**21-3(a)**. Prior to any debt reallocation, the opening books will be:

P | Q | |||

CA | OB | CA | OB | |

4,000 | 4,000 | 6,000 | 6,000 | Formation |

Because the debt is nonrecourse, it is allocated according to the three tiers. Under tier 1, there is no minimum gain because the debt of $6,000 does not exceed the $10,000 book-value of the property. Thus, no part of the debt is allocable under tier 1.

Under tier 2, we ask how much gain would be allocable to the partners under �704(c)(1)(A) if the property were sold for the amount of the debt and no other consideration. If the property were sold for $6,000, there would be a book loss of $4,000 but a tax gain of $2,000. This book loss would be allocated $1,600 to P and $2,400 to Q and the entire tax gain is allocable to P. This allocation implicates the ceiling limitation under 704(c)(1)(A). If the partners agree to use the remedial allocation method, there will be income of $4,400 to P under tier 2 (dispositional gain of $2,000 plus remedial allocation of $2,400).

The remainder of the debt will be allocated
according to the partners' profits interests. The partners have considerable flexibility
under tier 3; in particular, debt equal to the remaining �704(c) book/tax
disparity (i.e., the remaining $1,600) could be allocated to P. We will assume,
however, that the partnership elects to allocate tier 3 debt in accordance with
general profits interests that is, 40% to P and 60% to Q. The remaining $1,600
of the debt is thus allocated $640 to P and $960 to Q. Thus, **assuming
the partners use the remedial allocation method**, the debt is allocated
$5,040 to P and $960 to Q. That is a debt reduction of $960 for P and a debt
increase of $960 for Q. Accordingly, the books become:

P | Q | |||

CA | OB | CA | OB | |

4,000 | 4,000 | 6,000 | 6,000 | Formation |

0 |
(960) |
0 |
960 |
Debt reallocation |

4,000 | 3,040 | 6,000 | 6,960 | After debt reallocation |

3(b) The property's remaining depreciable life is 5 years while it
would have a 10-year useful life if newly purchased. Using the remedial
allocation method, we recover the book value of the property in two pieces: a
continuing piece with book value and adjusted basis of $4,000 recovered over the remaining 5 years and a new piece
with book value of $6,000 and $0 adjusted basis recovered over 10 years. Using the straight-line method of recovery,
that means there is book depreciation in year 1 of $1,400 ($800 from the
continuing piece and $600 from the new piece), while there is tax depreciation
of only $800 (all from the continuing piece). Under the terms of the partnership
agreement, this book depreciation is allocated equally between the partners,
$700 each. The noncontributing partner (that is, Q) gets tax depreciation equal
to book depreciation, while P as the contributing partner gets tax the remaining
tax depreciation of $100. (Note that there is no need of a remedial allocation
in this year because there is sufficient tax depreciation to cover the book
depreciation allocated to the non-contributing partner.) Accordingly, after one year
**but
prior to any debt reallocation**, the books of the partnership read:

P | Q | |||

CA | OB | CA | OB | |

4,000 | 3,040 | 6,000 | 6,960 | Starting Values |

(700) |
(100) |
(700) |
(700) |
Depreciation |

3,300 | 2,940 | 5,300 | 6,260 | After depreciation |

Note that even though the partners are using the remedial allocation to depreciate this property, there is no remedial allocation caused by the depreciation in year 1. Why? Because there was sufficient tax depreciation to cover the book depreciation of the noncontributing partner.

At this point, the property has a book value of $8,600, an adjusted basis to the partnership of $3,200, and remains encumbered by a debt of $6,000. Once again there is no tier 1 allocation because there is no partnership minimum gain (i.e., the debt does not exceed the book value of the partnership). Under tier 2, we ask how much income would be allocable under �704(c)(1)(A) if the property were sold for the debt and for no other consideration. Here, a sale for $6,000 would produce a book loss of $2,600 and a tax gain of $2,800. The book loss would be allocated $1,040 to P and $1,560 to Q, requiring a remedial allocation of $1,560 of deduction to Q and an offsetting remedial allocation of $1,560 of income to P. Thus, $4,360 ($2,800 + $1,560) of the debt is allocable to P under tier 2.

