United States: IRS Proposes Partnership Regulations On Loss Transfers, Basis Reductions And Revaluation Allocations

The IRS has issued long-awaited proposed regulations (REG-144468-05) that provide guidance on Section 704(c)(1)(C) built-in loss property; amend the basis allocation rules of Section 743 adjustments on substituted basis transactions and provide guidance on the allocations resulting from the revaluation of partnership property.

Contributed built-in loss property

Congress enacted Section 704(c)(1)(C) in 2004 to allow only a contributing partner to take into account a built-in loss from property that the partner had contributed to the partnership. The intent was to prohibit a duplication of losses if a partner contributed built-in loss property to a partnership and then sold at least a portion of the interest in the partnership to a second partner in a manner that could result in both partners recognizing the loss.

The proposed regulations define Section 704(c)(1)(C) property as Section 704(c) property with a built-in loss at the time of contribution. The proposed regulations define the Section 704(c)(1)(C) basis adjustment as initially equal to the excess of the adjusted basis over the fair market value of the Section 704(c)(1)(C) property and subsequently adjusted as provided in the proposed regulations (e.g., depreciation, amortization, etc., on the Section 704(c)(1)(C) basis adjustment amount). The annual recovery of the Section 704(c)(1)(C) basis adjustment is added to the Section 704(c)(1)(C) partner's distributive share of other partnership items.

The proposed regulations also address distributions by partnerships holding Section 704(c)(1)(C) property, transfers of a Section 704(c)(1)(C) partner's partnership interest and transfers of Section 704(c)(1)(C) property by the partnership. A key item to note is that the proposed regulations provide a change to the general rule that a Section 704(c)(1)(C) basis adjustment attributable to an interest transferred is eliminated upon such a transfer. The proposed regulations provide that this rule does not apply if the Section 704(c)(1)(C) partner transfers its partnership interest in a nonrecognition transaction.

In the preamble to the proposed regulations, the IRS said it considered whether the Section 704(c)(1)(C) rules should apply to "reverse" Section 704(c) allocations resulting from the revaluations of partnership property. It concluded that the proposed regulations would not apply to reverse Section 704(c) allocations because of the current administrative complexities that would arise from such an application. Also, the proposed regulations provide that Section 704(c)(1)(C) property does not include Treas. Reg. Sec. 1.752-7 liabilities, as the issues presented with such liabilities are appropriately addressed in those rules.

The proposed regulations also provide new reporting requirements by partnerships upon the contribution of built-in loss property by a partner, including attaching a statement to the partnership's tax return disclosing the information about the contributed built-in loss property and contributing partner.

Basis allocation rules for substituted basis transactions

The IRS explained in the preamble to the proposed regulations that the current language in the basis allocation rules for substituted basis transactions in Treas. Reg. Sec. 1.755-1(b)(5) may result in a partnership not being able to appropriately adjust the basis of property due to the "net gain" and "net loss" requirement. The proposed regulations instead state that an increase in basis under Section 743(b) resulting from substituted basis transactions are allocated between capital gain property and ordinary income property in proportion to the inherent "gross gains" or "gross income" in the partnership property in each class allocable to the transferee. A decrease to basis is allocated between capital gain property and ordinary income property in proportion to the inherent "gross losses" that would be allocable to the transferee.

The proposed regulations appear to prevent a situation in which a basis adjustment under Section 743(b) could not be allocated among the partnership property due to the absence of an overall "net gain" in the partnership property in the event of a positive Section 743(b) basis adjustment and the absence of an overall "net loss" in the partnership property in the event of a negative Section 743(b) basis adjustment. These changes apply to transfers of partnership interest occurring on or after Jan. 16, 2014.

Allocations resulting from revaluations of partnership property

The proposed regulations also provide for a layering approach to maintain separate forward and reverse Section 704(c) layers on each Section 704(c) property. Therefore, a new reverse Section 704(c) built-in gain or loss cannot be netted against existing Section 704(c) layers. These proposed regulations are in response to comments providing differing views on whether a layering or netting approach to maintaining multiple Section 704(c) built-in gains or built-in losses on the same property would be more appropriate. The IRS said in the preamble that a netting approach may lead to distortions in the Section 704(c) allocations and is, therefore, prohibited. However, the IRS did recognize that maintaining Section 704(c) layers might result in additional administrative burdens and requested comments on when it would be appropriate for partnerships to use a netting approach. Additionally, the proposed regulations reflect a measure of flexibility in permitting partnerships to use any "reasonable method" in allocating tax items.

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