Final Regs Provide Rules for Allocating Partnership Non-Recourse Liabilities

 [4830-01]

 ACTION: Final regulations

 SUMMARY: This document contains final regulations relating to the allocation among partners of certain losses or deductions and certain income or gain attributable to partnership nonrecourse liabilities. The final regulations affect partnerships and their partners, and are necessary to provide them with guidance needed to comply with the applicable tax law.

 EFFECTIVE DATE: These regulations are effective December 28, 1991, and generally apply to partnership taxable years beginning on or after December 28, 1991.

 FOR FURTHER INFORMATION CONTACT: Susan Pace Hamill, 202-377-9470 (not a toll free number).

SUPPLEMENTARY INFORMATION: PAPERWORK REDUCTION ACT

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1990 (44 U.S.C. 3504(h)) under control number 1545-1090. The estimated annual burden per respondent varies from 3 minutes to 8 minutes, depending on individual circumstances, with an estimated average of 5 minutes.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents may require greater or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, D.C. 20224 and to the office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

INTRODUCTION

 This document adds new regulation section 1.704-2 to the Income Tax Regulations (26 CFR part 1) under section 704(b) of the Internal Revenue Code of 1986 and removes existing section 1.704-1(b)(4)(iv) and section 1.704-1T(b)(4)(iv).

BACKGROUND

 On December 30, 1988, temporary regulations (TD 8237) relating to allocations attributable to nonrecourse liabilities were published in the Federal Register. A notice of proposed rulemaking (PS-229-84) cross referencing the temporary regulations was published in the Federal Register the same day. on November 21, 1989, amendments to the temporary regulations (TD 8274) were published. Written comments were received and a public hearing was held on October 30, 1991. After consideration of the comments, the proposed regulations are adopted as simplified and revised by this Treasury decision, and the corresponding temporary regulations are removed.

EXPLANATION OF PROVISIONS

I. INTRODUCTION

 Under section 704(b) of the Internal Revenue Code and the regulations thereunder, allocations of a partnership's income and deductions must have substantial economic effect to be valid for federal income tax purposes -- that is, they must affect, in a substantial way, the economic stakes of the partners in the partnership apart from the tax consequences. The substantial economic effect portion of the section 704(b) regulations (section 1.704-1(b)(1) and (b)(2)) contains a number of requirements designed to ensure that partners who are allocated losses bear the economic burden associated with those losses, and partners who are allocated income receive the economic benefit associated with that income. Allocations that do not have substantial economic effect under the tests in the section 704(b) regulations are reallocated according to the partners' interests in the partnership.

 Nonrecourse liabilities are liabilities for which no partner is personally liable. Accordingly, allocations of deductions attributable to partnership nonrecourse liabilities (nonrecourse deductions) cannot have substantial economic effect because the nonrecourse lender, rather than the partners, ultimately bears any economic loss attributable to those deductions. Similarly, allocations of the gain that would be realized if the property securing the debt were surrendered for no consideration other than full satisfaction of the liability cannot have substantial economic effect because these allocations merely offset the nonrecourse deductions.

 The final regulations provide rules that: (1) determine when a partnership has nonrecourse deductions; (2) provide a safe harbor, including a minimum gain chargeback requirement, under which allocations of nonrecourse deductions are deemed to be in accordance with the partners' interests in the partnership; and (3) determine when a partnership must allocate income to the partners who were previously allocated nonrecourse deductions, pursuant to the minimum gain chargeback requirement.

II.EXPLANATION OF THE RULES COMMON TO THE TEMPORARY AND FINAL REGULATIONS

A. MINIMUM GAIN

Allocations attributable to partnership nonrecourse liabilities are based on the concept of minimum gain. The amount of minimum gain with respect to a nonrecourse liability is the gain the partnership would realize if the property securing the liability were disposed of for no consideration other than relief from the liability. Consequently, minimum gain exists to the extent the amount of the liability exceeds the property's adjusted tax basis. The amount of minimum gain increases as the difference between the property's adjusted tax basis and the amount of the liability gets larger (for example as depreciation deductions are taken); minimum gain decreases as the difference between the property's adjusted tax basis and the amount of the liability gets smaller (for example if the property subject to the debt is disposed of or if the liability is paid).

B. NONRECOURSE DEDUCTIONS

In any taxable year, the amount of a partnership's nonrecourse deductions equals the net increase in the partnership's minimum gain reduced by any distributions of nonrecourse debt proceeds that are allocable to an increase in partnership minimum gain. A net increase or decrease in the partnership's minimum gain is an aggregate figure that is determined by comparing the current year's minimum gain with the prior year's minimum gain. If the partnership has a net increase in minimum gain, partnership deductions are generally treated as nonrecourse deductions to the extent of the net increase. Nonrecourse deductions must be allocated in accordance with the partners' interests in the partnership. The regulations provide a safe harbor under which an allocation of nonrecourse deductions is deemed to be in accordance with the partners' interests in the partnership. If the partnership has a net decrease in minimum gain, generally the minimum gain chargeback rules require income to be allocated to the partners who were previously allocated nonrecourse deductions or received distributions attributable to nonrecourse debt proceeds.

 The partnership's nonrecourse deductions consist first of depreciation or cost recovery deductions from property subject to nonrecourse debt. If there are not enough depreciation or cost recovery deductions to cover the partnership's nonrecourse deductions, a pro rata portion of the partnership's other deductions are treated as nonrecourse deductions. If the amount of nonrecourse deductions exceeds these other items, then the excess is treated as an increase in partnership minimum gain (to be aggregated with any other minimum gain increases and decreases) for the next taxable year.

C. ALLOCATIONS OF NONRECOURSE DEDUCTIONS AND MINIMUM GAIN CHARGEBACKS

Allocations of nonrecourse deductions are deemed to be in accordance with the partners' interests in the partnership if certain requirements are met. First, the partnership must meet all of the requirements of the economic effect rules under section 1.704-1(b) of the regulations (The final regulations clarify the temporary regulations by explicitly listing the requirement that partners agree to a qualified income offset or an unconditional deficit restoration obligation with the other economic effect requirements that must be satisfied.) Second, the partnership must allocate the nonrecourse deductions in a manner that reasonably consistent with the allocation that has substantial economic effect of another significant item attributable to property secured by nonrecourse debt (the reasonable consistency requirement). Finally, the partnership agreement must also contain a minimum gain chargeback provision that complies with the regulations. Part III below describes the minimum gain chargeback requirement in the temporary regulations, and Part IV describes the minimum gain chargeback requirement in the final regulations.

 The reasonable consistency requirement governs the ratio in which the partners are permitted to share the nonrecourse deductions. The ratio for sharing nonrecourse deductions must correspond to other allocations that are related to the nonrecourse deductions and that have substantial economic effect. The examples illustrate situations that meet the reasonable consistency requirement where the nonrecourse deductions are allocated according to how the partners share losses or profits, or any ratio between those two figures.

 Generally, when a partnership has a net decrease in minimum gain, there is a requirement to charge back minimum gain (the minimum gain chargeback requirement) (see parts III and IV below). The minimum gain chargeback requirement ensures that the nonrecourse deductions are replaced with income allocations at the appropriate time. The partnership's income used to satisfy the minimum gain chargeback requirement first consists of gains from the sale of property subject to nonrecourse debt. Any remaining minimum gain chargeback requirement is satisfied with a pro rata portion of the partnership's other items of income and gain (except gain from the sale of property subject to partner nonrecourse debt, which is treated separately). If there are not enough income items to satisfy the minimum gain chargeback requirement, the excess is carried over as a minimum gain chargeback requirement to succeeding taxable years until there is enough income to satisfy the minimum gain chargeback requirement. In certain circumstances, the temporary and the final regulations permit deferral of the minimum gain chargeback requirement until the occurrence of a subsequent event that triggers the chargeback. The temporary and final regulations also do not require the chargeback of minimum gain to a partner if the partner's share of minimum gain is or will be replaced with capital contributions.

D.NONRECOURSE DEDUCTIONS AND MINIMUM GAIN CHARGEBACKS IF THERE IS A BOOK/TAX DISPARITY

Book/tax disparities may exist if contributed property is subject to section 704(c) or if the partnership's property is revalued pursuant to section 1.704-1(b)(2)(iv)(f). If partnership property is reflected on the partnership's books at a value that is different from the adjusted tax basis, the minimum gain increases and decreases are determined with reference to the book value. The regulations contain examples illustrating this determination.

 If a revaluation of partnership property subject to nonrecourse liabilities causes an increase to the partners' capital accounts (a book-up), the regulations contain a special rule designed to prevent an inappropriate net decrease in minimum gain in the year the revaluation occurs. The partnership first calculates the net increase or decrease in minimum gain using the new book values and the prior year's minimum gain amount. Then, any decrease in minimum gain arising solely from the revaluation is added back (treated as an increase in minimum gain) to the net increase or decrease determined in the first step. In subsequent partnership taxable years, net increases or decreases in partnership minimum gain are determined using book values instead of adjusted tax basis. A special rule to compute minimum gain in the year of revaluation is not needed if the partners' capital accounts are decreased (a book-down. An artificial increase in minimum gain cannot occur if capital accounts are booked down because property cannot be revalued below the amount of any nonrecourse indebtedness to which it is subject. See section 7701(g) and section 1.704-1(b)(2)(iv)(f)(1).

E. DISTRIBUTIONS OF NONRECOURSE LIABILITY PROCEEDS

Encumbering property with additional nonrecourse debt that is not used to improve the property often causes an increase in minimum gain because the difference between the basis of the property and the total amount of the debt immediately increases. If the partnership distributes the proceeds of a nonrecourse liability, the distributee partner enjoys the economic benefit of the immediate use of the proceeds but does not bear the economic risk of loss if the partnership cannot pay the debt. If a nonrecourse liability encumbering the property causes minimum gain to increase and a distribution is allocable to the proceeds of this nonrecourse liability, the partner receiving this distribution also receives an additional share of minimum gain, which will be subject to the minimum gain chargeback requirement when the partnership's minimum gain decreases. Any reasonable method (including the rules under section 1.163-8T for allocating debt proceeds among expenditures) may be us to determine if a distribution is allocable to nonrecourse debt proceeds. If a net increase in minimum-gain arising from nonrecourse borrowing is carried over to a later taxable year (usually because the proceeds are not distributed in the year of the encumbrance and the partnership does not otherwise have enough deductions to cover the increase in minimum gain), the carried-over portion of the net increase is allocable to any distribution of nonrecourse debt proceeds in the succeeding taxable year.

F. TIERED PARTNERSHIPS

The regulations contain general rules that determine what effect a lower-tier partnership's items have on the upper-tier partnership's minimum gain. The rules are designed to allow the partners of the upper-tier partnership to look through and account for the lower-tier partnership's items as directly as possible. All nonrecourse deductions and distributions of nonrecourse debt proceeds from the lower-tier partnership increase the upper-tier partnership's minimum gain proportionately. The upper-tier partnership's share of the lower-tier partnership's net decrease in minimum gain is treated as a decrease in the upper-tier partnership's minimum gain (to be aggregated with the upper-tier partnership's other minimum gain increases or decreases). Distributions of nonrecourse debt proceeds from the lower-tier partnership generally retain their status (as nonrecourse debt proceeds) when received by the upper-tier partnership. Nonrecourse deductions allocated by the lower-tier partnership to the upper-tier partnership are treated as depreciation or cost recovery deductions arising from property owned by the upper- tier partnership.

