# Prop. Treas. Reg. § 1.751-1: Unrealized receivables and inventory items.

Proposed regulation, not in force. REG-151416-06, 79 FR 65151, published 2014-11-03 <https://www.federalregister.gov/documents/2014/11/03/2014-25487/certain-distributions-treated-as-sales-or-exchanges>. Interprets 26 U.S.C. § 751.

Par. 7. Section 1.751-1 is amended by: a. Revising paragraphs (a)(1) and (2). b. Revising the first sentence of paragraph (b)(1)(i) and adding a new sentence at the end of paragraph (b)(1)(i). c. Removing the last four sentences of paragraph (b)(1)(ii). d. Revising paragraphs (b)(1)(iii) and (b)(2) and (3). e. Redesignating paragraphs (b)(4) and (5) as paragraphs (b)(5) and (6). f. Adding a new paragraph (b)(4). g. Revising the paragraph heading of newly designated paragraph (b)(5). h. Further redesignating newly redesignated paragraph (b)(5)(ii) as paragraph (b)(5)(vi) and adding paragraphs (b)(5)(ii), (iii), (iv), and (v). i. Revising newly designated paragraph (b)(6). j. Revising paragraph (c)(4)(vi). k. Adding paragraph (c)(4)(x). l. Removing paragraphs (c)(5) and (6). m. Revising the first and second sentences of paragraph (d)(1). n. Revising paragraphs (e), (f), and (g). The additions and revisions read as follows:

(a) * * * (1) Character of amount realized. To the extent that money or property received by a partner in exchange for all or part of his partnership interest is attributable to his share of the value of partnership unrealized receivables or inventory items, the money or fair market value of  the property received shall be considered as an amount realized from the sale or exchange of property other than a capital asset. The remainder of the total amount realized on the sale or exchange of the partnership interest is realized from the sale or exchange of a capital asset under section 741. For definition of “unrealized receivables” and “inventory items,” see section 751(c) and (d). See paragraph (e) of this section for the definition of section 751 property.

(2) Determination of gain or loss. The income or loss realized by a partner upon the sale or exchange of its interest in section 751 property is the amount of income or loss from section 751 property (taking into account allocations of tax items applying the principles of section 704(c), including any remedial allocations under § 1.704-3(d), and any section 743 basis adjustment pursuant to § 1.743-1(j)(3)) that would have been allocated to the partner (to the extent attributable to the partnership interest sold or exchanged) if the partnership had sold all of its property in a fully taxable transaction for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)) immediately prior to the partner's transfer of the interest in the partnership. Any gain or loss recognized that is attributable to section 751 property will be ordinary gain or loss. The difference between the amount of capital gain or loss that the partner would realize in the absence of section 751 and the amount of ordinary income or loss determined under this paragraph (a)(2) is the transferor's capital gain or loss on the sale of its partnership interest. For purposes of section 751(a) and paragraph (a) of this section, the amount of money or the fair market value of property received by the partner in exchange for all or part of his partnership interest must take into account the partner's share of income or gain from section 751 property. See Example 1 in paragraph (g) of this section. See § 1.460-4(k)(2)(iv)(E) for rules relating to the amount of ordinary income or loss attributable to a contract accounted for under a long-term contract method of accounting.

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(b) Certain distributions treated as sales or exchanges —(1) In general. (i) Certain distributions to which section 751(b) applies are treated in whole or in part as sales or exchanges of property, and not as distributions to which sections 731 through 736 apply. * * * For purposes of section 751 and this section, a partner's interest in the partnership's section 751 property includes allocations of tax items applying the principles of section 704(c).

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(iii) If a distribution is a section 751(b) distribution, as described in paragraph (b)(2)(i) of this section, the tax consequences of the section 751(b) distribution, as determined under paragraph (b)(3) of this section, shall first apply, and then the rules of sections 731 through 736 shall apply. See paragraph (b)(5)(vi) of this section for treatment of payments under section 736(a).

(2) Distributions to which section 751(b) applies —(i) Section 751(b) amount. A distribution is a section 751(b) distribution if it gives rise to a “section 751(b) amount” for any partner. A partner's section 751(b) amount (if any) associated with a distribution of partnership property (including money) equals the greatest of—

(A) The amount by which the partner's net section 751 unrealized gain immediately before the distribution exceeds the partner's net section 751 unrealized gain immediately after the distribution;

(B) The amount by which the partner's net section 751 unrealized loss immediately after the distribution exceeds the partner's net section 751 unrealized loss immediately before the distribution; and

(C) The amount of the partner's net section 751 unrealized gain immediately before the distribution, increased by the total amount of the partner's net section 751 unrealized loss immediately after the distribution (where neither of those numbers equals zero).

(ii) Net section 751 unrealized gain or loss before a distribution. A partner's net section 751 unrealized gain or loss immediately before a distribution equals the amount of net income or loss, as the case may be, from section 751 property that would be allocated to the partner if the partnership disposed of all of the partnership's assets for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)). For this purpose, a partner's net section 751 unrealized gain or loss includes any remedial allocations under § 1.704-3(d), and takes into account any section 743 basis adjustment pursuant to § 1.743-1(j)(3) and any carryover basis adjustment described in §§ 1.743-1(g)(2)(ii), 1.755-1(b)(5)(iii)(D), or 1.755-1(c)(4) as though the carryover basis adjustment was applied to the basis of new partnership section 751 property with fair market value of zero.

(iii) Net section 751 unrealized gain or loss after a distribution. A partner's net section 751 unrealized gain or loss immediately after a distribution equals the sum of (to the extent applicable)—

(A) With respect to a partner remaining in the partnership immediately after the distribution (including a distributee partner remaining in the partnership), the amount of net income or loss, as the case may be (including any remedial allocations under § 1.704-3(d) and taking into account any section 743 basis adjustment pursuant to § 1.743-1(j)(3) and any carryover basis adjustment described in §§ 1.743-1(g)(2)(ii), 1.755-1(b)(5)(iii)(D), or 1.755-1(c)(4) as though the carryover basis adjustment was applied to the basis of new partnership section 751 property with fair market value of zero), from section 751 property that would be allocated to the partner if the partnership disposed of all of the partnership's assets for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)); and

(B) With respect to a partner receiving a distribution, the amount of net income or loss, as the case may be, from section 751 property that would be recognized by the distributee if, immediately after the distribution, the distributee disposed of the distributed assets for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)).

(iv) Revaluation of assets. For a partnership that distributes money or property (other than a de minimis amount) to a partner as consideration for an interest in the partnership, and that owns section 751 property immediately after the distribution, if the partnership maintains capital accounts in accordance with § 1.704-1(b)(2)(iv), the partnership must revalue its assets immediately prior to the distribution in accordance with § 1.704-1(b)(2)(iv)( f ). If a partnership does not maintain capital accounts in accordance with § 1.704-1(b)(2)(iv), the partnership must comply with this section by computing its partners' shares of partnership gain or loss immediately before the distribution as if the partnership assets were sold for cash in a fully taxable transaction (taking into account section 7701(g)), and by taking those computed shares of gain or loss into account under the principles of section 704(c) (making subsequent adjustments for cost recovery and other events that affect the basis of the property). In addition, if the partnership (upper-tier partnership) owns another partnership directly or indirectly through one or more  partnerships (lower-tier partnership), and the same persons own, directly or indirectly (through one or more entities), more than 50 percent of the capital and profits interests in both the upper-tier partnership and the lower-tier partnership, the lower-tier partnership must also revalue its assets immediately prior to the distribution in accordance with § 1.704-1(b)(2)(iv)( f ) if the lower-tier partnership owns section 751 property. If the same persons do not own, directly or indirectly, more than 50 percent of the capital and profits interests in both the upper-tier partnership and the lower-tier partnership, the upper-tier partnership must allocate its distributive share of the lower-tier partnership's items among its partners in a manner that reflects the allocations that would have been made had the lower-tier partnership revalued its property.

