Built-In Gain and Contributed Property in Partnerships: Section 704(c) Explained
The Core Problem Section 704(c) Solves
Here’s the situation. Partner A contributes a building worth $1,000,000 with a tax basis of $400,000. Partner B contributes $1,000,000 in cash. They’re 50/50 partners. The partnership now has $2,000,000 in assets: a building worth $1,000,000 (with $400,000 basis) and $1,000,000 in cash (with $1,000,000 basis).
For book purposes, each partner contributed $1,000,000 of value. Everything looks equal. But for tax purposes, the building only has $400,000 of basis. There’s $600,000 of built-in gain hiding in that property.
Without Section 704(c), here’s what would happen if the partnership sold the building for $1,000,000 the next day. The partnership would recognize $600,000 of gain ($1,000,000 sale price minus $400,000 basis). A simple 50/50 split would give each partner $300,000 of taxable gain. But that’s unfair to Partner B. They contributed cash. They had no appreciation in their contribution. Why should they pay tax on $300,000 of gain that accrued before they even joined the partnership?
Section 704(c) fixes this by requiring the partnership to allocate the $600,000 of built-in gain entirely to Partner A—the contributing partner. Partner B recognizes zero gain on the sale (the $500,000 of book gain attributable to Partner B’s share is entirely post-contribution economic gain, but since the property didn’t appreciate beyond its contributed value, there’s no taxable gain to allocate to B in this scenario). The tax result matches the economic reality: Partner A is the one who owned the property when it appreciated, so Partner A pays the tax.
The Fundamental Rule
Section 704(c) ensures that pre-contribution gain or loss is allocated to the contributing partner. Non-contributing partners shouldn’t pay tax on appreciation that happened before they joined the partnership.
How Built-In Gain Gets Created
Built-in gain arises whenever contributed property has a fair market value that differs from its tax basis at the time of contribution. The gap between value and basis is the built-in gain (or built-in loss, if basis exceeds value).
Common scenarios that create built-in gain in partnership contributions:
- Real estate contributions. A developer contributes a property purchased for $800,000 that’s now worth $2,500,000 after years of appreciation. Built-in gain: $1,700,000.
- Equipment or vehicles. A contractor contributes construction equipment with a depreciated tax basis of $50,000 and a fair market value of $120,000. Built-in gain: $70,000.
- Intellectual property. A partner contributes a patent with zero tax basis (they developed it internally, expensing the R&D costs) and a fair market value of $500,000. Built-in gain: $500,000.
- Investment securities. A partner contributes stock they purchased for $100,000 that’s now worth $400,000. Built-in gain: $300,000.
Built-in loss works the same way in reverse. If a partner contributes property with a basis of $300,000 and a value of $200,000, there’s $100,000 of built-in loss. Section 704(c) requires that loss to be allocated to the contributing partner when recognized, preventing non-contributing partners from benefiting from a loss they didn’t economically bear.
The built-in gain or loss is measured once, at the time of contribution, and it stays with the contributed property until the partnership disposes of it. Subsequent appreciation or depreciation in the property’s value is shared among all partners according to the partnership agreement.
Book vs. Tax: The Two-Ledger System
Understanding Section 704(c) requires understanding that partnerships keep two sets of books. Not in a shady way—this is how the tax code works.
Book capital accounts (also called Section 704(b) capital accounts) track economic value. When Partner A contributes a building worth $1,000,000, their book capital account is credited with $1,000,000. The building goes on the partnership’s books at $1,000,000.
Tax capital accounts track tax basis. Partner A’s tax basis in their partnership interest starts at $400,000 (the tax basis of the contributed property under IRC Section 722). The building’s inside basis on the partnership’s tax return is $400,000.
The $600,000 gap between the book value ($1,000,000) and the tax basis ($400,000) is the Section 704(c) layer. Every time the partnership takes a deduction related to that property (depreciation, amortization) or recognizes gain or loss on its sale, the partnership must reconcile the book and tax amounts and allocate the difference to the contributing partner.
