Par. 6. Section 1.734-2 is amended by revising the section heading and adding paragraph (c) to read as follows:
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(c)(1) Section 704(c)(1)(C) basis adjustments will be taken into account in determining the basis adjustment under section 734(b). However, section 704(c)(1)(C) basis adjustments, other than a section 704(c)(1)(C) basis adjustment applied as an adjustment to the basis of partnership property pursuant to paragraph (c)(2) of this section, will not be taken into account in making allocations under § 1.755-1(c).
(2) Liquidating distributions. If a section 704(c)(1)(C) partner receives a distribution of property (including money) in liquidation of its entire partnership interest, the section 704(c)(1)(C) partner's section 704(c)(1)(C) basis adjustments that are treated as basis in the distributed property pursuant to section 732 will be taken into account in determining the basis adjustment under section 734(b), regardless of whether the distributed property is section 704(c)(1)(C) property. If any section 704(c)(1)(C) basis adjustment cannot be reallocated to distributed property in connection with the distribution, then that remaining section 704(c)(1)(C) basis adjustment shall be treated as a positive section 734(b) adjustment. If the distribution also gives rise to a negative section 734(b) adjustment without regard to the section 704(c)(1)(C) basis adjustment reallocation, then the negative section 734(b) adjustment and the section 704(c)(1)(C) basis adjustment reallocation are netted together, and the net amount is allocated under § 1.755-1(c). If the partnership does not have a section 754 election in effect at the time of the liquidating distribution, the partnership shall be treated as having made a section 754 election solely for purposes of computing any negative section 734(b) adjustment that would arise from the distribution.
(3) The following examples illustrate the provisions of this paragraph (c).
Example 1
—(i) In Year 1, A contributes $5,000 cash and Property A, a capital asset, with an adjusted basis of $7,000 and a fair market value of $5,000; B contributes $8,000 cash and Property B, a capital asset, with an adjusted basis and fair market value of $2,000; and C contributes $7,000 cash and Property C, a capital asset, with an adjusted basis and fair market value of $3,000 to PRS, a partnership. In Year 3, Property B has appreciated in value to $8,000. PRS distributes Property B and $4,000 to C in complete liquidation of C's interest in PRS at a time when no partner's basis in PRS has changed. PRS revalues its property under § 1.704-1(b)(2)(iv)( f ) in connection with the distribution, and makes an election under section 754. C recognizes no gain or loss on the distribution.
(ii) C receives Property B with a basis of $6,000 (C's adjusted basis in PRS of $10,000 minus the $4,000 cash distributed). Because PRS has an election under section 754 in effect, PRS must reduce its basis in remaining partnership property under § 1.734-1(b)(2)(ii) by $4,000 (C's $6,000 basis in Property B minus PRS's $2,000 adjusted basis in Property B prior to the distribution. Under § 1.755-1(c)(2)(ii), that basis reduction must be allocated within a class first to properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation. Any remaining decrease must be allocated in proportion to the properties' adjusted bases. Because there is no unrealized depreciation in either Property A (disregarding A's section 704(c)(1)(C) basis adjustment) or Property C, the decrease must be allocated between the two properties in proportion to their adjusted bases, $2,500 ($4,000 multiplied by $5,000 divided by $8,000) to Property A and $1,500 ($4,000 multiplied by $3,000 divided by $8,000) to Property C.
(iii) In a subsequent year, PRS sells Property A for its fair market value of $7,500 and recognizes $5,000 of gain ($7,500 amount realized minus adjusted basis of $2,500). Pursuant to § 1.704-3(f)(3)(ii)(B), A's $2,500 distributive share of the $5,000 gain from the sale of Property A is reduced by A's $2,000 section 704(c)(1)(C) basis adjustment. Therefore, A recognizes a gain of $500 on the sale.
Example 2
—(i) A contributes Property 1 with an adjusted basis of $15,000 and a fair market value of $10,000 and Property 2 with an adjusted basis of $15,000 and a fair market value of $20,000, and B and C each contribute $30,000 cash to PRS, a partnership. A has a section 704(c)(1)(C) basis adjustment of $5,000 with respect to Property 1. PRS's adjusted bases in Property 1 and Property 2 are $10,000 and $15,000, respectively. When the fair market value of A's interest in PRS is still $30,000, and no partner's basis in its PRS interest has changed, PRS makes a liquidating distribution to A of $30,000 cash, which results in A realizing no gain or loss. PRS has an election under section 754 in effect.
(ii) A is unable to take into account A's section 704(c)(1)(C) basis adjustment in Property 1 upon the distribution of the cash as described in paragraph (c)(2) of this section because A cannot increase the basis of cash under § 1.704-3(f)(v)(C). Thus, A's $5,000 section 704(c)(1)(C) basis adjustment is treated as a positive section 734(b) adjustment to the partnership's assets retained. PRS's $5,000 section 734(b) adjustment will be allocated to Property 2, increasing its basis from $15,000 to $20,000 under § 1.755-1(c).
Example 3
—(i) A contributes Property 1 with an adjusted basis of $35,000 and a fair market value of $30,000, B contributes Property 2 with an adjusted basis and fair market value of $30,000, and C contributes $30,000 cash to PRS, a partnership. Property 1 is a capital asset, and Property 2 is inventory (as defined in section 751(d)). PRS's adjusted basis in Property 1 is $30,000 under section 704(c)(1)(C)(ii), and A has a section 704(c)(1)(C) basis adjustment of $5,000 with respect to Property 1. Later, at a time when the value and bases of the properties have not changed, PRS distributes $30,000 cash to A in complete liquidation of A's interest. A recognizes a ($5,000) loss under section 731(a)(2) on the distribution. PRS has an election under section 754 in effect.
(ii) The distribution results in a negative section 734(b) adjustment to capital gain property of ($5,000) (the amount of loss A recognizes under section 731(a)(2)). Additionally, because A is unable to take into account A's section 704(c)(1)(C) basis adjustment in Property 1 upon the distribution of the cash, A's $5,000 section 704(c)(1)(C) basis adjustment is treated as a positive section 734(b) adjustment. Pursuant to paragraph (c)(2) of this section, these two adjustments are netted together, resulting in no adjustment under section 734(b). Therefore, the partnership's basis in Property 1 and Property 2 remains $30,000.
Example 4
—(i) Assume the same facts as in Example 3 except that PRS distributes Property 2 to A in complete liquidation of A's interest in a transaction to which section 704(c)(1)(B) and section 737 do not apply.
(ii) Pursuant to § 1.704-3(f)(v)(C), A cannot include A's section 704(c)(1)(C) basis adjustment in the basis of the distributed property, because the section 704(c)(1)(C) property and the distributed property are not of like character. Accordingly, the basis to A of Property 2 is $30,000. A also recognizes a $5,000 capital loss under section 731(a)(2), resulting in a ($5,000) basis adjustment under section 734(b). Because the section 704(c)(1)(C) basis adjustment to Property 1 was not reallocated in connection with the distribution, that remaining $5,000 section 704(c)(1)(C) basis adjustment is treated as a positive section 734(b) adjustment. Pursuant to paragraph (c)(2) of this section, these two adjustments are netted together, resulting in no adjustment under section 734(b). Therefore, the basis of Property 1 remains $30,000.
(4) Effective/applicability date. This paragraph (c) applies to partnership distributions occurring on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register .