(3) Tax consequences of a section 751(b) distribution —(i) Reasonable approach. In the case of a section 751(b) distribution described in paragraph (b)(2) of this section, the partnership must choose a reasonable approach that is consistent with the purpose of section 751(b) under which each partner with a section 751(b) amount recognizes ordinary income (or takes it into account by eliminating a basis adjustment) equal to that section 751(b) amount immediately prior to the section 751(b) distribution. In certain circumstances described in paragraph (b)(3)(ii) of this section, a distributee partner may also be permitted or required to recognize capital gain. To be reasonable, an approach must conform to the general principles and anti-abuse rules described in paragraph (b)(4) of this section. An approach is not necessarily unreasonable merely because another approach would result in a higher aggregate tax liability. Once the partnership has adopted a reasonable approach, it must apply that approach consistently for all section 751(b) distributions, including for any distributions the partnership makes after a termination of the partnership under section 708(b)(1)(B). If the application of the adopted approach to a later section 751(b) distribution produces results inconsistent with the purpose of section 751, the partnership must adopt another reasonable approach that achieves the purposes of section 751 for that distribution only. See Example 3 through Example 8 in paragraph (g) of this section.

(ii) Gain Recognition —(A) Mandatory recognition. A partner's net section 751 unrealized gain or net section 751 unrealized loss for purposes of paragraph (b)(3)(i) of this section is determined before taking into account any basis adjustments required by paragraph (b)(3)(iii) of this section. In certain instances, the application of paragraph (b)(3)(iii) of this section may cause a partner to receive distributed property with a basis that differs from the basis of the property in the hands of the distributing partnership. If an adjustment to the basis of the distributed section 751 property results in a section 734(b) basis adjustment, and that basis adjustment would have altered the amount of net section 751 unrealized gain or loss computed under paragraph (b)(2) of this section if the section 734(b) adjustment had been included immediately prior to the distribution, then the distributee partner must recognize capital gain immediately prior to the distribution in an amount sufficient to eliminate that section 734(b) basis adjustment. See Examples5 and 6 in paragraph (g) of this section. If, however, the partnership makes an election under § 1.755-1(c)(2)(vi), then the partner must characterize all or a portion of the gain recognized under this paragraph as ordinary income or a dividend, as appropriate, to preserve the character of the gain in the adjusted asset. See Example 9 in paragraph (g) of this section.

(B) Elective recognition. A distributee partner may elect to recognize capital gain (in addition to amounts required to be recognized under this section) to eliminate section 732(a)(2) or (b) basis adjustments to the asset or assets received in distribution if, and to the extent that, the basis adjustments required by paragraph (b)(3)(iii) of this section would otherwise cause the distributee partner's net section 751 unrealized gain to be greater immediately after the distribution than it was immediately before the distribution or would cause the distributee partner's net section 751 unrealized loss to be less immediately after the distribution than it was immediately before the distribution. A distributee partner elects under this paragraph (b)(3)(ii)(B) by providing the partnership with written notification of its intent to make the election and reporting the capital gain on its return. An extension of time to make an election under this paragraph (b)(3)(ii)(B) will not be granted under § 301.9100-3 of this chapter. The requirement in paragraph (b)(1)(i) of this section that a partnership apply a chosen reasonable method consistently across all partnership distributions does not apply for purposes of this paragraph. See Example 7 in paragraph (g) of this section.

(iii) Adjustments to Basis. The partnership and its partners must make appropriate adjustments to the adjusted basis of the partners' interests in the partnership, and of section 751 property and other property held by the partnership or partners, in a manner consistent with the adopted approach to reflect any ordinary income or capital gain recognized upon application of paragraph (b)(3) of this section, and section 704(c) amounts must be adjusted accordingly.

(4) General principles and anti-abuse rules. (i) The purpose of section 751 is to prevent a partner from converting its rights to ordinary income into capital gain, including by relying on the rules of section 704(c) to defer ordinary income while monetizing most of the value of the partnership interest. The partnership and all partners of the partnership must apply the rules of section 751 and § 1.751-1 in a manner consistent with the purpose of section 751. Accordingly, if a principal purpose of a transaction is to achieve a tax result that is inconsistent with the purpose of section 751, the Commissioner may recast the transaction for federal tax purposes as appropriate to achieve tax results that are consistent with the purpose of section 751. The Commissioner will determine whether a tax result is inconsistent with the purpose of section 751 based on all the facts and circumstances. The existence of one or more of the situations set forth below is presumed to establish that a transaction is inconsistent with the purpose of section 751 and disclosure to the Internal Revenue Service in accordance with § 1.751-1(b)(4)(ii) is required.

(A) Circumstances in which a partner received a distribution that would otherwise be subject to section 751(b), but for the application of the principles of section 704(c), and one or more of the following conditions exist (whether at the time of the distribution or, in the case of paragraph (b)(4)(i)(A)( 2 ), ( 3 ), ( 4 ), or ( 5 ) of this section, a later date):

( 1 ) The partner's interest in net section 751 unrealized gain is at least four times greater than the partner's capital account immediately after the distribution, pursuant to § 1.704-1(b)(2)(iv) (or comparable amount for partnerships not maintaining capital accounts under § 1.704-1(b)(2)(iv));

( 2 ) The partner is substantially protected from losses from the partnership's activities and has little or no participation in the profits from the partnership's activities other than a preferred return that is in the nature of a payment for the use of capital;

( 3 ) The partner engages in a transaction that, at the time of the transaction, causes the net value of the partner (or its successor) to be less than the tax liability that the partner (or its successor) would incur with respect to its interest in the partnership's section 751 property upon a sale of its partnership interest for its fair market value at the time of the transaction. For this purpose, the net value of the partner (or its successor) equals—

( i ) The fair market value of all assets owned by the partner (or its successor) that may be subject to creditor's claims under local law (including the partner's enforceable right to contributions from its owner or owners), less

( ii ) All obligations of the partner (or its successor) other than the partner's obligation with respect to the tax liability for which the net value is being determined;

( 4 ) The partner transfers a portion of its partnership interest within five years after the distribution in a manner that does not trigger ordinary income recognition, and ordinary income or gain with respect to the partnership interest is subject to Federal income tax in the hands of the transferor partner immediately before the transfer, but any ordinary income or gain with respect to the partnership interest is exempt from, or otherwise not subject to, Federal income tax in the hands of the transferee partner immediately after the transfer;

( 5 ) The partnership transfers to a corporation in a nonrecognition transaction section 751 property other than pursuant to a transfer of all property used in a trade or business (excluding assets that are not material to a continuation of the trade or business); or

(B) The partners agree to change (other than a de minimis change) the manner in which the partners share any item or class of items of income, gain, loss, deduction or credit of the partnership under the partnership agreement and that change reduces the partner's net section 751 unrealized gain.

(ii) If a partner participates in a transaction described in paragraph (b)(4)(i)(A) or (B) of this section and does not recognize and report its share of ordinary income from section 751 property on its tax return for the taxable year of the transaction, the partner must file Form 8275-R, Regulation Disclosure Statement, or any appropriate successor form, disclosing its participation in the transaction for the taxable year in which the transaction occurred.

(5) Special rules. * * *

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(ii) The transferee in a nonrecognition transaction of all or a portion of the partnership interest of a contributing partner is treated as the contributing partner for purposes of section 751(b)(2) in an amount attributable to the interest transferred.