This two-ledger system is reported on Form 1065, Schedule M-2 (Analysis of Partners’ Capital Accounts) and on each partner’s Schedule K-1. The IRS now requires capital accounts to be reported on the tax basis method, which means the 704(c) differences are baked into the K-1 numbers partners receive. If your partnership has contributed property, these calculations affect your K-1 every single year the property is on the books.
The Three Allocation Methods Under Section 704(c)
The regulations under Treasury Regulation Section 1.704-3 provide three methods for allocating built-in gain items between contributing and non-contributing partners. The partnership agreement should specify which method applies. If it doesn’t, the IRS will look at whether the method used is “reasonable” and consistent with the purpose of Section 704(c).
1. The Traditional Method
This is the default and the most common approach. Under the traditional method, the partnership allocates tax items to match book items to the greatest extent possible, but it never creates an allocation that exceeds the partnership’s actual tax item.
Back to the example: Partner A contributes a building worth $1,000,000 with a $400,000 basis. Partner B contributes $1,000,000 cash. The building has a 20-year remaining useful life.
For book purposes, the partnership depreciates the building from $1,000,000 over 20 years: $50,000 per year. Each 50/50 partner gets $25,000 of book depreciation annually.
For tax purposes, the partnership depreciates the building from $400,000 over 20 years: $20,000 per year. Section 704(c) says that Partner B’s tax depreciation should match their book depreciation ($25,000), but the partnership only has $20,000 of total tax depreciation. Under the traditional method, all $20,000 goes to Partner B, and Partner A gets zero tax depreciation. But Partner B still has a $5,000 shortfall—their book depreciation is $25,000 but they only received $20,000 in tax depreciation.
This $5,000 annual shortfall is called the “ceiling rule limitation.” It’s a known imperfection of the traditional method. Over 20 years, Partner B misses out on $100,000 of tax depreciation they would have received if the building had been purchased (instead of contributed) at fair market value. The ceiling rule is a real economic cost to the non-contributing partner.
2. The Traditional Method with Curative Allocations
The curative method addresses the ceiling rule problem by allowing the partnership to allocate other tax items to offset the distortion. If Partner B is short $5,000 of depreciation deductions from the contributed building, the partnership can allocate $5,000 of some other tax item—like income from another source—away from Partner B or toward Partner A to make up the difference.
The curative allocation must be of the same type and character as the item being adjusted. A depreciation shortfall is a loss/deduction item, so the curative allocation should involve a loss/deduction item (or a corresponding income item). The regulations under Treas. Reg. Section 1.704-3(c) provide the specific rules, including the requirement that curative allocations cannot exceed the disparity caused by the ceiling rule.
In practice, curative allocations work well when the partnership has enough other tax items to use. If the partnership’s only asset is the contributed building and there are no other income or deduction items to reallocate, curative allocations have nothing to work with.
3. The Remedial Method
The remedial method is the most taxpayer-complete solution. When the ceiling rule creates a shortfall, the remedial method lets the partnership create a notional tax item out of thin air. The partnership fabricates a deduction for the non-contributing partner and a matching income item for the contributing partner, so the net effect on partnership taxable income is zero but each partner’s individual tax allocation is correct.
Using the same example: Partner B is short $5,000 of depreciation. Under the remedial method, the partnership creates $5,000 of remedial depreciation for Partner B and $5,000 of remedial ordinary income for Partner A. Partner B gets their full $25,000 of tax depreciation (matching their book depreciation). Partner A picks up $5,000 of additional taxable income. The partnership’s total taxable income is unchanged because the remedial items net to zero.
The remedial method eliminates the ceiling rule problem entirely, but at a cost: the contributing partner (Partner A) recognizes more income sooner than they would under the traditional method. For this reason, the remedial method tends to be favored by non-contributing partners and resisted by contributing partners. The partnership agreement should address which method applies, and the negotiation of this point is a real economic discussion—not just a technical footnote.