Since $4,360 of the debt has been allocated under tiers 1 and 2, there is $1,640 remaining of the debt for tier 3. At the start of this year, the book/tax disparity in the property was $5,400. Since $4,360 of the debt was allocated under tier 2, we could allocate debt equal to the remainder of the book/tax disparity (i.e., $5,400 less $4,360, or $1,040) to P, with the rest of the debt allocated in accordance with general profits interests. We will assume, however, that the partnership elects to allocate all tier 3 debt in accordance with general profits interests, so that the $1,640 tier 3 debt is allocated 40% (or $656) to P and 60% (or $984) to Q. Accordingly, P's total share of the debt is now $5,016 and Q's share of the debt is now $984. Since P's share of the debt used to be $5,040, P's share of the debt has decreased by $24. Equivalently, Q's share of the debt has increased from $960 to $984, for an increase of $24. Accordingly, the books of the partnership become:

P | Q | |||

CA | OB | CA | OB | |

3,300 | 2,940 | 5,300 | 6,260 | Prior to debt reallocation |

0 |
(24) |
0 |
24 |
Debt reallocation |

3,300 | 2,916 | 5,300 | 6,284 | End of year 1 |

**
We move on to year 2**, again with the assumptions that the partnership is using
the remedial allocation method to depreciate this property and that all tier 3
debt will be allocated in accordance with general profits interests.

There is again $1,400 of book depreciation and $800 of tax depreciation, so prior to any reallocation of the debt the book are:

P | Q | |||

CA | OB | CA | OB | |

3,300 | 2,916 | 5,300 | 6,284 | Starting of Year 2 |

(700) |
(100) |
(700) |
(700) |
Depreciation |

2,600 | 2,816 | 4,600 | 5,584 | After depreciation |

At this point, the property has a book value of $7,200, an adjusted basis to the partnership of $2,400, and remains encumbered by a debt of $6,000. Once again there is no tier 1 allocation because there is no partnership minimum gain (i.e., the debt does not exceed the book value of the partnership). Under tier 2, we ask how much income would be allocable under �704(c)(1)(A) if the property were sold for the debt and for no other consideration. Here, a sale for $6,000 would produce a book loss of $1,200 and a tax gain of $3,600. The book loss would be allocated $480 to P and $720 to Q, requiring a remedial allocation of $720 of deduction to Q and an offsetting remedial allocation of $720 of income to P. Thus, $4,320 ($3,600 + $720) of the debt is allocable to P under tier 2. The remainder of the debt, $1,680, is allocated $672 to P and $1,008 to Q. P's total share of the debt is thus $4,320 + 672, or $4,992, which is a $24 reduction in debt share. Thus, the final books at the close of year 2 are:

P | Q | |||

CA | OB | CA | OB | |

2,600 | 2,816 | 4,600 | 5,584 | Prior to debt reallocation |

0 |
(24) |
0 |
24 |
Debt reallocation |

2,600 | 2,792 | 4,600 | 5,608 | End of year 2 |

**We move on to year 3**, again with the assumptions that the partnership is
using the remedial allocation method to depreciate this property and that all
tier 3 debt will be allocated in accordance with general profits interests.

There is again $1,400 of book depreciation and $800 of tax depreciation, so prior to any reallocation of the debt the book are:

P | Q | |||

CA | OB | CA | OB | |

2,600 | 2,792 | 4,600 | 5,608 | Starting of Year 3 |

(700) |
(100) |
(700) |
(700) |
Depreciation |

1,900 | 2,692 | 3,900 | 4,908 | After depreciation |

At this point, the property has a book value of $5,800, an adjusted basis to the partnership of $1,600, and remains encumbered by a debt of $6,000. This means that $200 of the book depreciation are nonrecourse deductions. Thus, allocation of $1,200 of the depreciation must satisfy the general or alternate tests for economic effect while the remaining $200 must satisfy the special rules in Reg. �1.704-2 (including a minimum gain chargeback provision in the partnership agreement).

Now, there is a tier 1 allocation of $200, allocated $100 to P and $100 to Q (because that is how they shared the nonrecourse deductions giving rise to the partnership minimum gain).

Under tier 2, we ask how much income would be allocable under �704(c)(1)(A) if the property were sold for the debt and for no other consideration. Here, a sale for $6,000 would produce a book gain of $200 and a tax gain of $4,400. The book gain of $200 would be allocated equally between P and Q under the minimum gain chargeback provision, and a corresponding amount of tax gain would be allocated as well. That leaves a tax gain of $4,200 for P reflecting the entire remaining book/tax disparity in the property. Thus, $4,200 is allocated to P under tier 2.

The remainder of the debt, $1,600, is allocated under tier 3. There is no �704(c) component remaining after tier 2, so the partners have less flexibility. We continue to assume they allocate tier 3 debt according to general profits interest, so the tier 3 debt of $1,600 is allocated $640 to P and $960 to Q. Thus, P's total debt share is now $4,940 ($100 + $4,200 + $640) while Q's debt share is $1,060 ($100 + 0 + $960). This represents a shift of $52 away from P and to Q. Thus, the final books at the close of year 2 are:

P | Q | |||

CA | OB | CA | OB | |

1,900 | 2,692 | 3,900 | 4,908 | Prior to debt reallocation |

0 |
(52) |
0 |
52 |
Debt reallocation |

1,900 | 2,640 | 3,900 | 4,960 | End of year 1 |