(iii) For purposes of section 751(b)(2), if a partnership disposes of contributed section 751 property in a nonrecognition transaction, the substituted basis property (within the meaning of section 7701(a)(42)) received in exchange for such substituted basis property is treated as the contributed section 751 property with regard to the contributing partner. If a partnership transfers contributed section 751 property together with other property in a nonrecognition transaction, the substituted basis property (within the meaning of section 7701(a)(42)) is treated as the contributed section 751 property with regard to the contributing partner in the same proportion as the fair market value of the contributed section 751 property, at the time of the transfer, bears to the fair market value of the other property transferred at the time of the transfer. If a transfer described in this paragraph (b)(5)(iii) was in exchange for an interest in an entity, the interest in the entity will not be treated as the contributed section 751 property with regard to the contributing partner to the extent the value of the interest is attributable to other property the partnership contributed to the entity.

(iv) For purposes of section 751(b)(2), an interest in an entity previously contributed to the partnership is not treated as previously contributed property to the extent the value of the interest is attributable to property the partnership contributed to the entity after the interest was contributed to the partnership. The preceding sentence does not apply to the extent that the property contributed to the entity was contributed to the partnership by the partner that also contributed the interest in the entity to the partnership.

(v) For purposes of section 751(b)(2), the distribution of an undivided interest in property is treated as the distribution of previously contributed property to the extent that the undivided interest does not exceed the undivided interest, if any, contributed by the distributee partner in the same property.

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(6) Statements required —(i) Partnership. A partnership that makes a section 751(b) distribution must submit with its return for the year of the distribution a statement for each section 751(b) distribution made during the year that includes the following:

(A) A caption identifying the statement as the disclosure of a section 751(b) distribution and the date of the distribution; and

(B) A brief description of the reasonable approach adopted by the partnership pursuant to paragraph (b)(3)(i) of this section for recognizing the ordinary income; if applicable, the capital gain required to be recognized; and if relevant, whether the approach varies from an approach previously adopted within any of the three tax years preceding the current tax year.

(ii) Partner. A partnership that makes a section 751(b) distribution during the partnership's tax year must submit with its return for the year of the distribution a statement for each partner that has a section 751(b) amount greater than $0 in connection with that distribution. The statement must be attached to the statement for that partner required by section 6031(b) and § 1.6031(b)-1T(a), and must include the following:

(A) The date of the section 751(b) distribution;

(B) The amount of ordinary income the partner recognized pursuant to paragraph (b)(3)(i) of this section; and

(C) The amount of capital gain the partner recognized, if any, pursuant to paragraph (b)(3)(ii)(A) or (B) of this section.

(c) * * *

(4) * * *

(vi) With respect to any taxable year of a partnership beginning after July 18, 1984, amounts treated as ordinary income under section 467 are treated as ordinary income under this section in the same manner as amounts treated as ordinary income under section 1245 ( see paragraph (c)(4)(iii) of this section) or section 1250 ( see paragraph (c)(4)(v) of this section).

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(x) With respect to any taxable year of a partnership beginning after July 18, 1984, the term unrealized receivables, for purposes of this section and sections 731, 732, and 741 (but not for purposes of section 736), includes any market discount bond (as defined in section 1278) and any short-term obligation (as defined in section 1283) but only to the extent of the amount that would be treated as ordinary income if (at the time of the transaction described in this section or section 731, 732, or 741, as the case may be) such property had been sold by the partnership.

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(d) Inventory items which have substantially appreciated in value — (1) Substantial appreciation. Partnership  inventory items shall be considered to have appreciated substantially in value if, at the time of the distribution, the total fair market value of all the inventory items of the partnership exceeds 120 percent of the aggregate adjusted basis for such property in the hands of the partnership (without regard to any special basis adjustment to the partner). The terms “inventory items which have appreciated substantially in value” or “substantially appreciated inventory items” refer to the aggregate of all partnership inventory items but do not include any unrealized receivables. * * *

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(e) Section 751 property and other property. For purposes of paragraph (a) of this section, section 751 property means unrealized receivables or inventory items. For purposes of paragraph (b) of this section, section 751 property means unrealized receivables or substantially appreciated inventory items. For purposes of all paragraphs of this section, other property means all property (including money) that is not section 751 property.

(f) Applicability date. The rules contained in paragraph (a)(2) of this section apply to transfers of partnership interests that occur on or after November 3, 2014. The rules contained in paragraph (a)(3) of this section apply to transfers of partnership interests that occur on or after December 15, 1999. The rules contained in paragraphs (b)(2) and (3) of this section apply to distributions of partnership property that occur on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register . However, a partnership and its partners may apply the rules contained in paragraph (b)(2) of this section for purposes of determining a partner's interest in the partnership's section 751 property on or after November 3, 2014, provided the partnership and its partners apply paragraphs (a)(2), (b)(2), and (b)(4) of this section consistently for all partnership sales, exchanges, and distributions, including for any distributions the partnership makes after a termination of the partnership under section 708(b)(1)(B).

(g) Examples. Application of the provisions of section 751 may be illustrated by the following examples. In each of Examples 2 through 9 of this paragraph (g), none of the section 751 property qualifies as property that the distributee previously contributed as described in section 751(b)(2)(A), and no distribution to a retiring partner is a payment described in section 736(a):

Example 1.

(i)(A) A and B are equal partners in personal service partnership PRS. A contributed nondepreciable capital assets (the “Capital Assets”) to PRS with a basis and fair market value of $14,000. B contributed unrealized receivables described in paragraph (c) of this section (the “Unrealized Receivables”) to PRS with a basis of zero and fair market value of $14,000. Later, when the fair market value of the Capital Assets had declined to $2,000, B transferred its interest in PRS to T for $9,000 when PRS's balance sheet (reflecting a cash receipts and disbursements method of accounting) was as follows:

|  | Adjusted basis | Fair market value |
| --- | --- | --- |
| Assets |  |  |
| Cash | $ 4,000 | $ 4,000 |
| Capital Assets | 14,000 | 2,000 |
| Unrealized Receivables | 0 | 14,000 |
| Total | 18,000 | 20,000 |
| Liabilities and Capital |  |  |
| Liabilities | $2,000 | $2,000 |
| Capital: |  |  |
| A | 15,000 | 9,000 |
| B | 1,000 | 9,000 |
| Total | 18,000 | 20,000 |

(B) The total amount realized by B is $10,000, consisting of the cash received, $9,000, plus $1,000, B's share of the partnership liabilities assumed by T. See section 752. B's interest in the partnership property includes an interest in the partnership's Unrealized Receivables. B's basis in its partnership interest is $2,000 ($1,000, plus $1,000, B's share of partnership liabilities). If section 751(a) did not apply to the sale, B would recognize $8,000 of capital gain from the sale of the interest in PRS. However, section 751(a) does apply to the sale.

(ii) For purposes of section 751(a), the amount of money or the fair market value of property received by the partner in exchange for all or part of his partnership interest must take into account the partner's share of income or gain from section 751 property. If PRS sold all of its section 751 property in a fully taxable transaction immediately prior to the transfer of B's partnership interest to T, B would have been allocated $14,000 of ordinary income from the sale of PRS's Unrealized Receivables under section 704(c). Therefore, B will recognize $14,000 of ordinary income with respect to the Unrealized Receivables. The difference between the amount of capital gain or loss that the partner would realize in the absence of section 751 ($8,000) and the amount of ordinary income or loss determined under paragraph (a)(2) of this section ($14,000) is the transferor's capital gain or loss on the sale of its partnership interest. In this case, B will recognize a $6,000 capital loss.

Example 2.

(i) A, B, and C each contribute $120 to partnership ABC in exchange for a 1/3 interest. A, B, and C each share in the profits and losses of ABC in accordance with their 1/3 interest. ABC purchases land for $100 in Year 1. At the end of Year 3, when ABC holds $260 in cash and land with a value of $100 and has generated $90 in zero-basis unrealized receivables, ABC distributes $50 cash to C in a current distribution, reducing C's interest in ABC from 1/3 to 1/4. ABC has a section 754 election in effect. To determine if the distribution is a distribution to which section 751(b) applies, ABC must apply the test set forth in paragraph (b)(2) of this section.

(ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC revalues its assets and its partners' capital accounts are increased under § 1.704-1(b)(2)(iv)( f ) to reflect each partner's share of the unrealized gain in the partnership's assets. Before the distribution, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Cash | $260 | $260 | A | $120 | $150 |
| Unrealized Receivable | 0 | 90 | B | 120 | 150 |
| Real Property | 100 | 100 | C | 120 | 150 |
| Totals | 360 | 450 |  | 360 | 450 |

(B) If ABC disposed of all of its assets for cash in an amount equal to the fair market value of such property immediately before the distribution, A, B, and C would each be allocated $30 of net income from ABC's section 751 property. Accordingly, A, B, and C's net section 751 unrealized gain immediately before the distribution is $30 each under paragraph (b)(2)(ii) of this section.

(iii)(A) After the distribution (but before taking into account any consequences under this section), ABC's balance sheet would be as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Cash | $210 | $210 | A | $120 | $150 |
| Unrealized Receivable | 0 | 90 | B | 120 | 150 |
| Real Property | 100 | 100 | C | 70 | 100 |
| Totals | 310 | 400 |  | 310 | 400 |

(B) If ABC disposed of all of its assets in exchange for cash in amounts equal to the fair market values of those assets immediately after the distribution, A, B, and C would each still be allocated $30 of net income from ABC's section 751 property pursuant to § 1.704-3(a)(6). C did not receive any section 751 property in the distribution. Accordingly, A, B, and C's net section 751 unrealized gain immediately after the distribution is $30 each under paragraph (b)(2)(iii) of this section.

(iv) Because no partner's net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, and because no partner's net section 751 unrealized loss is greater immediately after the distribution than immediately before the distribution, the distribution is not a section 751(b) distribution under paragraph (b)(2)(i) of this section. Accordingly, section 751(b) does not apply to the distribution.

Example 3.

(i) Assume the same facts as in Example 2 of this paragraph (g), but assume ABC distributes $150 cash to C in complete liquidation of C's interest. To determine if the distribution is a distribution to which section 751(b) applies, ABC must apply the test set forth in paragraph (b)(2) of this section.

(ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC revalues its assets and its partners' capital accounts are increased under § 1.704-1(b)(2)(iv)( f ) to reflect each partner's share of the unrealized gain in the partnership's assets. Before the distribution, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Cash | $260 | $260 | A | $120 | $150 |
| Unrealized Receivable | 0 | 90 | B | 120 | 150 |
| Real Property | 100 | 100 | C | 120 | 150 |
| Totals | 360 | 450 |  | 360 | 450 |

(B) If ABC disposed of all of its assets in exchange for cash in amounts equal to the fair market values of these assets immediately before the distribution, A, B, and C would each be allocated $30 of net income from ABC's section 751 property. Accordingly, A, B, and C's net section 751 unrealized gain immediately before the distribution is $30 each under paragraph (b)(2)(ii) of this section.

(iii)(A) Because ABC has elected under section 754, and because A recognizes $30 gain on the distribution of cash, the basis of the real property is increased to $130 under section 734(b). After the distribution (but before taking into account any consequences under this section), ABC's balance sheet would be as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Cash | $110 | $110 | A | $120 | $150 |
| Unrealized Receivable | 0 | 90 | B | 120 | 150 |
| Real Property | 130 | 100 | C | 0 | 0 |
| Totals | 240 | 300 |  | 240 | 300 |

(B) Because C is no longer a partner in ABC, C would not be allocated any net income from ABC's section 751 property immediately after the distribution. Also, C did not receive any section 751 property in the distribution. Accordingly, C's net section 751 unrealized gain immediately after the distribution is $0 under paragraph (b)(2)(iii) of this section.

(iv) Because C's net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, section 751(b) applies to the distribution. Under paragraph (b)(2)(i) of this section, C has a section 751(b) amount equal to $30, the amount by which C's share of pre-distribution net section 751 unrealized gain ($30) exceeds C's share of post-distribution net section 751 unrealized gain ($0). Accordingly, paragraph (b)(3)(i) of this section requires C to recognize $30 of ordinary income using a reasonable approach consistent with the purpose of this section. ABC considers two approaches, the first of which is described in paragraphs (v) and (vi) of this example, and the second of which is described in paragraphs (vii) and (viii) of this example.

(v) Assume ABC adopts an approach under which, immediately before the section 751(b) distribution, C is deemed to recognize $30 of ordinary income. To reflect C's recognition of $30 of ordinary income, C increases its basis in its ABC partnership interest by $30, and the partnership increases its basis in the unrealized receivable by the $30 of income recognized by C, immediately before the distribution. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC's adopted approach is reasonable. After taking into account the tax consequences of the section 751(b) distribution immediately prior to the cash distribution, ABC's modified balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Cash | $260 | $260 | A | $120 | $150 |
| Unrealized Receivable | 30 | 90 | B | 120 | 150 |
| Real Property | 100 | 100 | C | 150 | 150 |
| Totals | 390 | 450 |  | 390 | 450 |

(vi) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Accordingly, C recognizes no gain or loss under section 731(a) upon the distribution. Because C recognizes no gain on the distribution, the basis of the partnership real property is not adjusted. After the distribution, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Cash | $110 | $110 | A | $120 | $150 |
| Unrealized Receivable | 30 | 90 | B | 120 | 150 |
| Real Property | 100 | 100 | C | 0 | 0 |
| Totals | 240 | 300 |  | 240 | 300 |

(vii) Assume alternatively that ABC adopts an approach under which, immediately before the section 751(b) distribution, C is deemed to—

(A) Receive a distribution of ABC's unrealized receivables with a fair market value of $30 and a tax basis of $0;

(B) Sell the unrealized receivable to ABC in exchange for $30, recognizing $30 of ordinary income; and

(C) Contribute the $30 to ABC. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC's adopted approach is reasonable. After taking into account the tax consequences of the section 751(b) distribution immediately prior to the cash distribution, ABC's modified balance sheet is the same as the balance sheet shown in paragraph (v) of this example.

(viii) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. The tax consequences under the rules of sections 731 through 736 are the same tax consequences described in paragraph (vi) of this example.

Example 4.

(i) A and B are equal partners in a partnership, AB, that owns Unrealized Receivable with a fair market value of $50 and nondepreciable real property with a basis of $50 and a fair market value of $100. A has an adjusted basis in its partnership interest of $25, and B has an adjusted basis in its partnership interest of $50. The partnership has a section 754 election in effect, and B has a basis adjustment under section 743(b) of $25 that is allocated to Unrealized Receivable. AB distributes Unrealized Receivable to A in a current distribution. To determine if the distribution is a distribution to which section 751(b) applies, AB must apply the test set forth in paragraph (b)(2) of this section.

(ii)(A) AB makes a non-mandatory revaluation of its assets and its partners' capital accounts are increased under § 1.704-1(b)(2)(iv)( f ) to reflect each partner's share of the unrealized gain in the partnership's assets. Before the distribution, AB's balance sheet is as follows:

|  | Tax | Basis adj. | Book | Capital | Tax | Special basis | Book |
| --- | --- | --- | --- | --- | --- | --- | --- |
| Unrealized Receivable | 0 | 25 | 50 | A | 25 |  | 75 |
| Real Property | 50 |  | 100 | B | 25 | 25 | 75 |
| Totals | 50 | 25 | 150 |  | 50 | 25 | 150 |

(B) If AB disposed of all of its assets in exchange for cash in amounts equal to the fair market values of these assets immediately before the distribution, A and B would each be allocated $25 of net income from AB's section 751 property. However, B's net income from Unrealized Receivable would be offset by its $25 section 743 adjustment. § 1.743-1(j)(3). Accordingly, A and B's net section 751 unrealized gain immediately before the distribution are $25 and $0, respectively, under paragraph (b)(2)(ii) of this section.