Choosing the Right Method
The traditional method is simplest and most common, but it disadvantages non-contributing partners through the ceiling rule. The remedial method fixes this but accelerates income for the contributing partner. Most sophisticated partnership agreements—especially in real estate—specify the method and negotiate the terms as part of the overall deal.
Section 704(c) and Property Sales
When the partnership sells contributed property, the built-in gain is allocated first to the contributing partner. This is the most straightforward application of Section 704(c) and where the rule is most intuitive.
Example: Partner A contributed property with a basis of $400,000 and a value of $1,000,000. Three years later, the partnership sells the property for $1,200,000. The total gain is $800,000 ($1,200,000 sale price minus $400,000 adjusted basis, ignoring depreciation for simplicity).
The first $600,000 of that gain (the original built-in gain) goes entirely to Partner A under Section 704(c). The remaining $200,000 of gain (the post-contribution appreciation) is split 50/50 per the partnership agreement, so $100,000 to each partner.
Final result: Partner A recognizes $700,000 of gain ($600,000 built-in + $100,000 share of post-contribution gain). Partner B recognizes $100,000 of gain. The total is $800,000, which matches the partnership’s recognized gain. Everyone pays tax only on the appreciation that occurred while they had an economic interest in the property.
Section 704(c) and Depreciation
Depreciation is where Section 704(c) gets the most complicated, because the book and tax depreciation run on different schedules and the gap needs to be managed every year for the remaining life of the asset.
The partnership computes book depreciation based on the property’s fair market value at contribution (the “booked-up” value) over the remaining useful life. Tax depreciation is based on the property’s carryover basis over its remaining recovery period under IRS Publication 946 (MACRS rules).
Each year, the partnership must allocate tax depreciation in a way that accounts for the Section 704(c) layer. Under the traditional method, the non-contributing partner receives tax depreciation up to their book depreciation (subject to the ceiling rule). Under the remedial method, the non-contributing partner receives full book-matched tax depreciation, with the gap filled by remedial allocations.
For properties with long depreciation lives—like a 39-year commercial building or a 27.5-year residential rental property—these annual computations continue for decades. If the partnership has multiple contributed properties with different built-in gain layers, the calculations multiply. This is one of the reasons partnership returns with contributed property cost more to prepare: every asset has its own Section 704(c) layer that must be tracked independently.
Software handles most of the computation, but someone still needs to set up the contribution correctly, identify the right method, and verify the K-1 allocations each year. That “someone” is usually a CPA with partnership experience. Errors in the initial setup compound over the life of the asset, and unwinding them after several years of filed returns is expensive and sometimes requires amended filings.
Distributions of Contributed Property
If the partnership distributes the contributed property to a partner other than the contributing partner within seven years of the contribution, IRC Section 704(c)(1)(B) requires the contributing partner to recognize the remaining built-in gain as if the property had been sold at its fair market value on the date of distribution.
This rule exists to prevent the following abuse: Partner A contributes appreciated property, the partnership distributes the property to Partner B, and Partner A claims they never “sold” anything. Without Section 704(c)(1)(B), the built-in gain would vanish because the contributing partner no longer owns the property and the partnership didn’t sell it.
The seven-year window (increased from five years by the American Jobs Creation Act of 2004) is generous by design. After seven years, the contributing partner is no longer penalized for distributions of the contributed property to other partners. But during that seven-year window, any distribution of the property to someone other than the contributing partner triggers gain recognition for the contributor.
There’s a related rule in IRC Section 737 that works in the other direction. If the contributing partner receives a distribution of other property from the partnership within seven years of contributing appreciated property, the contributing partner may have to recognize gain to the extent the distributed property’s value exceeds their outside basis, but limited to the remaining net precontribution gain on the contributed property. Section 737 and Section 704(c)(1)(B) work together to prevent partners from using distributions to avoid the built-in gain that Section 704(c) is designed to preserve.
