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FEDERAL TAXATION
PARTNERSHIP ALLOCATION OF
DEPRECIATION RECAPTURE GAIN AMONG PARTNERS
By Jeffrey M. Palley, CPA, Anchin, Block & Anchin LLP
The IRS recently finalized regulations (proposed regulations were issued in December 1996) that clarify how a partnership should allocate depreciation recapture gain among partners. These regulations clear up several uncertainties.
Pursuant to IRC section 1245, any gain on the sale (or any other disposition) of business personal property will be taxed at ordinary income rates to the extent of any depreciation or amortization previously deducted. The ordinary recapture gain will be limited to the lesser of the 1) total gain recognized or 2) the total of the deductions taken for depreciation or amortization (whether allowed or allowable).
Unless a partner had a special basis adjustment, each partner's distributive share of depreciation recapture was determined in accordance with the provisions of section 704. Neither section 1245 nor section 704 provided concrete guidance on how recapture gain was to be allocated. Generally, a partnership would have allocated the recapture gain in the same percentage as total gain. This method would allocate ordinary income recapture to partners that may have received little or no benefit of depreciation (or amortization) deductions in prior years. If a partner was admitted to a partnership after assets were fully depreciated (or amortized) and the assets were sold while he or she was a partner, some practitioners allocated ordinary income recapture to the newly admitted partner. This was truly inequitable to the new partner for he or she had to pay tax at ordinary income tax rates on the recapture when he or she never benefited from depreciation (or amortization) deductions at the higher ordinary income tax rates.
The newly issued regulations tie depreciation recapture more closely to the partners who enjoyed the depreciation benefits and reduce the likelihood of unjust partner recapture allocations. The final regulations provide that a partner's distributive allocation of recapture gain is equal to the lesser of 1) partner's share of the total gain from the sale of the property (gain limitation) or 2) partner's share of the total depreciation (or amortization) with respect to the property. Any remaining recapture gain that remains unallocated by the partnership under the general rule is allocated among the partners whose shares of the total gain (including recapture income) on the disposition of the property exceed their shares of depreciation (or amortization) with respect to the property. The excess depreciation (or amortization) recapture is allocated to the partners who are not subject to the gain limitation in proportion to their relative shares of total gain from the disposition of the property.
If a partner transfers his or her partnership interest, the transferee partner will receive the same allocation of depreciation (or amortization) as the transferor partner would have received. If only a portion of a partnership interest is transferred, the share of depreciation (or amortization) proportionate to the interest transfer must be allocated to the transferee partner.
On the contribution of property to a partnership by a partner, the final regulations provide that the partner's share of depreciation (or amortization) with respect to the property includes the depreciation or amortization allowed or allowable to the partner before it was contributed. The depreciation allowed or allowable prior to the contribution will now be allocated to the partner who derived the benefits.
The final regs clarify that allocations made pursuant to the traditional method with curative allocations and the remedial allocation method [see Treasury regulations sections 1.704-3(c) & (d) for a description of the traditional method with curative allocations and the remedial allocation method] may reduce a partner's share of depreciation (or amortization) to zero, but not below zero. Any additional unrecaptured gain will be allocated among the remaining partners in proportion to their relative shares of depreciation (or amortization) (subject to any gain limitation that might apply).
Example 1. The ABC partnership agreement provides that depreciation will be allocated evenly among A, B, and C and gains from the sale of depreciable property would be allocated as follows:
B 40%
C 0%
ABC partnership purchases property for $15,000, utilizes $15,000 of depreciation, and sells the fully depreciated asset for $16,000. The ABC partnership gain from the sale of depreciable property will be allocated as follows:
B $6,400 (40% of $16,000)
C $0
B should receive 40% of the excess depreciation of $5,000 (C's share) plus the depreciation it had deducted $5,000 totaling $7,000. Because the total depreciation recapture of $7,000 is more than B's total gain of $6,400, only $6,400 depreciation recapture will be allocated to B. A's gain of $9,600 will result in ordinary income of $8,600 ($5,000 of depreciation previously allocated to A plus the remaining unallocated excess depreciation of $3,600) and capital gain of $1,000.
(1) If there was a section 743(b) adjustment to the basis of section 1245 partnership property with respect to a transferee partner or (2) on the date the partnership interest was acquired by the transferee partner (from sale, exchange, or upon the death of another partner) a section 754 election was in effect and the partnership owned section 1245 property, the amount of gain to be recognized as ordinary income [section 1245(a)(1)] will be determined as follows: (a) The common partnership adjusted basis for the property and (b) the amount realized by the partnership upon the disposition of the property, (or its fair market value if disposed of other than by sale, exchange or involuntary conversion) must be allocated to each partner in the same proportion as the partnership's total gain is allocated. There shall also be an allocation of any adjustments reflected in the adjusted basis [as defined in paragraph (a)(2) of regulations section 1.1245-2], in the same proportion as the partnership's depreciation recapture is recognized. If on the date a partner acquired his partnership interest by way of a sale or exchange the partnership owned such property and an election under section 754 was in effect, then for purposes of the preceding sentence the amount of the adjustments reflected in the adjusted basis of such property in such date shall be deemed to be zero.
A partner's adjusted basis in respect to the property is the portion of the partnership's adjusted basis of the property allocated to the partner, adjusted for any special basis adjustments under section 743 that the partner may have in respect to the property on the date the partnership disposed of the property.
The partner's recomputed basis for the property is the sum of his or her adjusted basis of the property plus the recapturable depreciation reflected in the adjusted basis allocated to him or her. This sum is increased by any special basis adjustment described in section 743(b)(1) or [decreased by any special basis adjustment described in section 743(b)(2)] in respect of the property that was reduced, but only to the extent such amount was applied to adjust the amount of the deductions allowed or allowable to the partner for depreciation or amortization of section 1245 property attributable to the periods referred to in paragraph (a)(2) of regulations section 1.1245-2.
The application of the special basis adjustments above are illustrated in the following example extracted from regulations section 1.1245-2(e):
Example 2. A, B, and C each hold a one-third interest in calendar-year partnership ABC. On December 31, 1962, the firm holds section 1245 property that has an adjusted basis of $30,000 and a recomputed basis of $33,000. Depreciation deductions in respect of the property for 1962 were $3,000. On January 1, 1963, when D purchases C's partnership interest, the election under section 754 is in effect and a $5,000 special basis adjustment is made in respect of D to his one-third share of the common partnership adjusted basis for the property. For 1963 and 1964, the partnership deducts $6,000 as depreciation in respect of the property, thereby reducing its adjusted basis to $24,000, and D deducts $2,800, i.e., his distributive share of the partnership depreciation ($2,000) plus depreciation in respect of his special basis adjustment ($800). On March 15, 1965, the partnership sells the property for $48,000. Since the partnership's recomputed basis for the property ($33,000, i.e., $24,000 adjusted basis plus $9,000 in depreciation deductions) is lower than the amount realized upon the sale ($48,000), the excess of recomputed basis over adjusted basis, or $9,000, is treated as partnership gain under section 1245(a)(1). D's distributive share of such gain is $3,000 ( 1/3 of $9,000). However, the amount of gain recognized by D under section 1245(a)(1) is only $2,800, determined as follows:
Editor:
Contributing Editors.
Kevin Leifer, CPA
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