IRC Section 704(c) governs allocation of built-in gain or loss when a partner contributes appreciated or depreciated property to a partnership. If a partner contributes real estate with fair market value of $5 million but adjusted basis of $2 million, the partnership has $3 million in built-in gain on the contributed property. Section 704(c) requires that when the partnership later sells the property, the $3 million built-in gain is allocated to the contributing partner (not shared with other partners). This prevents partners from avoiding gain recognition by contributing appreciated property into partnerships, shifting gain to other partners, or deferring gain through partnership basis adjustments. Understanding Section 704(c) allocation methods (traditional method, remedial method, curative method) is critical for partnership taxation and avoiding IRS challenges on audit.
Built-In Gain and Loss: Property Contribution Mechanics
When a partner contributes property to a partnership in exchange for partnership interest, the contributed property's adjusted basis in the hands of the partnership equals the partner's adjusted basis in the property (IRC Section 723). If partner contributes property with FMV of $5 million and basis of $2 million, the partnership's basis in the property is $2 million. The difference ($3 million) is the built-in gain. The partnership's holding period for the property includes the partner's prior holding period (the basis carryover carries the holding period). If the partnership later sells the property for $5.2 million, the realized gain is $3.2 million. Under Section 704(c), the first $3 million of this gain is allocated to the contributing partner (built-in gain), and the remaining $200,000 gain is allocated under the partnership agreement's normal allocation provisions.
Traditional Method vs. Remedial Method vs. Curative Method
Section 704(c) provides three methods for allocating built-in gains and losses: (1) Traditional Method: allocate the built-in gain entirely to the contributing partner based on property-specific calculations. This is the most straightforward method. (2) Remedial Method: allocate built-in gain to contributing partner and create offsetting remedial allocations to other partners. This method can create different tax results but is more flexible. (3) Curative Method: allocate built-in gain to contributing partner and attempt to cure disparity through adjustments to other partnership allocations. This method is intermediate between traditional and remedial. The Traditional Method is the default if the partnership agreement does not specify otherwise. A partnership agreement should clearly specify which method applies to avoid IRS challenges.
Deemed Sale on Contribution and Basis Preservation
While IRC Section 721 permits nonrecognition treatment when property is contributed to a partnership, Section 704(c) preserves the built-in gain by deeming a future sale. The contributing partner does not recognize gain on contribution (Section 721 nonrecognition), but the built-in gain is preserved and recognized when the property is sold by the partnership. This is critical for multi-step transactions: partner contributes appreciated property to partnership in year 1 (no gain recognized), partnership holds and improves property in years 2-5, partnership sells property in year 5 (built-in gain from contribution is recognized to contributing partner). The economic result is equivalent to the partner having sold the property directly, but the timing of gain recognition is deferred until the partnership sale.
Partnership Distributions and Section 704(c) Adjustments
If a partnership distributes property to a partner other than the contributing partner, Section 704(c) adjustments may apply. If partnership distributes the contributed property (with built-in gain) to a non-contributing partner, IRC Section 704(c)(1)(B) requires gain recognition by the contributing partner to the extent of the distribution. This prevents partners from circumventing the built-in gain allocation through distributions. A partnership with $3 million built-in gain on contributed property that distributes the property to a non-contributing partner triggers gain recognition to the contributing partner. The amount of gain recognized depends on the method chosen (traditional, remedial, curative) and requires detailed calculations.
Multiple Properties and Aggregate Contributions
When a partner contributes multiple properties with different built-in gains and losses, Section 704(c) applies on a property-by-property basis (or group basis under regulations). A partner contributing five properties with aggregate FMV of $10 million and aggregate basis of $7 million has a $3 million aggregate built-in gain, but the gain is allocated by property. If property A has $2 million built-in gain and property B has a $1 million built-in loss, future partnership sales must allocate the $2 million built-in gain from property A to the contributing partner (even if the partnership also has $1 million loss on property B). The built-in losses do not offset the built-in gains; each property is separate.
Tiered Partnerships and Pass-Through Allocation
If a partnership is itself a partner in another partnership (tiered structure), the Section 704(c) built-in gain allocation flows through the tiers. A partner contributes property to Partnership A with $2 million built-in gain. Partnership A is a limited partner in Partnership B, which sells the contributed property. The $2 million built-in gain from Partnership A is allocated to the contributing partner in Partnership A, and then flows through Partnership A's allocation to its own partners. The allocation methodology must be consistently applied across tiers to avoid distortion.
Documentation and Schedule K-1 Reporting
Partnerships must document Section 704(c) built-in gains on their records and must disclose on Schedule K-1 (partnership tax reporting) any built-in gains or losses on contributed properties. The partnership agreement should specify the allocation method chosen (traditional, remedial, or curative) and the properties subject to Section 704(c). When the partnership sells contributed property, the Form 1065 (partnership return) must separately report the Section 704(c) allocation. Each partner's Schedule K-1 reflects the partner's allocable share of gains and losses, including any special Section 704(c) allocations. IRS audits frequently challenge partnership allocations if the Section 704(c) method is not properly documented.
Case Study: Real Estate Partnership Contribution
Three partners form a real estate partnership. Partner A contributes commercial property with FMV of $5 million and basis of $2 million (built-in gain of $3 million). Partners B and C each contribute $2.5 million cash. Partnership agreement specifies use of Traditional Method for Section 704(c) allocation. Partnership holds property for 3 years, then sells for $7 million. Realized gain is $5 million ($7 million sales price less $2 million adjusted basis). Under Section 704(c), the first $3 million of gain is allocated to Partner A (built-in gain), and the remaining $2 million gain is allocated per the partnership agreement (presumably equally to all partners). Partner A's gain: $3 million (built-in) plus proportionate share of $2 million post-contribution gain. Partners B and C's gain: proportionate share of post-contribution $2 million gain only.