Revaluations and “Reverse Section 704(c)”
Section 704(c) principles don’t only apply when property is first contributed. They also apply whenever the partnership “books up” (or “books down”) its assets to fair market value in connection with certain events. This is called “reverse Section 704(c)” because the mechanics are the same but the trigger is different.
A book-up happens when the partnership revalues its assets on its books, typically in connection with a new partner admission, a partner’s exit, a distribution of partnership property, or a grant of a partnership interest for services. Under Treas. Reg. Section 1.704-1(b)(2)(iv)(f), the partnership may (and in some cases must) adjust the book value of all assets to fair market value and reallocate the resulting book gain or loss among the existing partners.
After a book-up, every asset that has a different book value than tax basis gets its own Section 704(c) layer. If the partnership already had contributed property with existing 704(c) layers, those layers are preserved and the new reverse 704(c) layers are added on top. The result is multiple overlapping layers on the same asset, each tracked separately, each allocable to different partners.
For example: Partner A contributed a building with $600,000 of built-in gain. Three years later, the building has appreciated further, and the partnership admits Partner C by book-up. The book-up creates a new reverse 704(c) layer for the additional appreciation, allocable to Partners A and B (the pre-admission partners). Partner A now has two 704(c) layers on the same building: the original contribution layer and the reverse 704(c) layer from the book-up. The compliance complexity increases with every revaluation event.
Anti-Abuse Rules and Mixing Bowl Transactions
The IRS has specific anti-abuse provisions to prevent partners from using contributions and distributions to disguise what are really taxable sales. The main provisions are:
Section 704(c)(1)(B): As discussed above, distributions of contributed property to non-contributing partners within seven years trigger gain to the contributor.
Section 737: Distributions of other property to the contributing partner within seven years may trigger gain recognition up to the remaining net precontribution gain.
Section 707(a)(2)(B): If a partner contributes property and receives a “related” distribution from the partnership (or vice versa), the IRS can recharacterize the combined transaction as a disguised sale. The two-year presumption in Treas. Reg. Section 1.707-3 means that if the contribution and distribution occur within two years of each other, they are presumed to be a sale unless the taxpayer can prove otherwise. Between two and seven years, the presumption is that it’s not a sale, but the IRS can still challenge it.
These rules collectively create a web of restrictions around partnership contributions and distributions of appreciated property. The practical effect is that once property with built-in gain enters a partnership, it’s difficult to move that property around without triggering tax consequences for at least seven years. Partners and their advisors need to plan contribution and distribution transactions with these timing rules in mind.
We’ve seen situations where a partner contributed property to a partnership, the partnership distributed cash back to that partner two months later, and the IRS recharacterized the entire thing as a sale. The contributing partner owed capital gains tax on the built-in gain plus interest and penalties for not reporting the “sale” in the first place. The lesson: if a contribution and distribution happen close together, they need to be structured carefully or the whole arrangement falls apart. Talk to your tax advisor before executing these transactions.
Practical Compliance and Recordkeeping
Partnerships with contributed property need to track the following for every contributed asset:
- Fair market value at the date of contribution
- Contributing partner’s carryover basis
- Built-in gain (or loss) amount
- The Section 704(c) method selected (traditional, curative, or remedial)
- Remaining depreciable life for both book and tax purposes
- Any subsequent revaluations (reverse 704(c) layers)
- The seven-year window for Sections 704(c)(1)(B) and 737
This information must be maintained for the life of the asset in the partnership. If the partnership owns the building for 25 years, the Section 704(c) layer follows it for 25 years. Every Form 1065 and every Schedule K-1 must reflect the correct allocations each year.