(iii)(A) After the distribution (but before taking into account any consequences under this section), AB's balance sheet would be as follows:

|  | Tax | Basis adj. | Book | Capital | Tax | Carryover adjustment | Book |
| --- | --- | --- | --- | --- | --- | --- | --- |
| Carryover Adjustment |  | 25 | 0 | A | 25 |  | 25 |
| Real Property | 50 |  | 100 | B | 25 | 25 | 75 |
| Totals | 50 | 25 | 100 |  | 50 | 25 | 100 |

(B) If AB disposed of all of its assets in exchange for cash in amounts equal to the fair market values of those assets immediately after the distribution, no partner would be allocated net income or loss from section 751 property. However, B has a carryover basis adjustment to ordinary income property of $25 under §§ 1.743-1(g)(2)(ii) and 1.755-1(c)(4), which B must treat as applied to section 751 property with fair market value of $0 pursuant to paragraph (b)(2)(ii) of this section. Accordingly, B's net section 751 unrealized loss immediately after the distribution is $25 under paragraph (b)(2)(iii)(A) of this section. If, immediately after the distribution, A disposed of Unrealized Receivable in exchange for $50 cash, A would recognize $50 of net income from section 751 property. Accordingly, A's net section 751 unrealized gain immediately after the distribution is $50 under paragraph (b)(2)(iii)(B) of this section.

(iv) Because B's net section 751 unrealized loss immediately after the distribution ($25) exceeds B's net section 751 unrealized loss immediately before the distribution ($0), the distribution is a section 751(b) distribution. Under paragraph (b)(2)(i) of this section, B has a section 751(b) amount equal to $25, the difference of B's share of pre-distribution net section 751 unrealized gain ($0) and B's share of post-distribution net section 751 unrealized loss ($25). Accordingly, paragraph (b)(3)(i) of this section requires B to account for $25 of ordinary income using a reasonable approach consistent with the purpose of this section.

(v) Assume AB adopts an approach under which, immediately before the section 751(b) distribution, B is deemed to—

(A) Receive a distribution of Unrealized Receivable with a fair market value of $25 and a tax basis of $25 (which consists of B's section 743(b) basis adjustment and is determined solely for purposes of applying a reasonable method consistent with the purposes of section 751(b));

(B) Sell Unrealized Receivable to AB in exchange for $25, so that B recognizes $0 of ordinary income, and AB receives Unrealized Receivable with a basis of $25; and

(C) Contribute the $25 to AB. Provided the partnership applies the approach consistently for all section 751(b) distributions, AB's adopted approach is reasonable. After taking into account the tax consequences of the section 751(b) distribution, AB's modified balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
|  |  |  | A | 0 | 25 |
| Real Property | 50 | 100 | B | 50 | 75 |
| Totals | 50 | 100 |  | 50 | 100 |

(vi) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Accordingly, A recognizes no gain on the distribution of Unrealized Receivable, which A takes with a basis of $25.

Example 5. Capital Gain Recognition Required. (i) A, B, and C are each 1/3 partners in a partnership, ABC, that holds Unrealized Receivable 1 with a fair market value of $90, Unrealized Receivable 2 with a fair market value of $30, and nondepreciable real property with a fair market value of $180. The partnership has a section 754 election in effect. Each of the partners has an adjusted basis in its partnership interest of $0 with a fair market value of $100. None of the partners has a capital loss carryforward. ABC distributes to A Unrealized Receivable 1 in a current distribution. To determine if the distribution is a distribution to which section 751(b) applies, ABC must apply the test set forth in paragraph (b)(2) of this section.

(ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC revalues its assets and its partners' capital accounts are increased under § 1.704-1(b)(2)(iv)( f ) to reflect each partner's share of the unrealized gain in the partnership's assets. Before the distribution, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Unrealized Receivable 1 | $0 | $90 | A | $0 | $100 |
| Unrealized Receivable 2 | 0 | 30 | B | 0 | 100 |
| Real Property | 0 | 180 | C | 0 | 100 |
| Totals | 0 | 300 |  | 0 | 300 |

(B) If ABC disposed of all of its assets for cash in an amount equal to the fair market value of such property immediately before the distribution, A, B, and C would each be allocated $40 of net income from ABC's section 751 property ($30 each from Unrealized Receivable 1 and $10 each from Unrealized Receivable 2). Accordingly, A, B, and C's net section 751 unrealized gain immediately before the distribution is $40 each under paragraph (b)(2)(ii) of this section.

(iii)(A) After the distribution (but before taking into account any consequences under this section), ABC's balance sheet would be as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Unrealized Receivable 2 | $0 | $30 | A B | $0 0 | $10 100 |
| Real Property | 0 | 180 | C | 0 | 100 |
| Totals | 0 | 210 |  | 0 | 210 |

(B) If ABC disposed of all of its assets in exchange for cash in amounts equal to the fair market values of those assets immediately after the distribution, A, B, and C would each be allocated $10 of net income from ABC's section 751 property ($10 each from Unrealized Receivable 2). If immediately after the distribution, A disposed of Unrealized Receivable 1 in exchange for $90 cash, A would recognize $90 of net income from section 751 property. Accordingly, B and C's net section 751 unrealized gain immediately after the distribution is $10 each under paragraph (b)(2)(iii)(A) of this section, and A's is $100 under paragraphs (b)(2)(iii)(A) and (B) of this section.

(iv) Because B and C's net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, the distribution is a section 751(b) distribution. Under paragraph (b)(2)(i) of this section, each of B and C has a section 751(b) amount equal to $30, the amount by which each partner's share of pre-distribution net section 751 unrealized gain ($40) exceeds its share of post-distribution net section 751 unrealized gain ($10). Accordingly, paragraph (b)(3)(i) of this section requires each of B and C to recognize  $30 of ordinary income using a reasonable approach consistent with the purpose of this section. ABC considers three approaches, the first of which is described in paragraphs (v) and (vi) of this example, the second of which is described in paragraphs (vii) and (viii) of this example, and the third of which is described in paragraph (ix) of this example.

(v) Assume ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to recognize $30 of ordinary income. To reflect B and C's recognition of $30 of ordinary income, B and C increase their bases in their ABC partnership interests by $30 each, and the partnership increases its basis in Unrealized Receivable 1 by $60 immediately before the distribution to A. Following the distribution to A, A's basis in Unrealized Receivable 1 is $0 under section 732(a)(2). Because ABC has elected under section 754, the distribution of Unrealized Receivable 1 to A would result in a $60 section 734(b) adjustment to Unrealized Receivable 2. See § 1.755-1(c)(1). Because that basis adjustment would have altered the amount of net section 751 unrealized gain or loss computed under paragraph (b)(2) of this section, A must recognize $60 of capital gain prior to the distribution of Unrealized Receivable 1 pursuant to paragraph (b)(3)(ii)(A) of this section. This gain recognition increases A's basis in its ABC partnership interest by $60 immediately before the distribution to A, eliminating the section 734(b) adjustment. See section 732(a)(2). In addition, the partnership increases its basis in Real Property by $60 pursuant to paragraph (b)(3)(iii) of this section, and treats A's gain recognized as reducing A's $60 reverse section 704(c) amount in the Real Property. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC's adopted approach is reasonable. After taking into account the tax consequences of the deemed gain approach described in this example, ABC's modified balance sheet immediately prior to the distribution is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Unrealized Receivable 1 | $60 | $90 | A | $60 | $100 |
| Unrealized Receivable 2 | 0 | 30 | B | 30 | 100 |
| Real Property | 60 | 180 | C | 30 | 100 |
| Totals | 120 | 300 |  | 120 | 300 |

(vi) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Thus, Unrealized Receivable 1 would take a $60 basis in A's hands under section 732(a), and no section 734(b) adjustment would be made to Unrealized Receivable 2. After the distribution, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Unrealized Receivable 2 | $0 | $30 | A B | $0 30 | $10 100 |
| Real Property | 60 | 180 | C | 30 | 100 |
| Totals | 60 | 210 |  | 60 | 210 |

(vii) Assume alternatively that ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to:

(A) Receive a distribution of Unrealized Receivable 1 with a fair market value of $30 and tax basis of $0;

(B) Sell the unrealized receivable to ABC for $30, recognizing $30 of ordinary income; and

(C) Contribute the $30 to ABC. For the same reasons stated in paragraph (v) of this example, A recognizes capital gain of $60. To accomplish this, A, immediately before the section 751(b) distribution, is deemed to:

( 1 ) Receive a distribution of Real Property with a fair market value of $60 and tax basis of $0;

( 2 ) Sell the Real Property to ABC for $60, recognizing $60 of capital gain; and

( 3 ) Contribute the $60 to ABC.

