Section 704(c): How Built-In Gain and Loss Allocations Work

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Section 704(c) is a federal partnership tax rule for property whose fair market value differs from its tax basis when a partner contributes it to a partnership. The rule addresses a simple fairness problem: value that arose before contribution should not be shifted to the other partners merely because the property is now owned by the partnership.

This subject sits inside the federal tax system for partnerships. A partnership generally passes taxable items through to its partners and reports each partner’s share on Schedule K-1. Readers who want that broader reporting context may find this overview of Form 1065 and Schedule K-1 useful.

Why tax basis and fair market value create a 704(c) layer

Adjusted tax basis is the property’s tax investment after applicable adjustments, such as depreciation. Fair market value is the price the property would command in an arm’s-length exchange. When these figures differ at contribution, the difference is the property’s built-in gain or built-in loss.

Suppose Partner A contributes land worth $500,000 with an adjusted tax basis of $300,000, while Partner B contributes $500,000 in cash. The land carries $200,000 of built-in gain. If the partnership later sells it for $500,000, section 704(c) generally assigns that $200,000 tax gain to Partner A rather than dividing it equally. Any change in value after contribution is a separate economic layer and may be shared under the partnership’s allocation arrangement.

A built-in loss works in the opposite direction. If property has a $500,000 adjusted basis but is worth only $300,000 at contribution, the $200,000 precontribution loss generally belongs only to the contributing partner. For allocations to other partners, the statute generally treats the partnership’s basis as the property’s fair market value at contribution, subject to regulatory rules.

Section 704(c) affects deductions as well as a later sale

The rule is not limited to the year in which an asset is sold. For depreciable or amortizable property, the difference between book value and tax basis can affect how annual cost-recovery deductions are allocated. The partnership tracks both the economic, or “book,” treatment and the tax treatment of the contributed property.

A simplified example shows the point. A partner contributes equipment worth $100,000 with a $60,000 adjusted tax basis, and another partner contributes $100,000 in cash. Book depreciation may be computed from the $100,000 value, while available tax depreciation is computed from the $60,000 carryover basis. Section 704(c) allocations attempt to prevent that mismatch from transferring the contributor’s precontribution tax consequences to the cash-contributing partner.

The three commonly used allocation methods

Treasury regulations require a reasonable method consistent with section 704(c)’s purpose and describe three methods that are generally reasonable. The method chosen can change the timing and character of tax items allocated to each partner, even when the partnership’s overall economic arrangement is unchanged.

Traditional method

The traditional method allocates the partnership’s actual tax items from the contributed property to match the book allocations as closely as possible. It is constrained by the “ceiling rule”: tax income, gain, loss, or deduction allocated for the property cannot exceed the corresponding amount the partnership actually has for that property in the tax year.

Because a low-basis asset may produce less tax depreciation than book depreciation, the ceiling rule can leave a noncontributing partner with less tax depreciation than that partner’s book allocation. The traditional method does not independently create an offset for that shortfall.

Traditional method with curative allocations

This method begins with the traditional method but may use other actual partnership tax items to reduce a ceiling-rule disparity. A curative allocation must satisfy the regulation’s limits, including rules addressing amount, timing, and the type of tax item used. Its effectiveness therefore depends on whether the partnership has suitable tax items available.

Remedial allocation method

The remedial method creates offsetting tax allocations designed to eliminate book-tax disparities caused by the ceiling rule. Those allocations do not change the partnership’s total taxable income or loss, because a remedial deduction allocated to one partner is paired with an equal remedial income allocation to another. The method can produce different timing or character consequences from the other methods.

Method provisions ordinarily appear in the partnership agreement and interact with the agreement’s economic allocations. Section 704(c) is a tax allocation mechanism; it does not by itself determine voting rights, management authority, or cash distributions under state entity law.

Reverse section 704(c) starts with a partnership revaluation

Section 704(c) principles also apply when a partnership properly revalues its existing property for book-capital purposes, often after a partner joins or leaves. The resulting differences between book value and tax basis are commonly called reverse section 704(c) allocations.

The important distinction is timing. A forward section 704(c) layer begins when a partner contributes property whose value differs from basis. A reverse layer begins with a permitted revaluation of property already owned by the partnership. Both mechanisms seek to keep tax consequences aligned with the economic gain or loss associated with the relevant partners and period.

What appears on Form 1065 and Schedule K-1

The 2025 Form 1065 instructions require partnerships to track property contributed with built-in gain or loss. Schedule K-1 Item N reports a partner’s share of net unrecognized section 704(c) gain or loss at the beginning and end of the partnership’s tax year. For partnerships other than publicly traded partnerships, box 20, code AA reports the sum of income and deduction items on the K-1 that were determined by applying section 704(c).

These figures are informational parts of a larger partnership tax record. They do not necessarily equal currently recognized gain, a partner’s outside basis, or the partner’s book-capital balance. Each concept measures something different.

Distributions can accelerate precontribution gain or loss

Section 704(c)(1)(B) can trigger recognition when a partnership distributes contributed property to a partner other than its contributor within seven years after contribution. The contributing partner generally recognizes the gain or loss that would have been allocated if the partnership had sold the property at fair market value on the distribution date. The character follows the character the hypothetical sale would have produced.

A related but distinct rule in section 737 can apply when a contributor of built-in gain property receives other partnership property within seven years. These distribution rules are why section 704(c) records remain relevant even when the partnership has not sold the contributed asset.

What records make the calculation understandable

A workable section 704(c) schedule identifies each contributed asset, its contribution date, adjusted tax basis, fair market value, built-in gain or loss, allocation method, cost-recovery information, later revaluations, and remaining unrecognized layer. The partnership’s annual calculations then connect those records to the amounts reported on Form 1065 and each Schedule K-1.

The federal tax classification of an entity matters before any of these rules apply. For example, an LLC may be taxed as a partnership even though “LLC” and “partnership” describe different legal concepts; this distinction is explored in the overview of an LLC taxed or operated with partners. State law governs entity formation and internal authority, while federal tax law governs section 704(c)’s allocation system.

Sources

• 26 U.S.C. § 704, Partner’s distributive share
• 26 U.S.C. § 737, Recognition of precontribution gain in certain distributions
• 26 C.F.R. § 1.704-3, Contributed property
• IRS Publication 541, Partnerships
• IRS Instructions for Form 1065 (2025)
• IRS Partner’s Instructions for Schedule K-1 (Form 1065) (2025)
• Internal Revenue Bulletin 2017-7