Common errors we see in our review of incoming client returns include: recording the contributed property at fair market value instead of carryover basis on the tax return; failing to select a Section 704(c) method; applying the wrong method inconsistently across years; ignoring the seven-year rules when distributing property; and failing to create reverse 704(c) layers after admitting new partners. Each of these errors can shift taxable income between partners, potentially exposing both the partnership and individual partners to accuracy-related penalties under IRC Section 6662.
If you’re forming a partnership that will involve contributed property, the operating agreement should explicitly address the Section 704(c) method, property valuation procedures, and the partnership’s obligation to maintain adequate records. This isn’t boilerplate language—it has real dollar consequences. Our Partnership Tax Guide covers additional compliance considerations.
Frequently Asked Questions
What is Section 704(c) and why does it matter for contributed property in a partnership?
Section 704(c) of the Internal Revenue Code addresses the tax allocation of built-in gain or loss when a partner contributes property to a partnership with a fair market value different from its tax basis. The rule exists to prevent the non-contributing partner from bearing the tax burden on appreciation that occurred before the property entered the partnership.
Here’s the practical scenario. Partner A contributes a piece of real estate with a tax basis of $200,000 and a fair market value of $800,000. Partner B contributes $800,000 in cash. Both are 50/50 partners. For book purposes, each partner contributed $800,000 of value. For tax purposes, the building only has $200,000 of basis, creating $600,000 of built-in gain.
When the partnership depreciates the building or eventually sells it, Section 704(c) requires the $600,000 of built-in gain to be allocated to Partner A, not shared 50/50. This prevents Partner B from paying tax on gain that accrued before they joined the partnership. The rule also applies to depreciation deductions—the non-contributing partner should receive tax depreciation that matches their book depreciation, while the contributing partner receives reduced (or zero) tax depreciation because the property’s low tax basis limits the deductions available.
The regulations under Treas. Reg. Section 1.704-3 provide three methods for making these allocations: the traditional method, the traditional method with curative allocations, and the remedial method. Each produces different results for the contributing and non-contributing partners. The partnership agreement should specify which method applies, and this choice has real economic consequences that should be negotiated as part of the deal.
Section 704(c) also interacts with distribution rules. If the contributed property is distributed to a non-contributing partner within seven years, the contributing partner must recognize the remaining built-in gain under IRC Section 704(c)(1)(B). These timing rules prevent partners from using distributions to avoid the built-in gain allocation. For more on how distributions work, see our distributions guide or contact us directly.
What is the difference between the traditional method and the remedial method under Section 704(c)?
The traditional method and the remedial method are two of the three approaches partnerships use to allocate built-in gain items under Treas. Reg. Section 1.704-3. They produce meaningfully different tax results for the contributing and non-contributing partners.
Under the traditional method, the partnership allocates tax items (depreciation, gain on sale) to match the non-contributing partner’s book items, but only to the extent of the partnership’s actual tax items. If book depreciation for the non-contributing partner is $25,000 but total tax depreciation is only $20,000, the non-contributing partner receives $20,000 and the contributing partner receives zero. The $5,000 shortfall is the “ceiling rule limitation”—the traditional method can’t create tax depreciation that doesn’t exist.
Over the life of a long-lived asset, the ceiling rule limitation accumulates. On a contributed building with $600,000 of built-in gain and a 20-year life, the non-contributing partner could lose $100,000 or more of tax depreciation deductions they would have received if the property had been purchased instead of contributed. That’s real after-tax money—at a 37% federal rate, the lost deductions cost the non-contributing partner $37,000 in additional taxes over the holding period.
Under the remedial method, the partnership creates notional tax items to eliminate the ceiling rule shortfall. When the non-contributing partner is $5,000 short on depreciation, the partnership fabricates $5,000 of remedial depreciation for the non-contributing partner and an offsetting $5,000 of remedial ordinary income for the contributing partner. The partnership’s total taxable income is unchanged, but each partner’s individual allocation matches their book allocation perfectly.