(viii) The partnership treats the $60 of gain recognized by A as reducing A's $60 reverse section 704(c) amount in the Real Property. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC's adopted approach is reasonable. Before taking into account the tax consequences of the section 751(b) distribution, ABC's balance sheet is the same as the balance sheet shown in paragraph (v) of this example. After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. The tax consequences under the rules of sections 731 through 736 are the same tax consequences described in paragraph (vi) of this example.

(ix) Assume alternatively that A does not recognize capital gain of $60. As a result, upon the distribution of Unrealized Receivable 1 to A, ABC makes a $60 section 734(b) adjustment to Unrealized Receivable 2. The adopted approach is not reasonable because it is contrary to paragraph (b)(3)(ii)(A) of this section.

Example 6. Capital Gain Recognition Required.

(i)(A) Assume the same facts as Example 5 of this paragraph (g), except that Unrealized Receivable 1 has a $9 tax basis, and each of the partners has an adjusted basis in its partnership interest of $3. Before the distribution, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Unrealized Receivable 1 | $9 | $90 | A | $3 | $100 |
| Unrealized Receivable 2 | 0 | 30 | B | 3 | 100 |
| Real Property | 0 | 180 | C | 3 | 100 |
|  |  |  |  |  |  |
| Totals | 9 | 300 |  | 9 | 300 |

(B) If ABC disposed of all of its assets for cash in an amount equal to the fair market value of such property immediately before the distribution, A, B, and C would each be allocated $37 of net income from ABC's section 751 property ($27 each from Unrealized Receivable 1 and $10 each from Unrealized Receivable 2). Accordingly, A, B, and C's net section 751 unrealized gain immediately before the distribution is $37 each under paragraph (b)(2)(ii) of this section.

(ii)(A) After the distribution (but before taking into account any consequences under this section), ABC's balance sheet would be as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Unrealized Receivable 2 | $6 | $30 | A B | $0 3 | $10 100 |
| Real Property | 0 | 180 | C | 3 | 100 |
| Totals | 6 | 210 |  | 6 | 210 |

(B) If ABC disposed of all of its assets for cash in an amount equal to the fair market value of such property immediately after the distribution, taking into account the $6 section 734(b) adjustment allocated to Unrealized Receivable 2, A, B, and C would each be allocated $8 of net income from ABC's section 751 property ($8 each from Unrealized Receivable 2). If, immediately after the distribution, A disposed of Unrealized Receivable 1 for cash in an amount equal to its fair market value, A would recognize $87 of net income from section 751 property. Accordingly, B and C's net section 751 unrealized gain immediately after the distribution is $8 each under paragraph (b)(2)(iii)(A) of this section, and A's is $95 under paragraphs (b)(2)(iii)(A) and (B) of this section.

(iii) Because B and C's net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, the distribution is a section 751(b) distribution. Under paragraph (b)(2)(i) of this section, each of B and C has a section 751(b) amount equal to $29, the amount by which each partner's share of pre-distribution net section 751 unrealized gain ($37) exceeds its share of post-distribution net section 751 unrealized gain ($8). Accordingly, paragraph (b)(3)(i) of this section requires each of B and C to recognize $29 of ordinary income using a reasonable approach consistent with the purpose of this section. ABC considers two approaches, the first of which is described in paragraphs (iv) and (v) of this example, and the second of which is described in paragraphs (vi) and (vii) of this example.

(iv) Assume ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to recognize $29 of ordinary income. To reflect B and C's recognition of $29 of ordinary income, B and C increase their bases in their ABC partnership interests by $29 each, and the partnership increases its basis in Unrealized Receivable 1 by $58 to $67 immediately before the distribution to A. Following the distribution to A, A's basis in Unrealized Receivable 1 is $3 under section 732(a)(2). Because ABC has elected under section 754, the distribution of Unrealized Receivable 1 to A would result in a $64 section 734(b) adjustment to Unrealized Receivable 2 (rather than the $6 section 734(b) adjustment computed prior to the application of this section). See § 1.755-1(c)(1). Because that additional basis adjustment would have altered the amount of net section 751 unrealized gain or loss computed under paragraph (b)(2) of this section, A must recognize $58 of capital gain prior to the distribution of Unrealized Receivable 1 pursuant to paragraph (b)(3)(ii)(A) of this section. This gain recognition increases A's basis in its ABC partnership interest by $58 to $61 immediately before the distribution to A. In addition, the partnership increases its basis in Real Property by $58 pursuant to paragraph (b)(3)(iii) of this section, and treats A's gain recognized as reducing A's $60 reverse section 704(c) amount in the Real Property. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC's adopted approach is reasonable. After taking into account the tax consequences of the deemed gain approach described in this example, ABC's modified balance sheet immediately prior to the distribution is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Unrealized Receivable 1 | $67 | $90 | A | $61 | $100 |
| Unrealized Receivable 2 | 0 | 30 | B | 32 | 100 |
| Real Property | 58 | 180 | C | 32 | 100 |
| Totals | 125 | 300 |  | 125 | 300 |

(v) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Thus, A would take a $61 tax basis in Unrealized Receivable 1 under section 732(a), and a $6 section 734(b) adjustment would be made to Unrealized Receivable 2. After the distribution, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Unrealized Receivable 2 | $6 | $30 | A B | $0 32 | $10 100 |
| Real Property | 58 | 180 | C | 32 | 100 |
| Totals | 64 | 210 |  | 64 | 210 |

(vi) Assume alternatively that ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to:

(A) Receive a distribution of Unrealized Receivable 1 with a fair market value of $29 and tax basis of $0;

(B) Sell the unrealized receivable to ABC for $29, recognizing $29 of ordinary income; and

(C) Contribute the $29 to ABC. For the same reasons stated in paragraph (iv) of this example, A recognizes capital gain of $58. To accomplish this, A, immediately before the section 751(b) distribution, is deemed to:

( 1 ) Receive a distribution of Real Property with a fair market value of $58 and tax basis of $0;

( 2 ) Sell the Real Property to ABC for $58, recognizing $58 of capital gain; and

( 3 ) Contribute the $58 to ABC.

(vii) The partnership treats the $58 of gain recognized by A as reducing A's $60 reverse section 704(c) amount in the Real Property. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC's adopted approach is reasonable. After taking into account the tax consequences of the section 751(b) distribution, ABC's balance sheet is the same as the balance sheet shown in paragraph (iv) of this example. After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. The tax consequences under the rules of sections 731 through 736 are the same tax consequences described in paragraph (v) of this example.

Example 7. Capital Gain Recognition Elective.