G. RULES FOR PARTNER NONRECOURSE DEBT

The regulations contain rules, which generally parallel the rules applicable to nonrecourse debt, covering nonrecourse debt for which a partner bears the economic risk of loss ("partner nonrecourse debt"). A liability is treated as partner nonrecourse debt to the extent a partner bears the economic risk of loss solely because the partner or a related person (within the meaning of the section 752 regulations) is the creditor or the guarantor and the debt is considered nonrecourse for purposes of section 1.1001-2.

 The regulations require the deductions attributable to partner nonrecourse debt to be allocated to the lending or guaranteeing partner. This is accomplished by requiring minimum gain calculations for each separate partner nonrecourse debt. If there is a net increase in the minimum gain attributable to a specific partner nonrecourse debt, the depreciation or cost recovery deductions generated by the property subject to the debt must be allocated to the lending or guaranteeing partner. If there are not enough depreciation or cost recovery deductions to cover the entire net increase in minimum gain, a pro rata portion of the partnership's other loss items (except for depreciation or cost recovery deductions on property subject to a partnership nonrecourse liability) is used. A carryover rule applies if there are still not enough losses to cover the minimum gain increase.

 If there is a net decrease in the minimum gain attributable to a particular partner nonrecourse debt, a minimum gain chargeback requirement generally applies to the partner who was previously allocated the losses (or who received distributions) attributable to the debt. (See parts III and IV below). The minimum gain chargeback requirement is satisfied first with gain from the sale of the property subject to the partner to the partner nonrecourse debt and then by a pro rata portion of the partnership's other income and gain items (except to the extent these items have been allocated to satisfy a partnership minimum gain chargeback requirement). Unsatisfied minimum gain chargeback requirements carry over to succeeding taxable years.

III.DESCRIPTION OF MINIMUM GAIN CHARGEBACK APPROACH IN THE TEMPORARY REGULATIONS

 The temporary regulations based a partner's minimum gain chargeback requirement (with respect to both nonrecourse and partner nonrecourse debt) on a "two-prong" calculation. A partner's minimum gain chargeback equaled the greater of (1) the partner's share of the net decrease in minimum gain attributable to a disposition of property securing nonrecourse liabilities, or (2) the partner's deficit capital account, as specially defined. The computation of the partners' deficit capital accounts required a number of deemed increases and decreases that generally -- but not precisely -- paralleled the alternate test for economic effect under the section 704(b) regulations.

 The two-prong approach contained no explicit exceptions. If prong one applied to the net decrease in minimum gain, a chargeback was always imposed. Prong two, however, effectively provided partial relief from the minimum gain chargeback requirement in certain situations. When nonrecourse debt converted to recourse debt or to partner nonrecourse debt (by, for example, the creation of a guarantee) prong two precluded the chargeback to the extent the partner bore the risk of loss, so long as no part of the net decrease in minimum gain was attributable to a disposition of property. When calculating the minimum gain chargeback requirement, prong two increased the partner's deficit capital account to the extent the partner bore the risk of loss for partnership liabilities. Moreover, if the partners had previously restored the nonrecourse deductions and distributions attributable to nonrecourse debt proceeds with income allocations or capital contributions, prong two (but not prong one) did not impose a minimum gain chargeback to the extent the deficits in the partners' capital accounts had been eliminated by these income allocations and capital contributions.

IV. MODIFICATIONS TO THE MINIMUM GAIN CHARGEBACK REQUIREMENT MADE BY THE FINAL REGULATIONS

A. REASONS FOR THE MODIFICATIONS

The complexity of the two-prong calculation was heavily criticized in the comments. The comments stated that the second prong did not always preclude inappropriate chargebacks when debt was converted, refinanced, or otherwise changed. Modifications comments stated that, depending on whether the property was sold at the time of the decrease in minimum gain, the two-prong approach treated similar situations inconsistently if the partners restored their nonrecourse deductions with other income allocations (or capital contributions) before the partnership had a net decrease in minimum gain. Under the temporary regulations, if the partners restored their nonrecourse deductions with income allocations or capital contributions and prong one later applied to the net decrease in minimum gain, the minimum gain chargeback always applied and often created economic distortions. However, if prong two applied and if the income allocations and capital contributions fully restored the deficits in the partners' capital accounts, the minimum gain chargeback was not required. The final regulations address these concerns by basing the minimum gain chargeback solely on the partners' shares of minimum gain and providing exceptions where a chargeback is inappropriate.

B. MINIMUM GAIN CHARGEBACK REQUIREMENT IN THE FINAL REGULATIONS

 The final regulations contain a minimum gain chargeback requirement (for both nonrecourse and partner nonrecourse debt), with appropriate exceptions, based exclusively on the partners' shares of minimum gain. Specifically, a partner's minimum gain chargeback equals the partner's share of the partnership's net decrease in minimum gain. A partner's share of the net decrease is measured by that partner's percentage share of the partnership's total minimum gain. For example, if a partner had a 20 percent share of the partnership's total minimum gain and the partnership had a net decrease in minimum gain of $500, the partner's share of the net decrease (and minimum gain chargeback) is $100 (20 percent of $500). A partner's share of minimum gain equals the sum of all past nonrecourse deductions allocated to the partner and distributions attributable to nonrecourse debt proceeds received by the partner; those are the items that need to be restored by the minimum gain chargeback requirement.

 A number of exceptions to the mandatory minimum gain chargeback are included to address inappropriate chargebacks. A partner is not subject to a minimum gain chargeback to the extent (1) the partner's share of the net decrease in minimum gain is caused by a guarantee, refinancing, or other change in the debt instrument causing it no longer to be partially or wholly nonrecourse, and (2) the partner bears the economic risk of loss (under the section 752 regulations) for the new liability. A chargeback is inappropriate in this circumstance because partners who bear the risk of loss for the former nonrecourse debt have replaced their nonrecourse deductions with obligations either to contribute money to the partnership or to pay the creditor if the partnership cannot pay the liability. The minimum gain chargeback also does not apply to a partner to the extent the partner contributes capital to the partnership and that capital is used to repay the nonrecourse liability.

 The final regulations also contain exceptions to the minimum gain chargeback requirement for partner nonrecourse debt. If partner nonrecourse debt converts to partnership nonrecourse debt, the minimum gain chargeback is deferred. The partner is allocated a share of partnership minimum gain to the extent the chargeback is deferred and thus is subject to the deferred minimum gain chargeback when that debt is paid off or the encumbered property is sold. Other exceptions parallel the exceptions for partnership nonrecourse liabilities.

 The final regulations do not allow partners to reduce their shares of minimum gain if the nonrecourse deductions (or distributions of nonrecourse debt proceeds) are restored before there is a net decrease in minimum gain. However, the Commissioner has the discretion to waive the minimum gain chargeback requirement at the partnership's request if the partnership has a net decrease in minimum gain, the minimum gain chargeback would cause economic distortions, and it is not expected that the partnership will have sufficient other income to correct these distortions. In order for a waiver to be considered, the partnership must demonstrate that: (1) the partners have restored the previous nonrecourse deductions (and distributions of nonrecourse debt proceeds) with net income allocations or capital contributions; and (2) the income allocations that do not meet the minimum gain chargeback requirement more accurately reflect the partners' economic arrangement, as evidenced by the partnership's allocations and distributions and the partners' contributions.

V. OTHER COMMENTS ON THE TEMPORARY REGULATIONS

A. GUARANTEES OF PARTNERSHIP NONRECOURSE DEBT

Commentators have suggested that allocations attributable to partnership nonrecourse liabilities that have been guaranteed by a partner (or a related party) can be more appropriately treated under the substantial economic effect rules of section 1.704-1(b)(2) than under the partner nonrecourse debt rules. These commentators have argued that guaranteed nonrecourse debt should be distinguished from direct nonrecourse loans made by partners (or related parties) because, to the extent the debt can be satisfied by the guarantee, the partnership will not recognize gain if the lender forecloses on the property. Commentators advocate the distinction on the premise that, in the case of guaranteed debt, partners other than the guarantor may bear the economic burden under the substantial economic effect rules. The rights and obligations of partners and lenders under guarantee arrangements, however, may vary greatly from case to case. As a result, the distinction sought by the commentators may not always be appropriate; in many instances, guaranteed nonrecourse debt is more appropriately treated under the partner nonrecourse debt rules. In addition, the Service and the Treasury believe that, in the case of guaranteed nonrecourse debt and partner nonrecourse loans, transactions may be structured to ensure that partner nonrecourse deductions are allocated properly to the partners that economically bear the risk of loss attributable to those loans. Moreover, some of the commentators' concerns regarding the complexity of the partner nonrecourse debt rules may have been alleviated by the modifications made to the nonrecourse debt rules that are described in part IV above. Therefore, the final regulations continue to treat guaranteed nonrecourse debt under the partner nonrecourse debt rules. Nonetheless, the Service and the Treasury request comments on whether further simplification of the partner nonrecourse debt rules is needed and welcome suggestions for alternative approaches to accounting for allocations attributable to partner nonrecourse debt.

B. MINIMUM GAIN CALCULATIONS FOR EXCULPATORY LIABILITIES

A partnership may have a liability that is not secured by any specific property and that is recourse to the partnership as an entity, but explicitly not recourse to any partner (exculpatory liability). Section 1.704-2(b)(3) of the final regulations defines nonrecourse liability by referring to the definition of nonrecourse liability in the regulations under section 752. Under that definition, an exculpatory liability is a nonrecourse liability. The application of the nonrecourse debt rules of section 1.704-2 -- more specifically, the calculation of minimum gain -- may be difficult in the case of an exculpatory liability, however, because the liability is not secured by specific property and the bases of partnership properties that can be reached to the lender in the case of an exculpatory liability may fluctuate greatly. Section 1.704-2 does not prescribe precise rules addressing the allocation of income and loss attributable to exculpatory liabilities. Taxpayers, therefore, are left to treat allocations attributable to these liabilities in a manner that reasonably reflects the principles of section 704(b). Commentators have requested that the treatment of allocations attributable to exculpatory liabilities under the nonrecourse debt rules be clarified. The Service and the Treasury solicit further suggestions on the appropriate treatment of allocations attributable to these liabilities. Suggestions should take into account the practical concerns of partnerships as well as the Service's concerns about the proper allocation of loss and gain items attributable to these liabilities.

VI. EFFECTIVE DATES AND TRANSITION RULES

 Comments stated that the transition rules do not correspond exactly with the grandfather provisions of section 752 and are complex. However, a major change to the transition rules could adversely affect some partnerships retroactively. Therefore, the final regulations contain the transition rules as they appear in the temporary regulations with one modification.

