Built-In Gains Tax and the Section 704(c) Trap: What You Need to Know

                                       

By: Cara Pellicano

Senior Manager, Tax

When partners contribute appreciated property to a partnership — like real estate or equipment — it can trigger hidden tax consequences. Section 704(c) of the Internal Revenue Code ensures that the built-in gains tax (the difference between fair market value and tax basis) is taxed to the contributing partner, not shared among all partners.

Why It Matters

Without 704(c), a partner could contribute a property with a significant unrealized gain and shift the tax burden to others. This rule keeps things fair — but it also adds complexity.

Partnerships must choose how to allocate that gain using one of three IRS-approved methods:

• Traditional
• Traditional with Curative Allocations
• Remedial

Each method affects how income is reported and can impact future transactions.

Watch Out for Target Capital Allocations

If your partnership uses target capital allocations, your operating agreement must be crystal clear. These allocations rely on book value, which can clash with tax rules like 704(c). Without proper language, you risk misallocating income or creating unintended tax consequences.

Bottom Line

Built-in gains tax is more than a technicality — it’s a tax liability waiting to happen. Whether you’re forming a partnership or updating your agreement, make sure you get ahead of the sneaky 704(c).

Need help navigating Section 704(c) or updating your agreement? Reach out to our team for more insights on partnership tax strategy.

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