(i)(A) Assume the same facts as described in Example 6 of this paragraph (g),  including that ABC adopts the deemed gain approach described in paragraph (iv), except that ABC does not have a section 754 election in effect. As in Example 6, each of A, B, and C has net section 751 unrealized gain of $37 immediately before the distribution. After the distribution (but before taking into account any consequences under this section), ABC's balance sheet would be as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Unrealized Receivable 2 | $0 | $30 | A B | 0 3 | 10 100 |
| Real Property | 0 | 180 | C | 3 | 100 |
| Totals | 0 | 210 |  | 6 | 210 |

(B) If ABC disposed of all of its assets for cash in an amount equal to the fair market value of such property immediately after the distribution, because there is no section 734(b) adjustment allocated to Unrealized Receivable 2, A, B, and C would each be allocated $10 of net income from ABC's section 751 property ($10 each from Unrealized Receivable 2). If, immediately after the distribution, A disposed of Unrealized Receivable 1 for cash in an amount equal to its fair market value, A would recognize $87 of net income from section 751 property. Accordingly, B and C's net section 751 unrealized gain immediately after the distribution is $10 each under paragraph (b)(2)(iii)(A) of this section, and A's is $97 under paragraphs (b)(2)(iii)(A) and (B) of this section.

(ii) Because B and C's net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, the distribution is a section 751(b) distribution. Under paragraph (b)(2)(i) of this section B and C each have a section 751(b) amount equal to $27, the amount by which those partners' shares of pre-distribution net section 751 unrealized gain ($37), exceeds their shares of post-distribution net section 751 unrealized gain ($10). Accordingly, paragraph (b)(3)(i) of this section requires each of B and C to recognize $27 of ordinary income using a reasonable approach consistent with the purpose of this section.

(iii) Assume ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to recognize $27 of ordinary income. To reflect B and C's recognition of $27 of ordinary income, B and C increase their bases in their ABC partnership interests by $27, and the partnership increases its basis in Unrealized Receivable 1 by $54 to $63 immediately before the distribution to A. The distribution to A results in an adjustment to the basis of the distributed Unrealized Receivable 1 under section 732(a)(2), reducing the basis of Unrealized Receivable 1 in the hands of A to $3. Because ABC has not elected under section 754 and does not have a substantial basis reduction under section 734(d), this $60 decrease to the basis of Unrealized Receivable 1 will not affect the basis of other assets held by ABC. Thus, the distribution does not alter the amount of net section 751 unrealized gain or loss computed under paragraph (b)(2) of this section. Accordingly, A is not obligated under paragraph (b)(3)(ii)(A) of this section to recognize gain or income upon the distribution of Unrealized Receivable 1. However, A may elect to recognize $60 of capital gain under paragraph (b)(3)(ii)(B) of this section to eliminate the section 732 basis adjustment to the distributed Unrealized Receivable 1 which would otherwise cause A's net section 751 unrealized gain to be greater immediately after the distribution than it was immediately before the distribution. This gain recognition increases A's basis in its ABC partnership interest by $60 immediately before the distribution to A. In addition, the partnership increases its basis in Real Property by $60 pursuant to paragraph (b)(3)(iii) of this section, and treats A's gain recognized as reducing A's $60 reverse section 704(c) amount in the Real Property. A receives the distributed Unrealized Receivable 1 with a basis of $63, so that the distribution does not increase A's net section 751 unrealized gain. After the distribution, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| Unrealized Receivable 2 | $0 | $30 | A B | 0 30 | 10 100 |
| Real Property | 60 | 180 | C | 30 | 100 |
| Totals | 60 | 210 |  | 60 | 210 |

Example 8.

(i) A, B, and C, each domestic corporations, are 1/3 partners in a domestic partnership ABC. ABC purchased 100% of the stock in two foreign corporations, X and Y. X and Y each have one share of stock outstanding. ABC has a basis of $15 in its X share with a fair market value of $150, and a basis of $3 in its Y share with a fair market value of $30. The earnings and profits of X that are attributable to ABC's X stock under section 1248 are $135; the earnings and profits of Y that are attributable to ABC's Y stock are $27. ABC has a section 754 election in effect. Each of A, B, and C has a partnership interest with an adjusted basis of $6 and a fair market value of $60. On January 1, 2013, ABC distributes the Y share to A in a current distribution. To determine if the distribution is a distribution to which section 751(b) applies, ABC must apply the test set forth in paragraph (b)(2) of this section.

(ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC revalues its assets. Its partners' capital accounts are increased under § 1.704-1(b)(2)(iv)( f ) to reflect each partner's share of the unrealized gain in the partnership's assets. Before the distribution, ABC's balance sheet is as follows (with the shares of X and Y each reflected as having both an unrealized receivable component and a capital gain component):

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| X stock (total) | $15 | $150 | A | $6 | $60 |
| Unrealized receivable | 0 | 135 | B | 6 | 60 |
| Capital gain asset | 15 | 15 | C | 6 | 60 |
| Y stock (total) | 3 | 30 |  |  |  |
| Unrealized receivable | 0 | 27 |  |  |  |
| Capital gain asset | 3 | 3 |  |  |  |
| Totals | 18 | 180 |  | 18 | 180 |

(B) If ABC disposed of all of its assets for cash in an amount equal to the assets' fair market value immediately before the distribution, A, B, and C would each be allocated $54 of net income from ABC's section 751 property ($45 each from X stock and $9 each from Y stock). Accordingly, A, B, and C's net section 751 unrealized gain immediately before the distribution is $54 each under paragraph (b)(2)(ii) of this section.

(iii)(A) After the distribution (but before taking into account any consequences under this section), ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| X stock (total) | $15 | $150 | A | $3 | $30 |
| Unrealized receivable | 0 | 135 | B | 6 | 60 |
| Capital gain asset | 15 | 15 | C | 6 | 60 |
| Totals | 15 | 150 |  | 15 | 150 |

(B) If ABC disposed of its asset for cash in an amount equal to the fair market value of that asset immediately after the distribution, A, B, and C would each be allocated $45 of net income from ABC's section 751 property pursuant to § 1.704-3(a)(6). A, however, received Y stock, which continues to be section 751 property in A's hands under section 735(a), with a holding period that includes the partnership's holding period under section 735(b). If A disposed of its Y stock for cash in an amount equal to its fair market value, A would recognize $27 of gain under section 751(b) on the Y stock (a foreign corporation described in section 1248) that is included in A's income under section 1248 as a dividend to the extent of the attributable earnings. Accordingly, B and C's net section 751 unrealized gain immediately after the distribution is $45 each under paragraph (b)(2)(iii)(A) of this section, and A's is $72 under paragraphs (b)(2)(iii)(A) and (B) of this section.

(iv) Because B and C's net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, the distribution is a section 751(b) distribution. Under paragraph (b)(2)(i) of this section, B and C each have a section 751(b) amount equal to $9, the amount by which those partners shares of pre-distribution net section 751 unrealized gain ($54) exceeds their shares of post-distribution net section 751 unrealized gain ($45). Accordingly, paragraph (b)(3)(i) of this section requires each of B and C to recognize $9 as a dividend under section 1248 using a reasonable approach consistent with the purpose of this section. ABC considers two approaches, the first of which is described in paragraphs (v) and (vi) of this example, and the second of which is described in paragraph (vii) of this example.

