Sample Answer to Question 3
Partnership Tax
Spring 2003

No gain or loss is recognized to the partnership or any of the partners on the contributions. Iris and Jo's bases in their partnership interests increase to $610,000 each. Herb's basis in his interest increases to $340,000, on account of the $240,000 basis in the contributed building. IRC § 722. HIJ's basis in the building immediately after the contribution is $240,000, carried over from Herb. IRC § 723.

Under IRC § 704(c)(1)(A), the depreciation deductions attributable to the building must be allocated in such a way as to take into account the disparity between the building's fair market value and its adjusted basis to Herb at the time of its contribution to HIJ. Under Reg. § 1.704-3(b)(1), the noncontributing partners, Iris and Jo, are allocated depreciation deductions first, up to the book depreciation being allocated to each; only thereafter are deductions allocated to Herb. Here, the building has an initial book value of $510,000 (its fair market value upon contribution), and the depreciation period is 10 years. Thus, the book depreciation is $51,000 per year, allocated equally ($17,000 each) among Herb, Iris, and Jo.

Since the tax deprecation is only $24,000, Iris and Jo are eligible for only $12,000 each of annual depreciation deductions under the "traditional method" described in Reg. § 1.704-3(b)(1). Under that method (and its "ceiling rule"), Herb would not receive any depreciation deductions attributable to the building.

If HIJ elected, it could use the traditional method with curative allocations under Reg. § 1.704-3(c). Under that method, Iris and Jo would each be entitled to a $17,000 deduction, for a total of $34,000 of deductions each year. To reconcile the $10,000 difference between this total and the $24,000 depreciation deduction attributable to the building, Iris and Jo could be specially allocated, for tax purposes only, $10,000 of depreciation on other HIJ assets that is being charged to Herb's capital account. Alternatively, a "tax-only" allocation of $10,000 of ordinary income could be made to Herb with regard to $10,000 of income that is being credited to Iris's and Jo's capital accounts.

Under the remedial method, described in Reg. § 1.704-3(d), HIJ could avoid the "ceiling rule" by creating a fictional item of income each year equal to the excess of Iris's and Jo's book depreciation over the tax depreciation attributable to the building. However, for purposes of determining each partner's book depreciation, the remedial method would require that HIJ bifurcate the $510,000 of book depreciation as follows: an amount equal to the basis of the building, $240,000, would be depreciated for book purposes over a 10-year period, but the remainder of the book value, $270,000, would be depreciated for book purposes over the 30-year life that would be assigned to a newly purchased building.

Thus, the annual book depreciation would be ($240,000 / 10) + ($270,000 / 30). Doing the math, this is $24,000 + $9,000 = $33,000 annual book depreciation. This would be allocated $11,000 each to Herb, Iris, and Jo. Thus, of the $24,000 of tax depreciation deductions in 2003, $22,000 would be assigned to Iris and Jo ($11,000 each), and the remaining $2,000 would be deductible by Herb.

The $24,000 depreciation on the building in 2003 decreases its basis to $216,000. The deduction (if any) passing through to each partner reduce the partner's bases in his or her partnership interest. IRC § 705.

The deductions would be ordinary. The partners may encounter passive loss or at-risk issues when they attempt to deduct the losses on their individual tax returns.

If the partnership elects, it may be treated as an "association," taxable as a corporation.