The contributing partner pays for this fix through accelerated income recognition. Under the traditional method, the contributing partner gets zero depreciation (but no affirmative income item). Under the remedial method, the contributing partner gets zero depreciation plus $5,000 of phantom income each year. Over 20 years, that’s $100,000 of additional income allocated to the contributing partner. At a 37% rate, that’s $37,000 of tax—exactly matching what the non-contributing partner saves.
The choice of method is a negotiation point in the partnership agreement. Contributing partners prefer the traditional method (lower near-term tax burden). Non-contributing partners prefer the remedial method (full depreciation deductions). In real estate syndications and investment partnerships, this is a substantive economic term, not a footnote in the tax section of the agreement. See our Partnership Tax Guide for additional context.
What is built-in gain and how is it calculated when property is contributed to a partnership?
Built-in gain is the difference between a contributed property’s fair market value and its tax basis at the time of contribution to a partnership. Under IRC Section 721, the contribution itself is tax-free—the contributing partner doesn’t recognize gain when they transfer the property. But the built-in gain is preserved and tracked under Section 704(c) for allocation to the contributing partner when the partnership later sells, depreciates, or distributes the property.
The calculation is straightforward. If a partner contributes a rental property with a fair market value of $1,500,000 and an adjusted tax basis of $600,000 (original cost of $900,000 minus $300,000 of accumulated depreciation), the built-in gain is $900,000. This $900,000 must be allocated to the contributing partner when the partnership recognizes gain on the property, per IRC Section 704(c)(1)(A).
The contributing partner’s outside basis in their partnership interest equals the property’s carryover basis ($600,000 in this example) under IRC Section 722, adjusted for any liabilities assumed by the partnership under Section 752. If the property is subject to a $400,000 mortgage, the contributing partner’s basis is further adjusted by the debt allocation: they get relief from $400,000 of liability (reducing basis) but pick up their share of the partnership’s assumption of that liability (increasing basis). The net effect depends on the number of partners and their profit/loss sharing ratios.
Built-in loss works the same way in reverse. If a partner contributes property with a basis of $500,000 and a value of $350,000, there’s $150,000 of built-in loss. Section 704(c) requires that loss to be allocated to the contributing partner. Special rules under IRC Section 704(c)(1)(C) (added by the American Jobs Creation Act of 2004) require the partnership to use the built-in loss property’s fair market value as its basis for purposes of allocating depreciation and gain/loss to the non-contributing partners, preventing them from claiming losses on decline in value that occurred before the contribution.
Valuation of the contributed property is the most important practical issue. The built-in gain amount is locked in at contribution, and every subsequent allocation flows from that number. If the property is overvalued at contribution, the contributing partner is assigned too much built-in gain. If it’s undervalued, some of the pre-contribution gain escapes Section 704(c) and gets shared with the non-contributing partners. For high-value assets, we recommend a qualified appraisal at the time of contribution. For more guidance, reach out to our team or read our Helpful Guides.
How does Section 704(c) affect partnership depreciation deductions?
Section 704(c) creates a gap between book depreciation and tax depreciation for contributed property, and the allocation method chosen by the partnership determines how that gap affects each partner’s K-1 each year.
Start with the basics. When property is contributed to a partnership, the partnership depreciates it for book purposes from its fair market value at contribution, and for tax purposes from its carryover basis (the contributing partner’s original tax basis). If a building is contributed with a value of $1,000,000 and a basis of $400,000, both depreciated over 20 remaining years, book depreciation is $50,000/year and tax depreciation is $20,000/year. The $30,000 annual gap is the Section 704(c) depreciation differential.
Under the traditional method (Treas. Reg. Section 1.704-3(b)): the non-contributing partner receives tax depreciation up to their book depreciation ($25,000 in a 50/50 partnership), limited by the total tax depreciation available ($20,000). So the non-contributing partner gets $20,000 and the contributing partner gets $0. The $5,000 shortfall to the non-contributing partner is the ceiling rule limitation, and it accumulates every year.
