Guidance issued on the allocation of depreciation recapture from partnership dispositions.

On Dec. 11, 1996, the IRS issued proposed regulations on the allocation of depreciation recapture from the disposition of partnership property. The current regulations are unclear as to how depreciation recapture should be allocated under Sec. 704. Prior to the issuance of the proposed regulations, depreciation recapture was typically allocated to partners in the same manner as total gain. This technique increased the likelihood that the gain recapture was allocated in a method that differed from the allocation of the depreciation deductions that resulted in the recapture. Additionally, there was no guidance on the allocation of recapture gain from contributed property subject to Sec. 704(c). The proposed regulations (primarily revising Regs. Sec. 1.1245-1(e)(2)) are designed to achieve parity between those partners who received the depreciation deductions and those who are allocated the recapture.

Generally, a partner's distributive share of gain recognized under Sec. 1245(a)(1) by the partnership is the lesser of (1) the partner's share of the total gain from the sale of property or (2) the partner's share of the depreciation or amortization on the property. Any remaining recapture gain is allocated to the partners in proportion to their share of (but not in excess of) their total gain. A partner's share of depreciation or amortization on property equals the depreciation allowed or allowable that has been allocated to him. If a partner transfers an interest in the partnership, the previously allocated depreciation is also transferred to the transferee partner. A partner's share of depreciation or amortization with respect to his contributed property includes all depreciation or amortization allowed or allowable prior to the contribution. The depreciation allowed or allowable prior to contribution to a 1.704-3(c) or remedial allocations under Regs. Sec. 1.704-3(d).

Two examples, based on Regs. Sec. 1.1245- 1 (e) (2) (iv), show how these new rules are intended to work.

Example 1: A and B contribute $5,000 cash each to form AB, a general partnership. The partnership agreement provides that depreciation deductions will be allocated 90% to A and 10% to B, and, on the sale of depreciable property, A will first be allocated gain to the extent necessary to equalize A's and B's capital accounts. Any remaining gain will be allocated 50% to A and 50% to B. In its first year of operations, AB purchases depreciable equipment of $5,000. AB depreciates the equipment over its five-year recovery period and elects to use the straight-line method. In its first year of operations, AB's operating income equals its expenses other than depreciation. Assume no first-year conventions for depreciation purposes.

[] Year 1: In its first year of operations, AB has $1,000 of depreciation from the partnership equipment. In accordance with the partnership agreement, AB allocates $900 of depreciation to A and $100 depreciation to B. At the end of the year, AB sells the equipment for $5,200, recognizing gain of $1,200. In accordance with the partnership agreement, the first $800 of gain is allocated to A to equalize the capital accounts, and the remaining $400 is allocated equally between A and B.

[] Recapture allocations: $1,000 of the gain from the sale of the equipment is treated as gain recognized under Sec. 1245(a)(1). A's share of the Sec. 1245 gain is $900 (the lesser of A's share of the total gain ($1,000) or A's share of the depreciation ($900)) and B's share of the Sec. 1245 gain is $100 (also the lesser of B's share of the total gain ($200) or B's share of the depreciation ($100)).

Example 2: Assume the same facts as in Example 1, except that the partnership agreement provides that gains and losses from the sale of depreciable property will be allocated equally between the partners. On the sale of the equipment, AB's total gain of $1,200 is allocated $600 to A and $600 to B. A's share of the Sec. 1245 gain is limited to $600 (the lesser of the total gain ($600) or the depreciation ($900) allocated to A). The remaining $400 of Sec. 1245 gain must be allocated to B. Accordingly, all of A's $600 allocated gain will be treated as Sec. 1245 recapture and B's allocated gain of $600 will be treated as $400 of Sec. 1245 recapture and $200 of Sec. 1231 gain.

While these proposed regulations do not specifically address Sec. 1250 recapture, the rules would nevertheless apply to Sec. 1250 recapture by way of Regs. Sec. 1.1250-1(f), which states that the amount of gain recognized under Sec. 1250(a) by the partnership and by a partner shall be determined in a manner consistent with the principles provided in Regs. Sec. 1.1245-1(e).

These regulations are to be effective for properties acquired by a partnership on or after the date that the final regulations are published in the Federal Register.