
gains and losses separately in future returns relating to any period 
during which the partnership has one or more transferee partners that 
are subject to section paragraph (n)(2) of this section. If an electing 
investment partnership is not required to file a partnership return, 
the transferee of a partnership interest may be required to provide the 
Commissioner similar information regarding the partner's distributive 
share of gross gains and losses of the partnership under Sec.  
1.6031(a)-1(b)(4).
    (ii) Annual statement. An electing investment partnership must 
provide an annual statement to all of its partners. The statement must 
be attached to every statement provided to a partner or nominee under 
section 6031(b) that is issued with respect to any taxable year for 
which an election to be treated as an electing investment partnership 
is in effect (whether or not the election is in effect for the entire 
taxable year). The statement must include the following--
    (A) A statement that the partnership has elected to be treated as 
an electing investment partnership;
    (B) A statement that, unless the transferor partner recognizes a 
gain on the transfer and no prior transferor recognized a loss on any 
transfer, if a partner transfers an interest in the partnership to 
another person, the transferor partner must, within 30 days after 
receiving a Schedule K-1 from the partnership for the taxable year that 
includes the date of the transfer, provide the transferee with certain 
information, including the amount, if any, of loss that the transferor 
recognized on the transfer of the partnership interest, and the amount 
of losses, if any, recognized by prior transferors with respect to the 
same interest; and
    (C) A statement that if an interest in the partnership is 
transferred to a transferee partner, the transferee is required to 
reduce its distributive share of losses from the partnership, 
determined without regard to gains from the partnership, to the extent 
of any losses recognized by the transferor partner when that partner 
transferred the partnership interest to the transferee (and to the 
extent of other losses recognized on prior transfers of the same 
partnership interest that have not been offset by prior loss 
disallowances). The statement must also notify the transferee that it 
is required to reduce its share of losses as reported to the transferee 
by the partnership each year by the amount of any loss recognized by 
the transferor partner (or any prior transferor to the extent not 
already offset by prior loss disallowances) until the transferee has 
reduced its share of partnership losses by the total amount of losses 
required to be disallowed. Finally, the statement must state that if 
the transferor partner (or its nominee), or its legal representative in 
the case of a transfer by death, fails to provide the transferee with 
the required statement, the transferee must treat all losses allocated 
from the partnership as disallowed unless the transferee obtains, from 
the partnership or otherwise, the information necessary to determine 
the proper amount of losses disallowed.
    (o) Securitization partnerships--(1) General rule. A securitization 
partnership (as defined in paragraph (o)(2) of this section) shall not 
be treated as having a substantial built-in loss with respect to any 
transfer.
    (2) Definition of securitization partnership. A securitization 
partnership means any partnership the sole business activity of which 
is to issue securities that provide for a fixed principal (or similar) 
amount and that are primarily serviced by the cash flows of a discrete 
pool (either fixed or revolving) of receivables or other financial 
assets that by their terms convert into cash in a finite period, but 
only if the sponsor of the pool reasonably believes that the 
receivables and other financial assets comprising the pool are not 
acquired for the purpose of being disposed of.
    (p) Effective/applicability date. * * * Paragraph (f)(2) of this 
section and the provisions relating to substantial built-in losses in 
paragraph (a) and paragraphs (k), (l), (m), (n), and (o) of this 
section are effective for transfers of partnership interests occurring 
on or after the date of publication of the Treasury decision adopting 
these rules as final regulations in the Federal Register.
0
Par. 9. Section 1.755-1 is amended by:
0
1. Revising paragraph (b)(5).
0
2. Redesignating paragraph (e) as paragraph (f).
0
3. Adding a new paragraph (e).
0
4. Revising newly redesignated paragraph (f).
    The revisions and addition read as follows:


Sec.  1.755-1  Rules for allocation of basis.

* * * * *
    (b) * * *
* * * * *
    (5) Substituted basis transactions--(i) In general. This paragraph 
(b)(5) applies to basis adjustments under section 743(b) that result 
from exchanges in which the transferee's basis in the partnership 
interest is determined in whole or in part by reference to the 
transferor's basis in that interest and from exchanges in which the 
transferee's basis in the partnership interest is determined by 
reference to other property held at any time by the transferee. For 
example, this paragraph (b)(5) applies if a partnership interest is 
contributed to a corporation in a transaction to which section 351 
applies, if a partnership interest is contributed to a partnership in a 
transaction to which section 721(a) applies, or if a partnership 
interest is distributed by a partnership in a transaction to which 
section 731(a) applies.
    (ii) Allocations between classes of property--(A) No adjustment. 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).
    (B) Increases. If there is an increase in basis to be allocated to 
partnership assets, the increase must be allocated between capital gain 
property and ordinary income property in proportion to, and to the 
extent of, the gross gain or gross income (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 property in each class. Any 
remaining increase must be allocated between the classes in proportion 
to the fair market value of all property in each class.
    (C) Decreases. If there is a decrease in basis to be allocated to 
partnership assets, the decrease must be allocated