 The modification expands the grandfather rule for related-party partner nonrecourse debt. Both section 752 and the temporary regulations grant permanent grandfather status to nonrecourse loans or guarantees of nonrecourse debt made before January 30, 1989, by persons related to partners as long as there are no material modifications to the debt. The grandfather rule in the temporary regulations for related-party partner nonrecourse debt fails to grandfather certain situations, such as guarantees of interest and certain guarantees of a lower-tier partnership's debt by upper-tier partners. The final regulations amend the related-party grandfather provision to include all pre-January 30, 1989, debt, other than direct partner nonrecourse loans or guarantees of partnership nonrecourse debt, that is grandfathered under the section 752 regulations so long as all the partners in the partnership consistently treat the liability as nonrecourse.

SPECIAL ANALYSES

 These final regulations are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It is hereby certified that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations.

 It is hereby certified that these rules do not have a significant impact on a substantial number of small entities. Therefore, a final Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Administrator of the Small Business Administration for comments on their impact on small businesses.

DRAFTING INFORMATION

 The principal author of these regulations is Susan Pace Hamill, Office of the Assistant Chief Counsel (Passthroughs and Special Industries). However personnel from other offices in the Internal Revenue Service and the Treasury Department participated in their development.

Treasury Decision 8385

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR Part 1 is amended as follows: PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 continues to read in part as follows:

Authority: Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805 * * * section 1.704-1 [Amended]

Par. 2. In section 1.704-1(b)(0), the entry for section 1.704-1 (b)(4)(iv) is amended by revising the heading to read "Allocations Attributable to Nonrecourse Liabilities."

Par. 3. Section 1.704-1(b)(0) is further amended by removing from the table all headings and section numbers for section 1.704-1(b)(4)(iv) (a) through (h).

Par. 4. Section 1.704-1(b)(1)(i) is amended by adding the language "and section 1.704-2" at the end of the sixth sentence.

Par. 5-6. Section 1.704-1(b)(2)(ii)(d)(6) is amended by adding "under section 1.704-2 (f)" at the end of the paragraph.

Par. 7. Section 1.704-1(b)(4)(iv) is revised to read as follows:

SECTION 1.704-1 PARTNER'S DISTRIBUTIVE SHARE.

* * * * *

(b) * * *

(4) * * *

(iv) ALLOCATIONS ATTRIBUTABLE TO NONRECOURSE LIABILITIES. The rules for allocations attributable to nonrecourse liabilities are contained in section 1.704-2.

Par. 8. Section 1.704(b)(5) is amended by removing Examples (20) through (23).

* * * * *

Par. 9. Section 1.704-1T(b)(4)(iv) is removed.

Par. 10. New section 1.704-2 is added to read as follows:

SECTION 1.704-2 ALLOCATIONS ATTRIBUTABLE TO NONRECOURSE LIABILITIES.

(a) TABLE OF CONTENTS. This paragraph contains a listing of the major headings of this section 1.704-2.

SECTION 1.704-2 ALLOCATIONS ATTRIBUTABLE TO NONRECOURSE LIABILITIES.

 (a) Table of contents.

(2) DEFINITION OF AND ALLOCATIONS PURSUANT TO A MINIMUM GAIN CHARGEBACK. To the extent a nonrecourse liability exceeds the adjusted tax basis of the partnership property it encumbers, a disposition of that property will generate gain that at least equals that excess ("partnership minimum gain"). An increase in partnership minimum gain is created by a decrease in the adjusted tax basis of property encumbered by a nonrecourse liability below the amount of that liability and by a partnership nonrecourse borrowing that exceeds the adjusted tax basis of the property encumbered by the borrowing. Partnership minimum gain decreases as reductions occur in the amount by which the nonrecourse liability exceeds the adjusted tax basis of the property encumbered by the liability. Allocations of gain attributable to a decrease in partnership minimum gain (a "minimum gain chargeback," as required under paragraph (f) of this section) cannot have economic effect because the gain merely offsets nonrecourse deductions previously claimed by the partnership. Thus, to avoid impairing the economic effect of other allocations, allocations pursuant to a minimum gain chargeback must be made to the partners that either were allocated nonrecourse deductions or received distributions of proceeds attributable to a nonrecourse borrowing. Paragraph (e) of this section provides a test that, if met, deems allocations of partnership income pursuant to a minimum gain chargeback to be in accordance with the partners' interests in the partnership. If property encumbered by a nonrecourse liability is reflected on the partnership's books at a value that differs from its adjusted tax basis, paragraph (d)(3) of this section provides that minimum gain is determined with reference to the property's book basis. See also paragraph (i)(4) of this section for special rules regarding the minimum gain chargeback requirement for partner nonrecourse debt.

(3) DEFINITION OF NONRECOURSE LIABILITY. "Nonrecourse liability" means a nonrecourse liability as defined in section 1.752-1(a)(2).

(4) DEFINITION OF PARTNER NONRECOURSE DEBT. "Partner nonrecourse debt" or "partner nonrecourse liability" means any partnership liability to the extent the liability is nonrecourse for purposes of section 1.1001-2, and a partner (or related person (within the meaning of section 1.752-4(b)) bears the economic risk of loss under section 1.752-2 because, for example, the partner or related person is the creditor or a guarantor.

(c) AMOUNT OF NONRECOURSE DEDUCTIONS. The amount of nonrecourse deductions for a partnership taxable year equals the net increase in partnership minimum gain during the year (determined under paragraph (d) of this section), reduced (but not below zero) by the aggregate distributions made during the year of proceeds of a nonrecourse liability that are allocable to an increase in partnership minimum gain (determined under paragraph (h) of this section). See paragraph (m), Examples (1)(i) and (vi), (2), and (3) of this section. However, increases in partnership minimum gain resulting from conversions, refinancings, or other changes to a debt instrument (as described in paragraph (g)(3)) do not generate nonrecourse deductions. Generally, nonrecourse deductions consist first of certain depreciation or cost recovery deductions and then, if necessary, by a pro rata portion of other partnership losses, deductions, and section 705(a)(2)(B) expenditures for that year; excess nonrecourse deductions are carried over. See paragraphs (j)(1)(ii) and (iii) of this section for more specific ordering rules. See also paragraph (m), Example (1)(vi) of this section.

(d) PARTNERSHIP MINIMUM GAIN -- (1) AMOUNT OF PARTNERSHIP MINIMUM GAIN. The amount of partnership minimum gain is determined by first computing for each partnership nonrecourse liability any gain the partnership would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability, and then aggregating the separately computed gains. The amount of partnership minimum gain includes minimum gain arising from a conversion, refinancing, or other change to a debt instrument, as described in paragraph (g)(3) of this section, only to the extent a partner is allocated a share of that minimum gain. For any partnership taxable year, the net increase or decrease in partnership minimum gain is determined by comparing the partnership minimum gain on the last day of the immediately preceding taxable year with the partnership minimum gain on the last day of the current taxable year. See paragraph (m), Examples (1)(i) and (iv), (2), and (3) of this section.

(2) PROPERTY SUBJECT TO MORE THAN ONE LIABILITY. (i) In general. If property is subject to more than one liability, only the portion of the property's adjusted tax basis that is allocated to a nonrecourse liability under paragraph (d)(2)(ii) of this section is used to compute minimum gain with respect to that liability.

(ii) ALLOCATING LIABILITIES. If property is subject to two or more liabilities of equal priority, the property's adjusted tax basis is allocated among the liabilities in proportion to their outstanding balances. If property is subject to two or more liabilities of unequal priority, the adjusted tax basis is allocated first to the liability of the highest priority to the extent of its outstanding balance and then to each liability in descending order of priority to the extent of its outstanding balance, until fully allocated. See paragraph (m), Example (1)(v) and (vii) of this section.

(3) PARTNERSHIP MINIMUM GAIN IF THERE IS A BOOK/TAX DISPARITY. If partnership property subject to one or more nonrecourse liabilities is, under section 1.704-1(b)(2)(iv)(d), (f), or (r), reflected on the partnership's books at a value that differs from its adjusted tax basis, the determinations under this section are made with reference to the property's book value. See section 704(c) and section 1.704-1(b)(4)(i) for principles that govern the treatment of a partner's share of minimum gain that is eliminated by the revaluation. See also paragraph (m), Example (3) of this section.

(4) SPECIAL RULE FOR ONE YEAR OF REVALUATION. If the partners' capital accounts are increased pursuant to section 1.704-1(b)(2)(iv)(d), (f), or (r) to reflect a revaluation of partnership property subject to a nonrecourse liability, the net increase or decrease in partnership minimum gain for the partnership taxable year of the revaluation is determined by:

(i) First calculating the net decrease or increase in partnership minimum gain using the current year's book values and the prior year's partnership minimum gain amount; and

(ii) Then adding back any decrease in minimum gain arising solely from the revaluation. See paragraph (m), Example (3)(iii) of this section. If the partners' capital accounts are decreased to reflect a revaluation, the net increases or decreases in partnership minimum gain are determined in the same manner as in the year before the revaluation, but by using book values rather than adjusted tax bases. See section 7701(g) and section 1.704-1(b)(2)(iv)(f)(1) (property being revalued cannot be booked down below the amount of any nonrecourse liability to which the property is subject).

(e) REQUIREMENTS TO BE SATISFIED. Allocations of nonrecourse deductions are deemed to be in accordance with the partners' interests in the partnership only if --

(1) Throughout the full term of the partnership requirements (1) and (2) of section 1.704-1(b)(2)(ii)(b) are satisfied (i.e., capital accounts are maintained in accordance with section 1.704-1(b)(2)(iv) and liquidating distributions are required to be made in accordance with positive capital account balances), and requirement (3) of either section 1.704-1(b)(2)(ii)(b) or section 1.704-1(b)(2)(ii)(d) is satisfied (i.e., partners with deficit capital accounts have an unconditional deficit restoration obligation or agree to a qualified income offset);

(2) Beginning in the first taxable year of the partnership in which there are nonrecourse deductions and thereafter throughout the full term of the partnership, partnership agreement provides for allocations of nonrecourse deductions in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liabilities;

(3) Beginning in the first taxable year of the partnership that it has nonrecourse deductions or makes a distribution of proceeds of a nonrecourse liability that are allocable to an increase in partnership minimum gain, and thereafter throughout the full term of the partnership, the partnership agreement contains a provision that complies with the minimum gain chargeback requirements of paragraph (f) of this section; and

(4) All other material allocations and capital account adjustments under the partnership agreement are recognized under section 1.704-1(b) (without regard to whether allocations of adjusted tax basis and amount realized under section 613A(c)(7)(D) are recognized under section 1.704-1(b)(4)(v)).

(f) MINIMUM GAIN CHARGEBACK REQUIREMENT -- (1) In general. If there is a net decrease in partnership minimum gain for a partnership taxable year, the minimum gain chargeback requirement applies and each partner must be allocated items of partnership income and gain for that year equal to that partner's share of the net decrease in partnership minimum gain (within the meaning of paragraph (g)(2)).

