Allocations relating to property contributed to partnership.

• Author: Carman, William T.

Final Regs. Sec. 1.704-3, relating to allocations of built-in gain or loss associated with property contributed to a partnership, eliminated the "deferred sale" method as one of the methods proposed in 1992 as reasonable for performing Sec. 704(c) allocations. New temporary and proposed regulations (Temp. Regs. Sec. 1.704-3T) replace the deferred-sale method with a new and significantly different method--the "remedial allocation" method. Other changes to the proposed regulations include the adoption of aggregation rules that can be used to simplify the application of Sec. 704(c) principles to certain securities partnerships. The regulations (both final and temporary) are effective for property contributed to a partnership (or revalued under Regs. Sec. 1.704-1(b)(2)(iv)(f)) after Dec. 21, 1993.

Remedial allocation method

Final Regs. Sec. 1.704-3 eliminates the deferred-sale method from the list of Sec. 704(c) methods previously described as reasonable. Temp. Regs. Sec. 1.704-3T introduces a new method, referred to as the remedial allocation method.

Under the new remedial allocation method, depreciation for book and tax purposes is calculated by bifurcating the asset into a carryover component and a "book-up" component. The carryover component must be depreciated under normal tax depreciation rules; the partnership "steps into the shoes" of the contributor, and the book-up component can be depreciated using any applicable recovery period and depreciation method available to the partnership for newly purchased property. However, rather than allocating this depreciation the same for book and tax purposes, tax depreciation is instead allocated first to the noncontributing partners to the extent of their share of book depreciation (as under the traditional method). If the partnership encounters a ceiling limitation in making this allocation, it may "create" (for tax purposes only) deductions of a similar character to be allocated to the noncontributing partner. To offset this artificially created deduction, an equal amount of income is created (for tax purposes only) and allocated to the contributing partners. This item of income must be of the same character as the type of income "produced" by the property (through normal operations rather than on its disposition).

Thus, use of the remedial allocation method results in the conversion of any Sec. 1231 or capital gain to ordinary income. However, the remedial allocation method allows the built-in...