[[Page 3068]]

between capital gain property and ordinary income property in 
proportion to, and to the extent of, the gross 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 property in each class. Any 
remaining decrease must be allocated between the classes in proportion 
to the transferee's shares of the adjusted bases of all property in 
each class (as adjusted under the preceding sentence).
    (iii) Allocations within the classes--(A) Increases. If, under 
paragraph (b)(5)(ii) of this section, 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 
(to the extent attributable to the acquired partnership interest) 
before the 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 their fair market values.
    (B) Decreases. If, under paragraph (b)(5)(ii) of this section, 
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 (to the extent attributable to the 
acquired partnership interest) before the 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 a 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 assets in that class, the basis of the 
property is reduced to zero (but not below zero).
    (D) Carryover adjustment. Where a transferee's negative basis 
adjustment under section 743(b) cannot be allocated to any asset, 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.  * * *
    Example 2.  * * *
    Example 3 --(i) A is a one-third partner in UTP, a partnership, 
which has a valid election in effect under section 754. The three 
partners in UTP have equal interests in the capital and profits of 
UTP. UTP has three assets with the following adjusted bases and fair 
market values:

 
                                                            Fair market
                 Assets                   Adjusted basis       value
 
Intangible 1............................             $30            $200
Land....................................             200             200
50% interest in LTP.....................             190             200
 

    LTP, a partnership, has a section 754 election in effect for the 
year of the distribution. LTP owns three assets with the following 
adjusted bases and fair market values:

 
                                                            Fair market
                 Assets                   Adjusted basis       value
 
Intangible 2............................            $340            $100
Intangible 3............................              20             280
Inventory...............................              20              20
 

    UTP distributes its interest in LTP in redemption of A's 
interest in UTP. At the time of the distribution, A's adjusted basis 
in its UTP interest is $140. A recognizes no gain or loss on the 
distribution. Under section 732(b), A's basis in the distributed LTP 
interest is $140. Under sections 734(b) and 755, UTP increases its 
adjusted basis in Intangible 1 by $50, the amount of the basis 
adjustment to the LTP interest in the hands of A.
    (ii) The amount of the basis adjustment with respect to LTP 
under section 743(b) is the difference between A's basis in LTP of 
$140 and A's share of the adjusted basis to LTP of partnership 
property. A's share of the adjusted basis to LTP of partnership 
property is equal to the sum of A's share of LTP's liabilities of $0 
plus A's interest in the previously taxed capital of LTP of $190 
($200, A's cash on liquidation, increased by $120, the amount of tax 
loss allocated to A from the sale of Intangible 2 in the 
hypothetical transaction, decreased by $130, the amount of tax gain 
allocated to A from the sale of Intangible 3 in the hypothetical 
transaction). Therefore, the amount of the negative basis adjustment 
under section 743(b) to partnership property is $50.
    (iii) Under this paragraph (b)(5), LTP must allocate $50 of A's 
negative basis adjustment between capital gain property and ordinary 
income property in proportion to, and to the extent of, the gross 
loss (including any remedial allocations under Sec.  1.704-3(d)) 
that would be allocated to A from the hypothetical sale of all 
property in each class. If LTP disposed of its assets in a 
hypothetical sale, A would be allocated $120 of gross loss from 
Intangible 2 only. Accordingly, the $50 negative adjustment must be 
allocated to capital assets. Under paragraph (b)(5)(iii)(B) of this 
section, the $50 negative adjustment must be allocated to the assets 
in the capital class first to properties with unrealized 
depreciation in proportion to the transferee's shares of the 
respective amounts of unrealized depreciation. Thus, the $50 
negative adjustment must be allocated entirely to Intangible 2.
    Example 4 --(i) A is a one-third partner in LTP, a partnership 
that has made an election under section 754. The three partners in 
LTP have equal interests in the capital and profits of LTP. LTP has 
two assets: accounts receivable with an adjusted basis of $300 and a 
fair market value of $240 and a nondepreciable capital asset with an 
adjusted basis of $60 and a fair market value of $240. 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 LTP interest is 
$150. Under section 723, UTP's basis in its interest in LTP is $150.
    (ii) The amount of the basis adjustment under section 743(b) is 
the difference between UTP's $150 basis in its LTP interest and 
UTP's share of the adjusted basis to LTP of LTP's property. UTP's 
share of the adjusted basis to LTP of LTP's property is equal to the 
sum of UTP's share of LTP's liabilities of $0 plus UTP's interest in 
the previously taxed capital of LTP of $120 ($160, the amount of 
cash on liquidation, increased by $20, the amount of tax loss 
allocated to UTP from the hypothetical transaction, and decreased by 
$60, the amount of tax gain allocated to UTP from the hypothetical 
transaction). Therefore, the amount of the negative basis adjustment 
under section 743(b) to partnership property is $30.
    (iii) The total amount of gross loss that would be allocated to 
UTP from the hypothetical sale of LTP's ordinary income property is 
$20 (one third of the excess of the basis of the accounts receivable 
($300) over their fair market value ($240)). The hypothetical sale 
of LTP's capital gain property would result in a net gain. 
Therefore, under this paragraph (b)(5), $20 of the $30 basis 
adjustment must be allocated to ordinary income property. Because 
LTP holds only one ordinary income property, the $20 decrease must 
be allocated entirely to the accounts receivable. Pursuant to 
paragraph (b)(5)(ii)(C) of this section, the remaining $10 basis 
adjustment must be allocated between ordinary income property and 
capital gain property according to UTP's share of the adjusted bases 
of such properties. Therefore, $8 ($10 multiplied by $80 divided by 
$100) would be allocated to the accounts receivable and $2 ($10 
multiplied by $20 divided by $100) would be allocated to the 
nondepreciable capital asset. * * *
* * * * *
    (e) No allocation of basis decrease to stock of corporate partner--
(1) In general. In making an allocation under section 755(a) of any 
decrease in the adjusted basis of partnership property under section 
734(b)--
    (A) No allocation may be made to stock in a corporation (or any 
person related (within the meaning of sections