(2) EXCEPTION FOR CERTAIN CONVERSIONS AND REFINANCINGS. A partner is not subject to the minimum gain chargeback requirement to the extent the partner's share of the net decrease in partnership minimum gain is caused by a guarantee, refinancing, or other change in the debt instrument causing it to become partially or wholly recourse debt or partner nonrecourse debt, and the partner bears the economic risk of loss (within the meaning of section 1.752-2) for the newly guaranteed, refinanced, or otherwise changed liability.

(3) EXCEPTION FOR CERTAIN CAPITAL CONTRIBUTIONS. A partner is not subject to the minimum gain chargeback requirement to the extent the partner contributes capital to the partnership that is used to repay the nonrecourse liability, and the partner's share of the net decrease in partnership minimum gain results from the repayment. See paragraph (m), Example (1)(iv) of this section.

(4) WAIVER FOR CERTAIN INCOME ALLOCATIONS THAT FAIL TO MEET MINIMUM GAIN CHARGEBACK REQUIREMENT IF MINIMUM GAIN CHARGEBACK DISTORTS ECONOMIC ARRANGEMENT. In any taxable year that a partnership has a net decrease in partnership minimum gain, if the minimum gain chargeback requirement would cause a distortion in the economic arrangement among the partners and it is not expected that the partnership will have sufficient other income to correct that distortion, the Commissioner has the discretion, if requested by the partnership, to waive the minimum gain chargeback requirement. The following facts must be demonstrated in order for a request for a waiver to be considered:

(i) The partners have made capital contributions or received net income allocations that have restored the previous nonrecourse deductions and the distributions attributable to proceeds of a nonrecourse liability; and

(ii) The minimum gain chargeback requirement would distort the partners' economic arrangement as reflected in the partnership agreement and as evidenced over the term of the partnership by the partnership's allocations and distributions and the partners' contributions.

(5) ADDITIONAL EXCEPTIONS. The Commissioner may, by revenue ruling, provide additional exceptions to the minimum gain chargeback requirement.

(6) PARTNERSHIP ITEMS SUBJECT TO THE MINIMUM GAIN CHARGEBACK REQUIREMENT. Any minimum gain chargeback required for a partnership taxable year consists first of certain gains recognized from the disposition of partnership property subject to one or more partnership nonrecourse liabilities and then if necessary consists of a pro rata portion of the partnership's other items of income and gain for that year. If the amount of the minimum gain chargeback requirement exceeds the partnership's income and gains for the taxable year, the excess carries over. See paragraphs (j)(2)(i) and (iii) of this section for more specific ordering rules.

(7) EXAMPLES. The following examples illustrate the provisions in section 1.704-2 (f).

EXAMPLE 1. Partnership AB consists of two partners, limited partner A and general partner B. Partner A contributes $90 and Partner B contributes $10 to the partnership. The partnership agreement has a minimum gain chargeback provision and provides that, except as otherwise required by section 704 (c), all losses will be allocated 94 percent to A and 10 percent to B; and that all income will be allocated first to restore previous losses and thereafter 50 percent to A and 50 percent to B. Distributions are made first to return initial capital to the partners and then 50 percent to A and 50 percent to B. Final distributions are made in accordance with capital account balances. The partnership borrows $200 on a nonrecourse basis from an unrelated third party and purchases an asset for $300. The partnership's only tax item for each of the first three years is $100 of depreciation on the asset. A's and B's shares of minimum gain (under paragraph (g) of this section) and deficit capital account balances are $180 and $20 respectively at the end of the third year. In the fourth year, the partnership earns $400 of net operating income and allocates the first $300 to restore the previous losses (i.e., $270 to A and $30 to B); the last $100 is allocated $50 each. The partnership distributes $200 of the available cash that same year; the first $100 is distributed $90 to A and $10 to B to return their capital contributions; the last $100 is distribute; $50 each to reflect their ratio for sharing profits.

 A            B

EXAMPLE 2. A and B form a partnership, contribute $25 each to the partnership's capital, and agree to share all losses and profits 50 percent each. Neither partner has an unconditional deficit restoration obligation and all the requirements in paragraph (e) of this section are met. The partnership obtains a nonrecourse loan from an unrelated third party of $100 and purchases two assets, stock for %50 and depreciable property for $100. The nonrecourse loan is secured by the partnership's depreciable property. The partnership generates $20 of depreciation in each of the first five years as its only tax item. These deductions are properly treated as nonrecourse deductions and the allocation of these deductions 50 percent to A and 50 percent to B is deemed to be in accordance with the partners' interests in the partnership. At the end of year five, A and B each have a $25 deficit capital account and a $50 share of partnership minimum gain. In the beginning of year six, (at the lender's request), A guarantees the entire nonrecourse liability. Pursuant to paragraph (d)(1) of this section, the partnership has a net decrease in minimum gain of $100 and under paragraph (g)(2) of this section, A's and B's shares of that net decrease are $50 each. Under paragraph (f)(1) of this section (the minimum gain chargeback requirement), B is subject to a $50 minimum gain chargeback. Because the partnership has no income in year six, the entire $50 carries over as a minimum gain chargeback requirement to succeeding taxable years until there is enough income to cover the minimum gain chargeback requirement. Under the exception to the minimum gain chargeback in paragraph (f)(2) of this section, A is not subject to a minimum gain chargeback for A's $50 share of the net decrease because A bears the economic risk of loss for the liability. Instead, A's share of partner nonrecourse debt minimum gain is $50 pursuant to paragraph (i)(3) of this section. In year seven, the partnership earns $100 of net operating income and uses the money to repay the entire $100 nonrecourse debt (that A has guaranteed). Under paragraph (i)(3) of this section, the partnership has a net decrease in partner nonrecourse debt minimum gain of $50. B must be allocated $50 of the operating income pursuant to the carried over minimum gain chargeback requirement; pursuant to paragraph (i)(4) of this section, the other $50 of operating income must be allocated to A as a partner nonrecourse debt minimum gain chargeback.

(g) SHARES OF PARTNERSHIP MINIMUM GAIN -- (1) PARTNER'S SHARE OF PARTNERSHIP MINIMUM GAIN. Except as increased in paragraph (g)(3) of this section, a partner's share of partnership minimum gain at the end of any partnership taxable year equals:

(i) the sum of nonrecourse deductions allocated to that partner (and to that partner's predecessors in interest) up to that time and the distributions made to that partner (and to that partner's predecessors in interest) up to that time of proceeds of a nonrecourse liability allocable to an increase in partnership minimum gain (see paragraph (h)(1) of this section); minus

(ii) the sum of that partner's (and that partner's predecessors' in interest) aggregate share of the net decreases in partnership minimum gain plus their aggregate share of decreases resulting from revaluations of partnership property subject to one or more partnership nonrecourse liabilities.

For purposes of section 1.704-1(b)(2)(ii)(d), a partner's share of partnership minimum gain is added to the limited dollar amount, if any, of the deficit balance in the partner's capital account that the partner is obligated to restore. See paragraph (m), Examples (1)(i) and (3)(i) of this section.

(2) PARTNER'S SHARE OF THE NET DECREASE IN PARTNERSHIP MINIMUM GAIN. A partner's share of the net decrease in partnership minimum gain is the amount of the total net decrease multiplied by the partner's percentage share of the partnership's minimum gain at the end of the immediately preceding taxable year. A partner's share of any decrease in partnership minimum gain resulting from a revaluation of partnership property equals the increase in the partner's capital account attributable to the revaluation to the extent the reduction in minimum gain is caused by the revaluation. See paragraph (m), Example (3)(ii) of this section.

(3) CONVERSIONS OF RECOURSE OR PARTNER NONRECOURSE DEBT INTO NONRECOURSE DEBT. A partner's share of partnership minimum gain is in creased to the extent provided in this paragraph (g)(3) if a refinancing, the lapse of a guarantee, or other change to a debt instrument causes a recourse or partner nonrecourse liability to become partially or wholly nonrecourse. If a recourse liability becomes a nonrecourse liability, a partner has a share of the partnership's minimum gain that results from the conversion equal to the partner's deficit capital account (determined under section 1.704-1(b)(2)(iv)) to the extent the partner no longer bears the economic burden for the entire deficit capital account as a result of the conversion. For purposes of the preceding sentence, the determination of the extent to which a partner bears the economic burden for a deficit capital account is made by determining the consequences to the partner in the case of a complete liquidation of the partnership immediately after the conversion applying the rules described in section 1.704-1(b)(2)(iii)(c) that deem the value of partnership property to equal its basis, taking into account section 7701(g) in the case of property that secures nonrecourse indebtedness. If a partner nonrecourse debt becomes a nonrecourse liability, the partner's share of partnership minimum gain is increased to the extent the partner is not subject to the minimum gain chargeback requirement under paragraph (i)(4) of this section.

(h) DISTRIBUTION OF NONRECOURSE LIABILITY PROCEEDS ALLOCABLE TO AN INCREASE IN PARTNERSHIP MINIMUM GAIN -- (1)

IN GENERAL. If during its taxable year a partnership makes a distribution to the partners allocable to the proceeds of a nonrecourse liability, the distribution is allocable to an increase in partnership minimum gain to the extent the increase results from encumbering partnership property with aggregate nonrecourse liabilities that exceed the property's adjusted tax basis. See paragraph (m), Example (1)(vi) of this section. If the net increase in partnership minimum gain for a partnership taxable year is allocable to more than one nonrecourse liability, the net increase is allocated among the liabilities on a pro rata basis based on the outstanding balance of each liability.

(2) DISTRIBUTION ALLOCABLE TO NONRECOURSE LIABILITY PROCEEDS. A partnership may use any reasonable method to determine whether a distribution by the partnership to one or more partners is allocable to proceeds of a nonrecourse liability. The rules prescribed under section 1.163-8T for allocating debt proceeds among expenditures (applying those rules to the partnership as if it were an individual) constitute a reasonable method for determining whether the nonrecourse liability proceeds are distributed to the partners and the partners to whom the proceeds are distributed.

(3) OPTION WHEN THERE IS AN OBLIGATION TO RESTORE. A partnership may treat any distribution to a partner of the proceeds of a nonrecourse liability (that would otherwise be allocable to an increase in partnership minimum gain) as a distribution that is not allocable to an increase in partnership minimum gain to the extent the distribution does not cause or increase a deficit balance in the partner's capital account that exceeds the amount the partner is otherwise obligated to restore (within the meaning of section 1.704-1(b)(2)(ii)(c)) as of the end of the partnership taxable year in which the distribution occurs.