Under the remedial method (Treas. Reg. Section 1.704-3(d)): the non-contributing partner receives $25,000 of tax depreciation (matching book). The extra $5,000 above the partnership’s actual tax depreciation is a remedial allocation—the partnership creates a $5,000 deduction for the non-contributing partner and a $5,000 income item for the contributing partner. Net effect on partnership taxable income: zero. Effect on individual partners: the non-contributing partner gets full depreciation; the contributing partner picks up phantom income.
Under the curative method (Treas. Reg. Section 1.704-3(c)): the partnership reallocates other tax items (from non-contributed assets) to offset the ceiling rule limitation. This works only if the partnership has other income or deduction items available to reallocate. If the contributed property is the partnership’s only asset, curative allocations have nothing to cure.
For properties placed in service under MACRS, the depreciation method, recovery period, and convention all carry over from the contributing partner under IRS Publication 946. If the contributing partner was depreciating a building straight-line over 39 years with 15 years remaining, the partnership continues that schedule for tax purposes. The book depreciation, however, starts fresh at the contributed value over the remaining useful life. When the tax depreciation fully expires (15 years out, in this example), the book depreciation may still continue for another 5 years (if the total book life was 20 years). During those final 5 years, all book depreciation has zero corresponding tax depreciation, and the entire amount is a Section 704(c) differential. Our K-1 and basis guide covers how these items flow to the partners’ returns.
What happens to built-in gain when contributed property is distributed to another partner?
When contributed property is distributed to a partner other than the contributing partner within seven years of the contribution date, IRC Section 704(c)(1)(B) triggers gain recognition for the contributing partner. The contributing partner must recognize the remaining built-in gain as if the property had been sold at its fair market value on the date of distribution.
The seven-year window starts on the date of contribution and runs continuously. If Partner A contributes property with $500,000 of built-in gain on January 1, 2024, and the partnership distributes that property to Partner B on June 15, 2029 (within the seven-year window), Partner A recognizes the remaining built-in gain. If the partnership has been allocating some of the built-in gain through depreciation adjustments over those five and a half years, the remaining amount may be less than the original $500,000—but whatever remains is triggered by the distribution.
The character of the gain (ordinary income vs. capital gain) generally matches what it would have been had the property been sold. For depreciable real estate, this may include Section 1250 recapture (taxed at up to 25%) on the depreciation-related portion and capital gain on the remainder. For inventory or unrealized receivables, the gain may be ordinary under IRC Section 751.
After seven years, distributions of contributed property to non-contributing partners no longer trigger gain under Section 704(c)(1)(B). But the Section 704(c) layer itself doesn’t expire after seven years—it continues to affect depreciation allocations and gain/loss on sale for the life of the property. The seven-year rule only governs the distribution trigger, not the ongoing allocation mechanics.
There’s a companion rule in IRC Section 737 that applies when the contributing partner receives distributions of other property from the partnership within seven years. If Partner A contributed appreciated property and then receives a distribution of cash or other property, Section 737 may require Partner A to recognize gain up to the lesser of (a) the excess of the distribution’s fair market value over Partner A’s outside basis and (b) the remaining net precontribution gain on all properties Partner A has contributed. This rule prevents the contributing partner from extracting value from the partnership while leaving the built-in gain property behind.
The anti-abuse provisions in Treas. Reg. Section 1.707-3 add another layer. If a partner contributes property and receives a “related” distribution within two years, the IRS presumes the combined transaction is a disguised sale. The contributing partner would then owe tax on the entire built-in gain immediately, plus the gain from the sale portion. Planning around these rules requires careful timing and documentation. Consult our tax advisory team or start with a new client inquiry before executing contribution-distribution sequences.
Work With The Reed Corporation
Contributing appreciated property to a partnership? We’ll model the Section 704(c) allocations, select the right method, and make sure the operating agreement covers it.