[[Page 3069]]

267(b) or 707(b)(1)) to such corporation) that is a partner in the 
partnership; and
    (B) Any amount not allocable to stock by reason of paragraph (c)(1) 
of this section shall be allocated under section 755(a) to other 
partnership property.
    (2) Recognition of gain. Gain shall be recognized to the 
partnership to the extent that the amount required to be allocated 
under paragraph (e)(1)(B) of this section to other partnership property 
exceeds the aggregate adjusted basis of such other property immediately 
before the allocation required by paragraph (e)(1)(B) of this section.
    (3) Example. A, B, and C are equal partners in PRS, a 
partnership. C is a corporation. The adjusted basis and fair market 
value for each of their interests in PRS are $100. PRS owns Capital 
Asset 1 with an adjusted basis of $0 and a fair market value of 
$100, Capital Asset 2 with an adjusted basis of $150 and a fair 
market value of $50, and stock in Corp, a corporation that is 
related to C under section 267(b), with an adjusted basis and fair 
market value of $150. PRS has a section 754 election in effect. PRS 
distributes Capital Asset 1 to A in liquidation of A's interest in 
PRS. PRS will reduce the basis of its remaining assets under section 
734(b) by $100, to be allocated under section 755. The entire 
adjustment is allocated to Capital Asset 2, reducing its basis by 
$100 to $50. Pursuant to the general rule of paragraph (c) of this 
section, PRS would reduce the basis of Capital Asset 2 by $50 and 
the stock of Corp by $50. However, Pursuant to paragraph (e)(1)(A) 
of this section, the basis of the Corp stock is not adjusted. Thus, 
the basis of Capital Asset 2 is reduced by $100 from $150 to $50.

    (f) Effective date--(1) Generally. Except as provided in paragraph 
(f)(2) of this section, this section applies to transfers of 
partnership interests and distributions of property from a partnership 
that occur on or after December 15, 1999.
    (2) Special rules. Paragraphs (a) and (b)(3)(iii) of this section 
apply to transfers of partnership interests and distributions of 
property from a partnership that occur on or after June 9, 2003. 
Paragraph (b)(5) of this section applies to transfers of partnership 
interests occurring on or after January 16, 2014. Paragraph (e) of this 
section applies to transfers of partnership interests occurring on or 
after the date of publication of the Treasury decision adopting these 
rules as final regulations in the Federal Register.
* * * * *


Sec.  1.1502-13  [Amended]

0
Par. 10. Section 1.1502-13 is amended by:
0
1. Amending paragraph (h)(2), Example 4, by removing ``Five years'' and 
adding in its place ``Seven years''.

Beth Tucker,
Deputy Commissioner for Operations Support.
[FR Doc. 2014-00649 Filed 1-15-14; 8:45 am]
BILLING CODE 4830-01-P