A and B form partnership AB and agree that each will be allocated a 50 percent share of all partnership items. A contributes depreciable property with an adjusted tax basis of 4,000 and a book value (fair market value) of 10,000; B contributes 10,000 cash. Because the book value of the contributed property exceeds its adjusted tax basis, A has a section 704(c) built-in gain of 6,000 at the time of contribution — book value less tax basis.
Under the traditional method of Treas. Reg. § 1.704-3(b), the partnership makes allocations that take the built-in gain into account. The property is depreciated straight-line over a 10-year recovery period. Although each partner is allocated 500 of book depreciation per year, the partnership has only 400 of tax depreciation. The ceiling rule of paragraph (b)(1) limits tax items to the partnership’s actual tax items, so the entire 400 of tax depreciation is allocated to B to offset the book/tax disparity created by A’s built-in gain.
If AB sells the property at the beginning of its second year for 9,000, it realizes a tax gain of 5,400 (9,000 amount realized less 3,600 adjusted tax basis), all of which is allocated to A to account for A’s remaining built-in gain. Section 704(c) gain is reduced over time by decreases in the difference between the property’s book value and its adjusted tax basis.
A’s 704(c) built-in gain of 6,000 is the excess of the contributed property’s book value (fair market value of 10,000) over its adjusted tax basis of 4,000 at the time of contribution.
Each partner is entitled to 500 of book depreciation, but AB has only 400 of tax depreciation. Under the ceiling rule of paragraph (b)(1), all 400 must be allocated to noncontributing partner B.
On a later sale, the tax gain attributable to the built-in gain is allocated to A. Selling the property for 9,000 produces 5,400 of tax gain, all allocated to A to account for the contributed built-in gain.
As book depreciation and tax depreciation reduce the property’s book value and adjusted tax basis, the book/tax difference — and thus A’s remaining 704(c) gain — decreases each year.