(4) CARRYOVER TO IMMEDIATELY SUCCEEDING TAXABLE YEAR. The carryover rule of this paragraph applies if the net increase in partnership minimum gain for a partnership taxable year that is allocable to a nonrecourse liability under paragraph (h)(2) of this section exceeds the distributions allocable to the proceeds of the liability ("excess allocable amount"), and all or part of the net increase in partnership minimum gain for the year is carried over as an increase in partnership minimum gain for the immediately succeeding taxable year (pursuant to paragraph (j)(1)(iii) of this section). If the carryover rule of this paragraph applies, the excess allocable amount (or the amount carried over under paragraph (j)(1)(iii) of this section, if less) is treated in the succeeding taxable year as an increase in partnership minimum gain that arose in that year as a result of incurring the nonrecourse liability to which the excess allocable amount is attributable. See paragraph (m), Example (1)(vi) of this section. If for a partnership taxable year there is an excess allocable amount with respect to more than one partnership nonrecourse liability, the excess allocable amount is allocated to each liability on a pro rata basis based on the *utstanding balance of each liability.

(i) PARTNERSHIP NONRECOURSE LIABILITIES WHERE A PARTNER BEARS THE ECONOMIC RISK OF LOSS -- (1) IN GENERAL. Partnership losses, deductions, or section 705(a)(2)(B) expenditures that are attributable to a particular partner nonrecourse liability ("partner nonrecourse deductions," as defined in paragraph (i)(2) of this section) must be allocated to the partner that bears the economic risk of loss for the liability. If more than one partner bears the economic risk of loss for a partner nonrecourse liability, any partner nonrecourse deductions attributable to that liability must be allocated among the partners according to the ratio in which they bear the economic risk of loss. If partners bear the economic risk of loss for different portions of a liability, each portion is treated as a separate partner nonrecourse liability.

(2) DEFINITION OF AND DETERMINATION OF PARTNER NONRECOURSE DEDUCTIONS. For any partnership taxable year, the amount of partner nonrecourse deductions with respect to a partner nonrecourse debt equals the net increase during the year in minimum gain attributable to the partner nonrecourse debt ("partner nonrecourse debt minimum gain"), reduced (but not below zero) by proceeds of the liability distributed during the year to the partner bearing the economic risk of loss for the liability that are both attributable to the liability and allocable to an increase in the partner nonrecourse debt minimum gain. See paragraph (m), Example (1)(viii) and (ix) of this section. The determination of which partnership items constitute the partner nonrecourse deductions with respect to a partner nonrecourse debt must be made in a manner consistent with the provisions of paragraphs (c) and (j)(1)(i) and (iii) of this section.

(3) DETERMINATION OF PARTNER NONRECOURSE DEBT MINIMUM GAIN. For any partnership taxable year, the determination of partner nonrecourse debt minimum gain and the net increase or decrease in partner nonrecourse debt minimum gain must be made in a manner consistent with the provisions of paragraphs (d) and (g)(3) of this section.

(4) CHARGEBACK OF PARTNER NONRECOURSE DEBT MINIMUM GAIN. If during a partnership taxable year there is a net decrease in partner nonrecourse debt minimum gain, any partner with a share of that partner nonrecourse debt minimum gain (determined under paragraph (i)(5) of this section) as of the beginning of the year must be allocated items of income and gain for the year (and, if necessary, for succeeding years) equal to that partner's share of the net decrease in the partner nonrecourse debt minimum gain. A partner's share of the net decrease in partner nonrecourse debt minimum gain is determined in a manner consistent with the provisions of paragraph (g)(2) of this section. A partner is not subject to this minimum gain chargeback, however, to the extent the net decrease in partner nonrecourse debt minimum gain arises because the liability ceases to be partner nonrecourse debt due to a conversion, refinancing, or other change in the debt instrument that causes it to become partially or wholly a nonrecourse liability. The amount that would otherwise be subject to the partner nonrecourse debt minimum gain chargeback is added to the partner's share of partnership minimum gain under paragraph (g)(3) of this section. In addition, rules consistent with the provisions of paragraphs (f)(2), (3), (4), and (5) of this section apply with respect to partner nonrecourse debt in appropriate circumstances. The determination of which items of partnership income and gain must be allocated pursuant to this paragraph (i)(4) is made in a manner that is consistent with the provisions of paragraph (f)(5) of this section. See paragraph (j)(2)(ii) and (iii) of this section for more specific rules.

(5) PARTNER'S SHARE OF PARTNER NONRECOURSE DEBT MINIMUM GAIN. A partner's share of partner nonrecourse debt minimum gain at the end of any partnership taxable year is determined in a manner consistent with the provisions of paragraphs (g)(1) and (g)(3) of this section with respect to each particular partner nonrecourse debt for which the partner bears the economic risk of loss. For purposes of section 1.704-1(b)(2)(ii)(d), a partner's share of partner nonrecourse debt minimum gain is added to the limited dollar amount if any, of the deficit balance in the partner's capital account that the partner is obligated to restore, and the partner is not otherwise considered to have a deficit restoration obligation as a result of bearing the economic risk of loss for any partner nonrecourse debt. See paragraph (m), EXAMPLE (1)(viii) of this section.

(6) DISTRIBUTION OF PARTNER NONRECOURSE DET PROCEEDS ALLOCABLE TO AN INCREASE IN PARTNER NONRECOURSE DEBT MINIMUM GAIN. Rules consistent with the provisions of paragraph (h) of this section apply to distributions of the proceeds of partner nonrecourse debt.

(j) ORDERING RULES. For purposes of this section, the following ordering rules apply to partnership items. Notwithstanding any other provision in this section and section 1.704-1 allocations of partner nonrecourse deductions, nonrecourse deductions, and minimum gain chargebacks are made before any other allocations.

(1) Treatment of partnership losses and deductions. (i) Partner nonrecourse deductions. Partnership losses, deductions, and section 705(a)(2)(B) expenditures are treated as partner nonrecourse deductions in the amount determined under paragraph (i)(2) of this section (determining partner nonrecourse deductions) in the following order:

(A) First, depreciation or cost recovery deductions with respect to property that is subject to partner nonrecourse debt;

(B) Then, if necessary, a pro rata portion of the partnership's other deductions, losses, and section 705(a)(2)(B) items.

Depreciation or cost recovery deductions with respect to property that is subject to a partnership nonrecourse liability is first treated as a partnership nonrecourse deduction and any excess is treated as a partner nornrecourse deduction under this paragraph (j)(1)(i).

(ii) PARTNERSHIP NONRECOURSE DEDUCTIONS. Partnership losses, deductions, and section 705(a)(2)(B) expenditures are treated as partnership nonrecourse deductions in the amount determined under paragraph (c) of this section (determining nonrecourse deductions) in the following order:

(A) First, depreciation or cost recovery deductions with respect to property that is subject to partnership nonrecourse liabilities;

(B) Then, if necessary, a pro rata portion of the partnership's other deductions, losses, and section 705(a)(2)(B) items.

Depreciation or cost recovery deductions with respect to property that is subject to partner nonrecourse debt is first treated as a partner nonrecourse deduction and any excess is treated as a partnership nonrecourse deduction under this paragraph (j)(1)(ii). Any other item that is treated as a partner nonrecourse deduction will in no event be treated as a partnership nonrecourse deduction.

(iii) CARRYOVER TO SUCCEEDING TAXABLE YEAR. If the amount of partner nonrecourse deductions or nonrecourse deductions exceed the partnership's losses, deductions, and section 705(a)(2)(B) expenditures for the taxable year (determined under paragraphs (j)(1)(i) and (ii) of this section), the excess is treated as an increase in partner nonrecourse debt minimum gain or partnership minimum gain in the immediately succeeding partnership taxable year. See paragraph (m), EXAMPLE (1)(vi) of this section.

(2) TREATMENT OF PARTNERSHIP INCOME AND GAINS. (i) MINIMUM GAIN CHARGEBACK. Items of partnership income and gain equal to the minimum gain chargeback requirement (determined under paragraph (f) of this section) are allocated as a minimum gain chargeback in the following order:

(A) First, gain from the disposition of property subject to partnership nonrecourse liabilities;

(B) Then, if necessary, a pro rata portion of the partnership's other items of income and gain for that year. Gain from the disposition of property subject to partner nonrecourse debt is allocated to satisfy a minimum gain chargeback requirement for partnership nonrecourse debt only to the extent not allocated under paragraph (j)(2)(ii) of this section.

(ii) CHARGEBACK ATTRIBUTABLE TO DECREASE IN PARTNER NONRECOURSE DEBT MINIMUM GAIN. Items of partnership income and gain equal to the partner nonrecourse debt minimum gain chargeback (determined under paragraph (i)(4) of this section) are allocated to satisfy a partner nonrecourse debt minimum gain chargeback in the following order:

(A) First, gain from the disposition of property subject to partner nonrecourse debt;

(B) Then, if necessary, a pro rata portion of the partnership's other items of income and gain for that year. Gain from the disposition of property subject to a partnership nonrecourse liability is allocated to satisfy a partner nonrecourse debt minimum gain chargeback only to the extent not allocated under paragraph (j)(2)(i) of this section. An item of partnership income and gain that is allocated to satisfy a minimum gain chargeback under paragraph (f) of this section is not allocated to satisfy a minimum gain chargeback under paragraph (i)(4).

(iii) CARRYOVER TO SUCCEEDING TAXABLE YEAR. If a minimum gain chargeback requirement (determined under paragraphs (f) and (i)(4) of this section) exceeds the partnership's income and gains for the taxable year, the excess is treated as a minimum gain chargeback requirement in the immediately succeeding partnership taxable years until fully charged back.

(k) TIERED PARTNERSHIPS. For purposes of this section, the following rules determine the effect on partnership minimum gain when a partnership ("upper-tier partnership") is a partner in another partnership ("lower-tier partnership").

(1) INCREASE IN UPPER-TIER PARTNERSHIP'S MINIMUM GAIN. The sum of the nonrecourse deductions that the lower-tier partnership allocates to the upper-tier partnership for any taxable year of the upper-tier partnership, and the distributions made during that taxable year from the lower-tier partnership to the upper-tier partnership of proceeds of nonrecourse debt that are allocable to an increase in the lower-tier partnership's minimum gain, is treated as an increase in the upper-tier partnership's minimum gain.

(2) DECREASE IN UPPER-TIER PARTNERSHIP'S MINIMUM GAIN. The upper-tier partnership's share for its taxable year of the lower-tier partnership's net decrease in its minimum gain is treated as a decrease in the upper-tier partnership's minimum gain for that taxable year.

(3) NONRECOURSE DEBT PROCEEDS DISTRIBUTED FROM THE LOWER-TIER PARTNERSHIP TO THE UPPER-TIER PARTNERSHIP. All distributions from the lower-tier partnership to the upper-tier partnership during the upper-tier partnership's taxable year of proceeds of a nonrecourse liability allocable to an increase in the lower-tier partnership's minimum gain are treated as proceeds of a nonrecourse liability of the upper-tier partnership. The increase in the upper-tier partnership's minimum gain (under paragraph (k)(1) of this section) attributable to the receipt of those distributions is, for purposes of paragraph (h) of this section, treated as an increase in the upper-tier partnership's minimum gain arising from encumbering property of the upper-tier partnership with a nonrecourse liability of the upper-tier partnership.

