Gains before contributions are not acknowledged, but rather they are acknowledged after sales and calculated based on the gain. Deferred tax gain is recorded on financial books a deferred tax liability rahter than a deferred tax asset.

When a partner contributes property to a partnership, there is no direct recognition of precontribution gains. Instead of being counted immediately when the property is sold or distributed, they are allocated according to tax rules under Section 704(c). The process is as follows:

• Whenever an individual contributes to a property as an investment in a business that is valued highly, the built-in gain (the difference between fair market value and baseline at the time of donation) are not immediately acknowledged.
• Instead, the built-in gain is tracked separately and allocated to the contributing partner only when the partnership sells the property or distributes it in a way that triggers recognition.

Example: Precontribution Gain Allocation in a Partnership

Step 1: Contribution to the Partnership

• A taxpayer (Partner A) contributes property to a partnership in exchange for one-third interest.

• The property's adjusted basis at the time of contribution: $60,000.

• The fair market value (FMV) of the property at the time of contribution: $100,000.

• The built-in gain (FMV - Basis) = $40,000.

• The built-in gain is not taxed at the time of contribution but is tracked under Section 704(c).

• The other two partners (Partner B & Partner C) each invest $100,000 in the business.

Step 2: Sale of Property

• The partnership sells the contributed property later for $120,000.

• The total gain on the property = $120,000 – $60,000 = $60,000.

  • This gain includes the built-in gain contributed by Partner A.

Step 3: Allocation of Gain

• Under Section 704(c) rules, the built-in gain of $40,000 must be allocated entirely to Partner A (the contributing partner).

• The remaining gain of $20,000 (post-contribution appreciation) is split equally among the three partners.

Step 4: Tax Recognition for Each Partner

Partner    Allocated Gain

• Partner A (Contributing Partner)    $40,000 (Built-in Gain) + $6,667 = $46,667
• Partner B    $6,667
• Partner C    $6,667

• Partner A recognizes $46,667 in taxable gain on their tax return.

• Partners B and C each recognize $6,667 in taxable gain.

Tax Reporting

• The partnership reports the gain on IRS Form 1065.

• Each partner receives a Schedule K-1, reflecting their allocated share of the gain.

• Partner A's built-in gain ($40,000) is reported separately under Section 704(c).

This ensures that Partner A bears the tax burden for the appreciation that occurred before the property entered the partnership.