What Triggers a Gain Under Section 737?

Section 737 of the Internal Revenue Code is a rule for partners and partnerships that can trigger a taxable gain upon a property distribution. Its purpose is to prevent partners from avoiding tax on property that has increased in value. The rule targets transactions that look like a sale but are structured as a contribution of property followed by a distribution of different property. When a partner contributes appreciated property and soon after receives other property, the transaction is economically similar to a sale. Section 737 addresses this by potentially creating a tax liability, preventing an indefinite deferral of tax on the property’s built-in gain.

Core Applicability of Section 737

For Section 737 to apply, three conditions must be met. First, a partner must contribute “appreciated property” to a partnership. This is any property with a fair market value higher than the partner’s adjusted basis at the time of contribution, representing a built-in, unrealized gain.

Second, the same partner must receive a distribution of other property from the partnership. The rule is not triggered if the partner receives back the same property they originally contributed. The distribution must consist of different assets, such as cash, securities, or other tangible or intangible property.

Third, the distribution must occur within seven years of the property contribution. This seven-year look-back period is a strict test. A distribution occurring even one day after this window expires is not subject to the rule, distinguishing routine distributions from those linked to the initial contribution.

These rules are connected to Section 704(c), which requires that the built-in gain on contributed property be allocated to the contributing partner when the partnership eventually sells it. Section 737 effectively accelerates this gain recognition if the partner receives other property within the seven-year timeframe.

Calculating the Recognized Gain

When Section 737 is triggered, the recognized gain is the lesser of two amounts: the “excess distribution” or the partner’s “net pre-contribution gain.” This calculation ensures the recognized gain does not exceed the partner’s economic gain from the distribution or the original unrealized gain from the contributed property.

The excess distribution is the amount by which the fair market value of the distributed property exceeds the partner’s adjusted basis in their partnership interest. This basis, known as “outside basis,” is calculated immediately before the distribution and is first reduced by any money received in the same transaction. This figure represents the extent to which the distributed property’s value exceeds the partner’s investment.

The net pre-contribution gain is the gain the partner would have recognized under the pre-contribution gain allocation rules if the partnership had sold all the appreciated property contributed by that partner within the seven-year window. This calculation totals the remaining built-in gains on all property the partner contributed that the partnership still holds. The character of the recognized gain, such as capital gain or ordinary income, is based on the character of this net pre-contribution gain.

To illustrate, assume Partner A contributes land to a partnership with a tax basis of $50,000 and a fair market value of $150,000. The land has a pre-contribution gain of $100,000. Four years later, Partner A has an adjusted basis in her partnership interest of $60,000 and receives a distribution of securities with a fair market value of $120,000. The excess distribution is $60,000 ($120,000 fair market value minus her $60,000 outside basis). Her net pre-contribution gain is the $100,000 built-in gain on the land. Because the recognized gain is the lesser of these two amounts, Partner A must recognize a $60,000 gain.

Basis Adjustments After Gain Recognition

After a partner recognizes a gain under Section 737, two basis adjustments are required to prevent the same gain from being taxed again. These adjustments are made to both the partner’s basis in their partnership interest and the partnership’s basis in the contributed property.

First, the partner’s adjusted basis in their partnership interest (“outside basis”) is increased by the amount of gain recognized. Under Treasury Regulations, this increase is treated as occurring immediately before the distribution. This timing affects the subsequent calculation of the partner’s basis in the distributed property under the rules of Section 732.

Second, the partnership increases its basis (“inside basis”) in the specific appreciated property that the partner originally contributed. This upward adjustment is for the same amount as the recognized gain. This step reduces the amount of taxable gain the partnership will have if it later sells that asset, reflecting that the pre-contribution gain has been partially or fully taxed.

These coordinated adjustments ensure the economic gain is not taxed twice. The increased outside basis results in less gain on a future sale of the partnership interest. The increased inside basis reduces the remaining built-in gain on the property, preventing other partners from being allocated a gain already accounted for.

Key Exceptions to the Rule

Several specific exceptions can prevent Section 737 from applying, even if a transaction meets the initial criteria. These exceptions protect certain non-abusive transactions from inadvertently triggering a taxable gain.

The most common exception applies when a partnership distributes property that was previously contributed by that same partner. If a partner receives an asset they themselves put into the partnership, that property is not taken into account when calculating gain, as the transaction does not resemble a disguised sale.

Other exceptions may apply to certain complex transactions, such as partnership mergers, consolidations, or incorporations where assets are being reorganized. Additionally, some distributions related to the complete liquidation of a partnership may be exempt under the regulations.

Another carve-out relates to transactions governed by Section 751(b). If a distribution involves a shift in a partner’s interest in certain ordinary income assets of the partnership, known as “hot assets,” the rules of that section take precedence. To the extent a distribution is treated as a sale under that section, it is not also subject to gain recognition under Section 737.