(4) NONRECOURSE DEDUCTIONS OF LOWER-TIER PARTNERSHIP TREATED AS DEPRECIATION BY UPPER-TIER PARTNERSHIP. For purposes of paragraph (c) of this section, all nonrecourse deductions allocated by the lower- tier partnership to the upper-tier partnership for the upper-tier partnership's taxable year are treated as depreciation or cost recovery deductions with respect to property owned by the upper-tier partnership and subject to a nonrecourse liability of the upper-tier partnership with respect to which minimum gain increased during the year by the amount of the nonrecourse deductions.

(5) COORDINATION WITH PARTNER NONRECOURSE DEBT RULES. The lower- tier partnership's liabilities that are treated as the upper-tier partnership's liabilities under section 1.752-4(a) are treated as the upper-tier partnership's liabilities for purposes of applying paragraph (i) of this section. Rules consistent with the provisions of paragraphs (k)(1) through (k)(5) of this section apply to determine the allocations that the upper-tier partnership must make with respect to any liability that constitutes a nonrecourse debt for which one or more partners of the upper-tier partnership bear the economic risk of loss.

(l) EFFECTIVE DATES -- (1) IN GENERAL. (i) PROSPECTIVE APPLICATION. Except as otherwise provided in this paragraph (l), this section applies for partnership taxable years beginning on or after December 28, 1991. For the rules applicable to taxable years beginning after December 29, 1988, and before December 28, 1991, see former section 1.704-1T(b)(4)(iv). For the rules applicable to taxable years beginning on or before December 29, 1988, see former section 1.704-1(b)(4)(iv).

(ii) PARTNERSHIPS SUBJECT TO TEMPORARY REGULATIONS. If a partnership agreement entered into after December 29, 1988, and before December 28, 1991, complied with the provisions of former section 1.704-1T(b)(4)(iv) before December 28, 1991, --

(A) The provisions of former section 1.704-1T(b)(4)(iv) continue to apply to the partnership for any taxable year beginning on or after December 28, 1991, (unless the partnership makes an election under paragraph (l)(4) of this section) and ending before any subsequent material modification to the partnership agreement; and

(B) The provisions of this section do not apply to the partnership for any of those taxable years.

(iii) PARTNERSHIPS SUBJECT TO FORMER REGULATIONS. If a partnership agreement entered into on or before December 29, 1988, complied with the provisions of former section 1.704-1(b)(C)(iv)(d) on or before that date --

(A) The provisions of former section 1.704-1(b)(4)(iv)(a) through (f) continue to apply to the partnership for any taxable year beginning after that date (unless the partnership made an election under section 1.704-1T(b)(4)(iv)(m)(4) in a partnership taxable year ending before December 28, 1991, or makes an election under paragraph (l)(4) of this section) and ending before any subsequent material modification to the partnership agreement; and

(B) The provisions of this section do not apply to the partnership for any of those taxable years.

(2) SPECIAL RULE APPLICABLE TO PRE-JANUARY 30, 1989, RELATED PARTY NONRECOURSE DEBT. For purposes of this section and former section 1.704-1T(b)(4)(iv), if --

(i) A partnership liability would, but for this paragraph (l)(2) of this section, constitute a partner nonrecourse debt; and

(ii) Sections 1.752-1 through -3 or former sections 1.752-1T through -3T (whichever is applicable) do not apply to the liability; the liability is, notwithstanding paragraphs (i) and (b)(4) of this section, treated as a nonrecourse liability of the partnership, and not as a partner nonrecourse debt, to the extent the liability would be so treated under this section (or section 1.704-1T(b)(4)(iv)) if the determination of the extent to which one or more partners bears the economic risk of loss for the liability under section 1.752-1 or former section 1.752-1T were made without regard to the economic risk of loss that any partner would otherwise be considered to bear for the liability by reason of any obligation undertaken or interest as a creditor acquired prior to January 30, 1989, by a person related to the partner (within the meaning of section 1.752-4(b) or former section 1.752-1T(h)). For purposes of the preceding sentence, if a related person undertakes an obligation or acquires an interest as a creditor on or after January 30, 1989, pursuant to a written binding contract in effect prior to January 30, 1989, and at all times thereafter, the obligation or interest as a creditor is treated as if it were undertaken or acquired prior to January 30, 1989. However, for partnership taxable years beginning on or after December 28, 1991, a pre-January 30, 1989, liability, other than a liability subject to paragraph (l)(3) of this section or former section 1.704-1T(b)(4)(iv)(m)(3) (whichever is applicable), that is treated as grandfathered under former sections 1.752-1T through -3T (whichever is applicable) will be treated as a nonrecourse liability for purposes of this section provided that all partners in the partnership consistently treat the liability as nonrecourse for partnership taxable years beginning on or after December 28, 1988.

(3) TRANSITION RULE FOR PRE-MARCH 1, 1984, PARTNER NONRECOURSE DEBT. If a partnership liability would, but for this paragraph (l)(3) or former section 1.704-1T(b)(4)(iv), constitute a partner nonrecourse debt and the liability constitutes grandfathered partner nonrecourse debt that is appropriately treated as a nonrecourse liability of the partnership under section 1.752-1 (as in effect prior to December 29, 1988) --

(i) The liability is, notwithstanding paragraphs (i) and (b)(4) of this section, former section 1.704-1T(b)(4)(iv), and former section 1.704-1(b)(4)(iv), treated as a nonrecourse liability of the partnership for purposes of this section and for purposes of former section 1.704-1T(b)(4)(iv) and former section 1.704-1(b)(4)(iv) to the extent of the amount, if any by which the smallest outstanding balance of the liability during the period beginning at the end of the first partnership taxable year ending on or after December 31, 1986, and ending at the time of any determination under this paragraph (l)(3)(i) or former section 1.704-1T(b)(4)(iv)(m)(3)(i) exceeds the aggregate amount of the adjusted basis (or book value) of partnership property allocable to the liability (determined in accordance with former section 1.704-1(b)(4)(iv)(c)(1) and (2) at the end of the first partnership taxable year ending on or after December 31, 1986); and

(ii) In applying this section to the liability, former section 1.704-1(b)(c)(iv)(c)(1) and (2) is applied as if all of the adjusted basis of partnership property allocable to the liability is allocable to the portion of the liability that is treated as a partner nonrecourse debt and as if none of the adjusted basis of partnership property that is allocable to the liability is allocable to the portion of the liability that is treated as a nonrecourse liability under this paragraph (l)(3) and former section 1.704-1T(b)(4)(iv)(m)(3)(i).

For purposes of the preceding sentence, a grandfathered partner debt is any partnership liability that was not subject to former sections 1.752-1T and -3T but that would have been subject to those sections under section 1.752-4T(b) if the liability had arisen (other than pursuant to a written binding contract) on or after March 1, 1984. A partnership liability is not considered to have been subject to sections 1.752-2T and -3T solely because a portion of the liability was treated as a liability to which those sections apply under section 1.752-4T(e).

(4) ELECTION. A partnership may elect to apply the provisions of this section to the first taxable year of the partnership ending on or after December 28, 1991. An election under this paragraph (l)(4) is made by attaching a written statement to the partnership return for the first taxable year of the partnership ending on or after December 28, 1991. The written statement must include the name, address, and taxpayer identification number of the partnership making the statement and just declare that an election is made under this paragraph (l)(4).

(m) EXAMPLES. The principles of this section are illustrated by the following examples:

EXAMPLE 1. NONRECOURSE DEDUCTIONS AND PARTNERSHIP MINIMUM GAIN. For EXAMPLE 1, unless otherwise provided, the following facts are assumed. LP, the limited partner, and GP, the general partner, form a limited partnership to acquire and operate a commercial office building. LP contributes $180,000, and GP contributes $20,000. The partnership obtains an $800,000 nonrecourse loan and purchases the building (on leased land) for $1,000,000. The nonrecourse loan is secured only by the building, and no principal payments are due for 5 years. The partnership agreement provides that GP will be required to restore any deficit balance in GP's capital account following the liquidation of GP's interest (as set forth in section 1.704-1(b)(2)(ii)(b)(3)), and LP will not be required to restore any deficit balance in LP's capital account following the liquidation of LP's interest. The partnership agreement contains the following provisions required by paragraph (e) of this section: a qualified income offset (as defined in section 1.704-1(b)(2)(ii)(d)); a minimum gain chargeback (in accordance with paragraph (f) of this section); a provision that the partners' capital accounts will be determined and maintained in accordance with section 1.704-1(b)(2)(ii)(b)(1); and a provision that distributions will be made in accordance with partners' positive capital account balances (as set forth in section 1.704-1(b)(2)(ii)(b)(2)). In addition, as of the end of each partnership taxable year discussed herein, the items described in section 1.704-1(b)(2)(ii)(d)(4), (5), and (6) are not reasonably expected to cause or increase a deficit balance in LP's capital account. The partnership agreement provides that, except as otherwise required by its qualified income offset and minimum gain chargeback provisions, all partnership items will be allocated 90 percent to LP and 10 percent to GP until the first time when the partnership has recognized items of income and gain that exceed the items of loss and deduction it has recognized over its life, and all further partnership items will be allocated equally between LP and GP. Finally, the partnership agreement provides that all distributions, other than distributions in liquidation of the partnership or of a partner's interest in the partnership, will be made 90 percent to LP and 10 percent to GP until a total of $200,000 has been distributed, and thereafter all the distributions will be made equally to LP and GP. In each of the partnership's first 2 taxable years, it generates rental income of $95,000, operating expenses (including land lease payments) of $10,000, interest expense of $80,000, and a depreciation deduction of $90,000, resulting in a net taxable loss of $85,000 in each of those years. The allocations of these losses 90 percent to LP and 10 percent to GP have substantial economic effect.

 LP        GP

(i) CALCULATION OF NONRECOURSE DEDUCTIONS AND PARTNERSHIP MINIMUM GAIN. If the partnership were to dispose of the building in full satisfaction of the nonrecourse liability at the end of the third year, it would realize $70,000 of gain ($800,000 amount realized less $730,000 adjusted tax basis). Because the amount of partnership minimum gain at the end of the third year (and the net increase in partnership minimum gain during the year) is $70,000, there are partnership nonrecourse deductions for that year of $70,000, consisting of depreciation deductions allowable with respect to the building of $70,000. Pursuant to the partnership agreement, all partnership items comprising the net taxable loss of $85,000, including the $70,000 nonrecourse deduction, are allocated 90 percent to LP and 10 percent to GP. The allocation of these items, other than the nonrecourse deductions, has substantial economic effect.

 LP        GP

(ii) ILLUSTRATION OF REASONABLE CONSISTENCY REQUIREMENT. Assume instead that the partnership agreement provides that all nonrecourse deductions of the partnership will be allocated equally between LP and GP. Furthermore, at the time the partnership agreement is entered into, there is a reasonable likelihood that over the partnership's life it will realize amounts of income and gain significantly in excess of amounts of loss and deduction (other than nonrecourse deductions). The equal allocation of excess income and gain has substantial economic effect.

