Property Contribution Curatives: Pre-Funded Flexibility or Impermissible Contingency?

Medium

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🏢 Client

We're looking at a deal where we're contributing appreciated real estate into a new fund partnership — we bought this office building three years ago for $50 million, it's now worth $80 million, so we've got $30 million of built-in gain. We're contributing it as 20% of our capital commitment, and outside investors are coming in with $320 million cash for the other 80%. The fund will hold the prop…

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Case Summary ▾

Complexity ⓘ Medium

Fact Pattern Partner contributed appreciated real estate (FMV $80M, basis $50M, $30M built-in gain) for 20% interest in fund partnership; outside investors contributed $320M cash for 80%. Partnership agreement elected curative allocation method under Section 704(c), intending to reallocate depreciation from subsequently acquired properties to cure contributing partner's ceiling rule distortion over 5-7 year holding period.

Position Taken Curative allocation method is appropriate and compliant with Treas. Reg. § 1.704-3(d). Partnership may reallocate actual depreciation deductions from properties acquired with cash partner capital to cure contributing partner's built-in gain, provided allocations are of same character (capital items for capital gain), properly documented in partnership agreement, and reflected on annual K-1s. Method avoids creating artificial tax items (unlike remedial method) while providing partial relief from ceiling rule limitations. Residual built-in gain at exit is accepted consequence where fund-generated depreciation insufficient to fully cure $30M over holding period.

IRS Challenge IRS may challenge curative allocations from post-contribution acquisitions as lacking substantial economic effect under Section 704(b) and Treas. Reg. § 1.704-1(b)(2), arguing that: (1) allocations were contingent on future acquisitions not yet owned at contribution date, failing economic effect test; (2) reducing cash partners' depreciation below their capital contributions to benefit contributing partner lacks economic reality and constitutes improper capital shift; (3) partnership anti-abuse rule (Treas. Reg. § 1.701-2) applies where allocation pattern inconsistent with partners' economic arrangement. Service would propose reallocation under traditional method, resulting in full $30M built-in gain recognition at sale, amended K-1s for all partners for open years, and potential Section 6662(a) accuracy-related penalties for substantial understatement.

Authorities

IRC § 704(c)(1)(A) IRC § 704(b) Treas. Reg. § 1.704-3(d) Treas. Reg. § 1.704-1(b)(2) Treas. Reg. § 1.701-2