(v) Assume ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to recognize $9 of gain includible as a dividend with respect to the distribution of the Y stock, which is treated as a sale or exchange for purposes of section 1248. To reflect B and C's recognition of $9 of dividend income, B and C increase the bases in their ABC partnership interests by $9 each, and the partnership increases its basis in the Y share unrealized receivable component by $18 immediately before the distribution. The portion of the unrealized receivable component of the Y share that is deemed to be sold or exchanged under section 1248 has a new holding period beginning on the day after the section 751(b) distribution (“the new holding period portion”). The earnings and profits of $18 attributable to the new holding period portion of the Y share are 2/3 of the total earnings and profits attributable to the Y share immediately before the distribution (B and C's $18 aggregate gain recognized under section 751(b) divided by $27, the aggregate of all the partners' net section 751 unrealized gain immediately before the distribution). The remaining earnings and profits are allocated to the remainder of the Y share. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC's adopted approach is reasonable. After taking into account the tax consequences of the deemed gain approach described in this example, ABC's modified balance sheet immediately before the distribution is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| X stock | $15 | $150 | A | $6 | $60 |
| Unrealized receivable | 0 | 135 | B | 15 | 60 |
| Capital gain asset | 15 | 15 | C | 15 | 60 |
| Y stock | 21 | 30 |  |  |  |
| New holding period portion | 18 | 18 |  |  |  |
| Unrealized receivable | 0 | 9 |  |  |  |
| Capital gain asset | 3 | 3 |  |  |  |
| Totals | 36 | 180 |  | 36 | 180 |

(vi) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Accordingly, the basis of the distributed Y stock in A's hands is limited under section 732(a)(2) to A's $6 basis in its partnership interest. Pursuant to section 732(c)(3)(B), the $15 decrease in basis from $21 to $6 must be allocated to the distributed components of the Y stock in proportion to their respective adjusted bases. A must allocate the $15 decrease in basis in the Y stock between the new holding period portion (which has a basis of $18) and the remainder of the Y share (which has a basis of $3). Accordingly, A receives the new holding period portion of the Y share with an adjusted basis of $5.14 ($6 multiplied by ($18 divided by $21)), and the remainder of the Y share with an adjusted basis of $0.86 ($6 multiplied by ($3 divided by $21)). Because the basis of the distributed Y stock in A's hands was reduced from $21 (the basis of the Y stock in the hands of ABC) to $6 (the basis in A's hands), ABC must increase the basis of its remaining asset under section 734(b)(1)(B) by $15. ABC must allocate the $15 under § 1.755-1(c)(1)(i) to the capital gain portion of the X stock. After the distribution, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| X stock | $30 | $150 | A | $0 | $30 |
| Unrealized receivable | 0 | 135 | B | 15 | 60 |
| Capital gain asset | 30 | 15 | C | 15 | 60 |
| Totals | 30 | 150 |  | 30 | 150 |

(vii) Assume alternatively that ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to:

(A) Receive a distribution of the portion of the partnership's Y stock with a fair market value of $9 and a tax basis of $0;

(B) Sell the Y stock back to ABC for $9, recognizing $9 of gain includible as a dividend; and

(C) Contribute the $9 to ABC. ABC will be deemed to have purchased for $18 a portion of the Y stock unrealized receivable component, which will have a new holding period. The deemed sale of Y stock by B and C to ABC will be treated as a sale or exchange for purposes of section 1248. Provided that the partnership applies the approach consistently for all section 751(b) distributions, Partnership ABC's adopted approach is reasonable. After taking into account the tax consequences of the deemed transaction, ABC's balance sheet is the same as the balance sheet shown in paragraph (v) of this example. After taking into account the tax consequences of the section 751(b) distribution, ABC's balance sheet is the same as the balance sheet shown in paragraph (vi) of this example.

(viii) Assume that in a later unrelated transaction, A sells its Y stock at a time when its fair market value, earnings and profits, and adjusted basis have not changed. The sale of Y stock by A is a sale or exchange subject to section 1248. Pursuant to § 1.732-1(c)(2)(v), in determining the dividend portion of its gain on the Y stock under section 1248, A does not take into account the $15 decrease in basis under section 732. Accordingly, upon the sale of the Y stock, A recognizes $9 of gain, the lesser of $9 ($0 gain on the new holding period portion ($18 fair market value minus $18 basis) plus $9 gain on the remainder ($12 fair market value minus $3 basis)) or $9 (earnings and profits attributable to the remainder of the Y share) as dividend income under section 1248. A recognizes $15 of capital gain in addition to the $9 of dividend income ($30 amount realized minus $15 ($6 aggregate basis in Y share plus $9 section 1248 dividend income)).

(ix) Assume that ABC also sells its X stock in a later unrelated transaction at a time when its fair market value has declined to $120 but earnings and profits have remained the same. ABC has not made an election under § 1.755-1(c)(2)(vi). In determining the dividend portion of its gain on the X stock under section 1248, ABC does not take into account the $15 increase in basis under section 734(b). Upon the sale of the stock, ABC recognizes $105, the lesser of $105 ($120-$15) or $135 (earnings and profits attributable to the X stock for the partnership's holding period) as dividend income. In addition to the $105 of gain includible as a dividend, ABC recognizes $15 of capital loss ($120 amount realized minus $135 ($30 aggregate basis in X stock plus $105 section 1248 dividend income)).

Example 9.

(i) Assume the same facts as in Example 8 of this paragraph (g), except assume that Partnership ABC makes an election under § 1.755-1(c)(2)(vi). As in Example 8, paragraph (b)(3)(i) of this section requires each of B and C to recognize $9 as a dividend under section 1248 using a reasonable approach consistent with the purpose of this section for the reasons described in paragraphs (ii) through (iv) of Example 8. Further assume that ABC adopts the deemed gain approach described in paragraph (v) of Example 8. As in Example 8, B and C are each deemed to recognize $9 of dividend income with respect to the distribution of the Y stock, which is treated as a sale or exchange for purposes of section 1248. To reflect B and C's recognition of $9 of dividend income, B and C increase the bases in their ABC partnership interests by $9 each. The partnership increases its basis in the Y share unrealized receivable component by $18 immediately before the distribution. The portion of the unrealized receivable component of the Y share that is deemed to be sold or exchanged under section 1248 has a new holding period beginning on the day after the section 751(b) distribution (“the new holding period portion”).

(ii) Because ABC makes an election under § 1.755-1(c)(2)(vi), the distribution of the Y share to A results in a $15 section 734(b) adjustment to the unrealized receivable component of the X share. Because that basis adjustment would have altered the amount of net section 751 unrealized gain or loss computed under paragraph (b)(2) of this section, A must recognize $15 of gain with respect to the X share pursuant to paragraph (b)(3)(ii)(A) of this section. Also pursuant to paragraph (b)(3)(ii)(A) of this section, A's recognition of income with respect to the X stock is a sale or exchange for purposes of section 1248 and begins a new holding period for this portion of ABC's X stock, including for purposes of attributing earnings and profits. This income recognition increases A's basis in its ABC partnership interest by $15 immediately before the distribution to A. In addition, the partnership increases its basis in the X share by $15, immediately before the distribution to A. The partnership treats the $15 of dividend income recognized by A as reducing A's $15 reverse section 704(c) amount in the X stock. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC's adopted approach is reasonable. After taking into account the tax consequences of the deemed gain approach described above, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| X stock | $30 | $150 | A | $21 | $60 |
| Unrealized receivable | 0 | 120 | B | 15 | 60 |
| Capital gain asset | 30 | 30 | C | 15 | 60 |
| Y stock | 21 | 30 |  |  |  |
| Unrealized receivable | 0 | 9 |  |  |  |
| Capital gain asset | 21 | 21 |  |  |  |
| Totals | 51 | 180 |  | 51 | 180 |

(iii)(A) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Accordingly, the Y stock would take a $21 basis in A's hands under section 732(a), and no section 734(b) adjustment would be made to the X stock. After the distribution, ABC's balance sheet is as follows:

|  | Tax | Book | Capital | Tax | Book |
| --- | --- | --- | --- | --- | --- |
| X stock | $30 | $150 | A | $0 | $30 |
| Unrealized receivable | 0 | 120 | B | 15 | 60 |
| Capital gain asset | 30 | 30 | C | 15 | 60 |
| Totals | 30 | 150 |  | 30 | 150 |

(B) If the partnership sells the X stock, the gain recognized is $120 ($150—$30), all of which is recharacterized as a dividend under section 1248. Because A's recognition of $15 of dividend income reduced A's reverse section 704(c) amount in the X stock, this gain is allocated $45 to B, $45 to C, and $30 to A.