 LP        GP

(iii) ALLOCATION OF NONRECOURSE DEDUCTIONS THAT FAILS REASONABLE CONSISTENCY REQUIREMENT. Assume instead that the partnership agreement provides that LP will be allocated 99 percent, and GP 1 percent, of all nonrecourse deductions of the partnership. Allocating nonrecourse deductions this way does not satisfy requirement (2) of paragraph (e) of this section because the allocations are not reasonably consistent with allocations, having substantial economic effect, of any other significant partnership item attributable to the building. Therefore, the allocation of nonrecourse deductions will be disregarded, and the nonrecourse deductions of the partnership will be reallocated according to the partners' overall economic interests in the partnership, determined under section 1.704-1(b)(3)(ii).

(iv) CAPITAL CONTRIBUTION TO PAY DOWN NONRECOURSE DEBT. At the beginning of the partnership's fourth taxable year, LP contributes $144,000 and GP contributes $16,000 of additional capital to the partnership, which the partnership immediately uses to reduce the amount of its nonrecourse liability from $800,000 to $640,000. In addition, in the partnership's fourth taxable year, it generates rental income of $95,000, operating expenses of $10,000, interest expense of $64,000 (consistent with the debt reduction), and a depreciation deduction of $90,000, resulting in a net taxable loss of $69,000. If the partnership were to dispose of the building in full satisfaction of the nonrecourse liability at the end of that year, it would realize no gain ($640,000 amount realized less $640,000 adjusted tax basis). Therefore, the amount of partnership minimum gain at the end of the year is zero, which represents a net decrease in partnership minimum gain of $70,000 during the year. LP's and GP's shares of this net decrease are $63,000 and $7,000 respectively, so that at the end of the partnership's fourth taxable year, LP's and GP's shares of partnership minimum gain are zero. Although there has been a net decrease in partnership minimum gain, pursuant to paragraph (f)(3) of this section LP and GP are not subject to a minimum gain chargeback.

 LP        GP

(vi) NONRECOURSE BORROWING; DISTRIBUTION OF PROCEEDS IN SUBSEQUENT YEAR. The partnership obtains an additional nonrecourse loan of $200,000 at the end of its fourth taxable year, secured by a second mortgage on the building, and distributes $180,000 of this cash to its partners at the beginning of its fifth taxable year. In addition, in its fourth and fifth taxable years, the partnership again generates rental income of $95,000, operating expenses of $10,000, interest expense of $80,000 ($100,000 in the fifth taxable year reflecting the interest paid on both liabilities), and a depreciation deduction of $90,000, resulting in a net taxable loss of $85,000 ($105,000 in the fifth taxable year reflecting the interest paid on both liabilities). The partnership has distributed its $5,000 of operating cash flow in each year ($95,000 of rental income less $10,000 of operating expense and $80,000 of interest expense) to LP and GP at the end of each year. If the partnership were to dispose of the building in full satisfaction of both nonrecourse liabilities at the end of its fourth taxable year, the partnership would realize $360,000 of gain ($1,000,000 amount realized less $640,000 adjusted tax basis). Thus, the net increase in partnership minimum gain during the partnership's fourth taxable year is $290,000 ($360,000 of minimum gain at the end of the fourth year less $70,000 of minimum gain at the end of the third year). Because the partnership did not distribute any of the proceeds of the loan it obtained in its fourth year during that year, the potential amount of partnership nonrecourse deductions for that year is $290,000. Under paragraph (c) of this section, if the partnership had distributed the proceeds of that loan to its partners at the end of its fourth year, the partnership's nonrecourse deductions for that year would have been reduced by the amount of that distribution because the proceeds of that loan are allocable to an increase in partnership minimum gain under paragraph (h)(1) of this section. Because the nonrecourse deductions of $290,000 for the partnership's fourth taxable year exceed its total deductions for that year, all $180,000 of the partnership's deductions for that year are treated as nonrecourse deductions, and the $110,000 excess nonrecourse deductions are treated as an increase in partnership minimum gain in the partnership's fifth taxable year under paragraph (c) of this section.

 LP        GP

 LP        GP

(vii) PARTNER GUARANTEE OF NONRECOURSE DEBT. LP and GP personally guarantee the "first" $100,000 of the $800,000 nonrecourse loan (i.e., only if the building is worth less than $100,000 will they be called upon to make up any deficiency). Under paragraph (d)(2) of this section, only $630,000 of the adjusted tax basis of the building is allocated to the $700,000 nonrecourse portion of the loan because the collateral will be applied first to satisfy the $100,000 guaranteed portion, making it superior in priority to the remainder of the loan. On the other hand, if LP and GP were to guarantee the "last" $100,000 (i.e., if the building is worth less than $800,000, they will be called upon to make up the deficiency up to $100,000), $700,000 of the adjusted tax basis of the building would be allocated to the $700,000 nonrecourse portion of the loan because the guaranteed portion would be inferior in priority to it.

(viii) PARTNER NONRECOURSE DEBT. Assume instead that the $800,000 loan is made by LP, the limited partner. Under paragraph (b)(4) of this section, the $800,000 obligation does not constitute a nonrecourse liability of the partnership for purposes of this section because LP, a partner, bears the economic risk of loss for that loan within the meaning of section 1.752-2. Instead, the $800,000 loan constitutes a partner nonrecourse debt under paragraph (b)(4) of this section. In the partnership's third taxable year, partnership minimum gain would have increased by $70,000 if the debt were a nonrecourse liability of the partnership. Thus, under paragraph (i)(3) of this section, there is a net increase of $70,000 in the minimum gain attributable to the $800,000 partner nonrecourse debt for the partnership's third taxable year, and $70,000 of the $90,000 depreciation deduction from the building for the partnership's third taxable year constitutes a partner nonrecourse deduction with respect to the debt. See paragraph (i)(4) of this section. Under paragraph (i)(2) of this section, this partner nonrecourse deduction must be allocated to LP, the partner that bears the economic risk of loss for that liability.

(ix) NONRECOURSE DEBT AND PARTNER NONRECOURSE DEBT OF DIFFERING PRIORITIES. As in Example 1 (viii) of this paragraph (m), the $800,000 loan is made to the partnership by LP, the limited partner, but the loan is a purchase money loan that "wraps around" a $700,000 underlying nonrecourse note (also secured by the building) issued by LP to an unrelated person in connection with LP's acquisition of the building. Under these circumstances, LP bears the economic risk of loss with respect to only $100,000 of the liability within the meaning of section 1.752-2. See section 1.752-2(f) (Example 6). Therefore, for purposes of paragraph (d) of this section, the $800,000 liability is treated as a $700,000 nonrecourse liability of the partnership and a $100,000 partner nonrecourse debt (inferior in priority to the $700,000 liability) of the partnership for which LP bears the economic risk of loss. Under paragraph (i)(2) of this section, $70,000 of the $90,000 depreciation deduction realized in the partnership's third taxable year constitutes a partner nonrecourse deduction that must be allocated to LP.

EXAMPLE 2. NETTING OF INCREASES AND DECREASES IN PARTNERSHIP MINIMUM GAIN. For Example 2 unless otherwise provided, the following facts are assumed. X and Y form a general partnership to acquire and operate residential real properties. Each partner contributes $150,000 to the partnership. The partnership obtains a $1,500,000 nonrecourse loan and purchases 3 apartment buildings (on leased land) for $720,000 ("Property A"), $540,000 ("Property B"), and $540,000 ("Property C"). The nonrecourse loan is secured only by the 3 buildings, and no principal payments are due for 5 years. In each of the partnership's first 3 taxable years, it generates rental income of $225,000, operating expenses (including land lease payments) of $50,000, interest expense of $175,000, and depreciation deductions on the 3 properties of $150,000 ($60,000 on Property A and $45,000 on each of Property B and Property C), resulting in a net taxable loss of $150,000 in each of those years. The partnership makes no distributions to X or Y.

(i) CALCULATION OF NET INCREASES AND DECREASES IN PARTNERSHIP MINIMUM GAIN. If the partnership were to dispose of the 3 apartment buildings in full satisfaction of its nonrecourse liability at the end of its third taxable year, it would realize $150,000 of gain ($1,500,000 amount realized less $1,350,000 adjusted tax basis). Because the amount of partnership minimum gain at the end of that year (and the net increase in partnership minimum gain during that year) is $150,000, the amount of partnership nonrecourse deductions for that year is $150,000, consisting of depreciation deductions allowable with respect to the 3 apartment buildings of $150,000. The result would be the same if the partnership obtained 3 separate nonrecourse loans that were "cross-collateralized" (i.e., if each separate loan were secured by all 3 of the apartment buildings).

(ii) NETTING OF INCREASES AND DECREASES IN PARTNERSHIP MINIMUM GAIN WHEN THERE IS A DISPOSITION. At the beginning of the partnership's fourth taxable year, the partnership (with the permission of the nonrecourse lender) disposes of Property A for $835,000 and uses a portion of the proceeds to repay $600,000 of the nonrecourse liability (the principal amount attributable to Property A), reducing the balance to $900,000. As a result of the disposition, the partnership realizes gain of $295,000 ($835,000 amount realized less $540,000 adjusted tax basis). If the disposition is viewed in isolation, the partnership has generated minimum gain of $60,000 on the sale of Property A ($600,000 of debt reduction less $540,000 adjusted tax basis). However, during the partnership's fourth taxable year it also generates rental income of $135,000, operating expenses of $30,000, interest expense of $105,000, and depreciation deductions of $90,000 ($45,000 on each remaining building). If the partnership were to dispose of the remaining two buildings in full satisfaction of its nonrecourse liability at the end of the partnership's fourth taxable year, it would realize gain of $180,000 ($900,000 amount realized less $720,000 aggregate adjusted tax basis), which is the amount of partnership minimum gain at the end of the year. Because the partnership minimum gain increased from $150,000 to $180,000 during the partnership's fourth taxable year, the amount of partnership nonrecourse deductions for that year is $30,000, consisting of a ratable portion of depreciation deductions allowable with respect to the two remaining apartment buildings. No minimum gain chargeback is required for the taxable year, even though the partnership disposed of one of the properties subject to the nonrecourse liability during the year, because there is no net decrease in partnership minimum gain for the year. See paragraph (f)(1) of this section.

EXAMPLE 3. NONRECOURSE DEDUCTIONS AND PARTNERSHIP MINIMUM GAIN BEFORE THIRD PARTNER IS ADMITTED. For purposes of Example 3, unless otherwise provided, the following facts are assumed. Additional facts are given in each of EXAMPLES 3 (ii), (iii), and (iv). A and B form a limited partnership to acquire and lease machinery that is 5-year recovery property. A, the limited partner, and B, the general partner, contribute $100,000 each to the partnership, which obtains an $800,000 nonrecourse loan and purchases the machinery for $1,000,000. The nonrecourse loan is secured only by the machinery. The principal amount of the loan is to be repaid $50,000 per year during each of the partnership's first 5 taxable years, with the remaining $550,000 of unpaid principal due on the first day of the Partnership's sixth taxable year. The partnership agreement contains all of the provisions required by paragraph (e) of this section, and, as of the end of each partnership taxable year discussed herein, the items described in section 1.704-1(b)(2)(ii)(d)(4), (5), and (6) are not reasonably expected to cause or increase a deficit balance in A's or B's capital account. The partnership agreement provides that, except as otherwise required by its qualified income offset and minimum gain chargeback provisions, all partnership items will be allocated equally between A and B. Finally, the partnership agreement provides that all distributions, other than distributions in liquidation of the partnership or of a partner's interest in the partnership, will be made equally between A and B. In the partnership's first taxable year it generates rental income of $130,000, interest expense of $80,000, and a depreciation deduction of $150,000, resulting in a net taxable loss of $100,000. In addition, the partnership repays $50,000 of the nonrecourse liability, reducing that liability to $750,000. Allocations of these losses equally between A and B have substantial economic effect.

 A         B

 A         B

(ii) NONRECOURSE DEDUCTIONS AND RESTATEMENT OF CAPITAL ACCOUNTS. (a) ADDITIONAL FACTS. C is admitted to the partnership at the beginning of the partnership's third taxable year. At the time of C's admission, the fair market value of the machinery is $900,000. C contributes $100,000 to the partnership (the partnership invests $95,000 of this in undeveloped land and holds the other $5,000 in cash) in exchange for an interest in the partnership. In connection with C's admission to the partnership, the partnership's machinery is revalued on the partnership's books to reflect its fair market value of $900,000. Pursuant to section 1.704-1(b)(2)(iv)(f), the capital accounts of A and B are adjusted upwards to $100,000 each to reflect the revaluation of the partnership's machinery. This adjustment reflects the manner in which the partnership gain of $270,000 ($500,000 fair market value minus $630,000 adjusted tax basis) would be shared if the machinery were sold for its fair market value immediately prior to C's admission to the partnership.

 A         B

(b) EFFECT OF REVALUATION. Because the requirements of section 1.704-1(b)(2)(iv)(g) are satisfied, the capital accounts of the partners (as adjusted) continue to be maintained in accordance with section 1.704-1(b)(2)(iv). If the partnership were to dispose of the machinery in full satisfaction of the nonrecourse liability immediately following the revaluation of the machinery, it would realize no book gain ($700,000 amount realized less $900,000 book value). As a result of the revaluation of the machinery upward by $270,000, under part (i) of paragraph (d)(4) of this section, the partnership minimum gain is reduced from $70,000 immediately prior to the revaluation to zero; but under part (ii) of paragraph (d)(4) of this section, the partnership minimum gain is increased by the $70,000 decrease arising solely from the revaluation. Accordingly, there is no net increase or decrease solely on account of the revaluation, and so no minimum gain chargeback is triggered. All future nonrecourse deductions that occur will be the nonrecourse deductions as calculated for book purposes, and will be charged to all 3 partners in accordance with the partnership agreement. For purposes of determining the partners' shares of minimum gain under paragraph (g) of this section, A and B's shares of the decrease resulting from the revaluation are $35,000 each. However, as illustrated below, under section 704(c) principles, the tax capital accounts of A and B will eventually be charged $35,000 each, reflecting their 50 percent shares of the decrease in partnership minimum gain that resulted from the revaluation.

(iii) ALLOCATION OF NONRECOURSE DEDUCTIONS FOLLOWING RESTATEMENT OF CAPITAL ACCOUNTS. (a) ADDITIONAL FACTS. During the partnership's third taxable year, the partnership generates rental income of $130,000, interest expense of $70,000, a depreciation deduction of $210,000, and a book depreciation deduction (attributable to the machinery) of $300,000. As a result, the partnership has a net taxable loss of $150,000 and a net book loss of $240,000. In addition, the partnership repays $50,000 of the nonrecourse liability (after the date of C's admission), reducing the liability to $650,000, and distributes $5,000 of cash to each partner.

(b) ALLOCATIONS. If the partnership were to dispose of the machinery in full satisfaction of the nonrecourse liability at the end of the year, $50,000 of book gain would result ($650,000 amount realized less $600,000 book basis). Therefore, the amount of partnership minimum gain at the end of the year is $50,000, which represents a net decrease in partnership minimum gain of $20,000 during the year. (This is so even though there would be an increase in partnership minimum gain in the partnership's third taxable year if minimum gain were computed with reference to the adjusted tax basis of the machinery.) Nevertheless, pursuant to paragraph (d)(4) of this section, the amount of nonrecourse deductions of the partnership for its third taxable year is $50,000 (the net increase in partnership minimum gain during the year determined by adding back the $70,000 decrease in partnership minimum gain attributable to the revaluation of the machinery to the $20,000 net decrease in partnership minimum gain during the year). The $50,000 of partnership nonrecourse deductions for the year consist of book depreciation deductions allowable with respect to the machinery of $50,000. Pursuant to the partnership agreement, all partnership items comprising the net book loss of $240,000, including the $50,000 nonrecourse deduction, are allocated equally among the partners. The allocation of these items, other than the nonrecourse deductions, has substantial economic effect. Consistent with the special partners' interests in the partnership rule contained in section 1.704-1(b)(4)(i), the partnership agreement provides that the depreciation deduction for tax purposes of $210,000 for the partnership's third taxable year is, in accordance with section 704(c) principles, shared $55,000 to A, $55,000 to B, and $100,000 to C.

 A                   B                  C

(iv) SUBSEQUENT ALLOCATION OF NONRECOURSE DEDUCTIONS FOLLOWING RESTATEMENT OF CAPITAL ACCOUNTS. (a) ADDITIONAL FACTS. The partners' capital accounts at the end of the second and third taxable years of the partnership are as stated in Example 3 (iii) of this paragraph (m). In addition, during the partnership's fourth taxable year the partnership generates rental income of $130,000, interest expense of $65,000, a tax depreciation deduction of $210,000, and a book depreciation deduction (attributable to the machinery) of $300,000. As a result, the partnership has a net taxable loss of $145,000 and a net book loss of $235,000. In addition, the partnership repays $50,000 of the nonrecourse liability, reducing that liability to $600,000, and distributes $5,000 of cash to each partner.

(b) ALLOCATIONS. If the partnership were to dispose of the machinery in full satisfaction of the nonrecourse liability at the end of the fourth year, $300,000 of book gain would result ($600,000 amount realized less $300,000 book value). Therefore, the amount of partnership minimum gain as of the end of the year is $300,000, which represents a net increase in partnership minimum gain during the year of $250,000. Thus, the amount of partnership nonrecourse deductions for that year equals $250,000, consisting of book depreciation deductions of $250,000. Pursuant to the partnership agreement, all partnership items comprising the net book loss of $235,000, including the $250,000 nonrecourse deduction, are allocated equally among the partners. That allocation of all items, other than the nonrecourse deductions, has substantial economic effect. Consistent with the special partners' interests in the partnership rule contained in section 1.704-1(b)(4)(i), the partnership agreement provides that the depreciation deduction for tax purposes of $210,000 in the Partnership's fourth taxable year is, in accordance with section 704(c) principles, allocated $55,000 to A, $55,000 to B, and $100,000 to C.

 A                   B                  C

(v) DISPOSITION OF PARTNERSHIP PROPERTY FOLLOWING RESTATEMENT OF CAPITAL ACCOUNTS. (a) Additional facts. The partners' capital accounts at the end of the fourth taxable year of the partnership are as stated above in (iv). In addition, at the beginning of the partnership's fifth taxable year it sells the machinery for $650,000 (using $600,000 of the proceeds to repay the nonrecourse liability), resulting in a taxable gain of $440,000 ($650,000 amount realized less $210,000 adjusted tax basis) and a book gain of $350,000 ($650,000 amount realized less $300,000 book basis). The partnership has no other items of income, gain, loss, or deduction for the year.

(b) EFFECT OF DISPOSITION. As a result of the sale, partnership minimum gain is reduced from $300,000 to zero, reducing A's, B's, and C's shares of partnership minimum gain to zero from $100,000 each. The minimum gain chargeback requires that A, B, and C each be allocated $100,000 of that gain (an amount equal to each partner's share of the net decrease in partnership minimum gain resulting from the sale) before any allocation is made to them under section 704 (b) with respect to partnership items for the partnership's fifth taxable year. Thus, the allocation of the first $300,000 of book gain $100,000 to each of the partners is deemed to be in accordance with the partners' interests in the partnership under paragraph (e) of this section. The allocation of the remaining $50,000 of book gain equally among the partners has substantial economic effect. Consistent with the special partners' interests in the partnership rule contained in section 1.704-1(b)(4)(i), the partnership agreement provides that the $440,000 taxable gain is, in accordance with section 704(c) principles, allocated $161,667 to A, $161,667 to B, and $116,666 to C.

 A                   B                  C

(i) ALLOCATION OF INCREASE IN PARTNERSHIP MINIMUM GAIN. The net increase in partnership minimum gain during that partnership taxable year is $9,000, so that the amount of nonrecourse deductions of the partnership for that taxable year is $9,000. Those nonrecourse deductions consist of $3,000 of depreciation deductions with respect to Property W and $6,000 of depreciation deductions with respect to Property X. See paragraph (c) of this section. The amount of nonrecourse deductions consisting of depreciation deductions is determined as follows. With respect to the nonrecourse liability secured by Property Z, for which there is no depreciation deduction, the amount of depreciation deductions that constitutes nonrecourse deductions is zero. Similarly, with respect to the nonrecourse liability secured by Property Y, for which there is no increase in minimum gain, the amount of depreciation deductions that constitutes nonrecourse deductions is zero. With respect to each of the nonrecourse liabilities secured by Properties W and X, which are secured by property for which there are depreciation deductions and for which there is an increase in minimum gain, the amount of depreciation deductions that constitutes nonrecourse deductions is determined by the following formula:

 total depreciation deductions on

(ii) ALTERNATIVE ALLOCATION OF INCREASE IN PARTNERSHIP MINIMUM GAIN AMONG PARTNERSHIP PROPERTIES. Assume instead that the loan secured by Property Z is $15,000 (rather than $5,000), resulting in a net increase in minimum gain with respect to that liability of $13,000. Thus, the net increase in partnership minimum gain is $19,000, and the amount of nonrecourse deductions of the partnership for that taxable year is $19,000. Those nonrecourse deductions consist of $5,000 of depreciation deductions with respect to Property W, $10,000 of depreciation deductions with respect to Property X, and a pro rata portion of the partnership's other items of deduction, loss, and section 705(a)(2)(B) expenditure for that year. The method for computing the amounts of depreciation deductions that constitute nonrecourse deductions is the same as in (i) of this Example 4 for the liabilities secured by Properties Y and Z. With respect to each of the nonrecourse liabilities secured by Properties W and X, the amount of depreciation deductions that constitutes nonrecourse deductions equals the total depreciation deductions with respect to the partnership property securing that particular liability to the extent of the increase in minimum gain with respect to that liability.

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 11. The authority for part 602 continues to read as follows:

Authority: (26 U.S.C. 7805).

Par. 12. Section 602.101 (c) is amended by removing the citation "1.704-1T . . . 1545-1090" and

adding the following citation to read as follows:

"1.704-2 . . . 1545-1090.