704(b) allocations

Section 704(b) is the part of the code that governs how a partnership allocates its income, gain, loss, and deduction among the partners. Every special allocation, every capital account rule, every question of whether the IRS will respect your split, traces back here. If special allocations is the what and capital accounts is the ledger, 704(b) is the rulebook that ties them together, plus one more piece the other pages only gestured at: what happens when the losses are funded by debt.

The rule in one line, then the exception that runs real estate

The core of 704(b) is simple to state. An allocation is respected if it has substantial economic effect. If it does not, the IRS reallocates the item according to the partners’ interests in the partnership, usually pro-rata by ownership. That is the whole engine: pass the test, keep your allocation; fail it, lose it.

But real estate does something that the plain economic-effect test cannot handle, and it does it constantly. It funds losses with nonrecourse debt, a mortgage no partner is personally liable for. That creates a problem the rest of 704(b) has to solve, and the solution is the reason real estate partnership drafting is its own specialty.

The 704(b) rule is pass-the-economic-effect-test-or-be-reallocated, but nonrecourse debt breaks the basic test and forces a separate set of rules.

Why nonrecourse debt breaks the basic test

Economic effect depends on a partner actually bearing the loss they are allocated: your capital account drops, and at liquidation you either restore the deficit or the money genuinely came out of your pocket. But losses funded by nonrecourse debt are not economically borne by any partner, because no partner is on the hook for the loan. The bank bears the downside. So depreciation funded by a nonrecourse mortgage, exactly the depreciation that dominates a leveraged real estate deal, cannot have economic effect in the ordinary sense, because there is no partner whose economics it truly affects.

The regulations solve this with a parallel regime for “nonrecourse deductions.” Instead of the ordinary economic-effect test, these deductions are respected if the agreement meets a different set of conditions, the centerpiece of which is a minimum gain chargeback: a promise that when the nonrecourse debt is eventually relieved, and the phantom gain shows up, the partners who took the nonrecourse deductions get allocated that gain back. It is the code saying: you can allocate losses no one economically bore, as long as you agree to eat the matching gain later.

Depreciation funded by a nonrecourse mortgage cannot have ordinary economic effect, so 704(b) uses a separate nonrecourse-deduction regime anchored by a minimum gain chargeback.

Why this matters for who gets the depreciation

Put it together and you see why real estate partnership agreements are drafted so carefully. A deal wants to send the big first-year depreciation, including a cost-segregation loss, to the partner who can use it. Much of that depreciation sits on a leveraged building, so much of it is nonrecourse deduction. Allocating it validly is not just the economic-effect test; it is the nonrecourse rules, the minimum gain chargeback, and correct capital account maintenance, all at once. Get the drafting right and the depreciation flows where the deal intends. Get it wrong and 704(b) reallocates it pro-rata, and the partner who joined for the losses does not get them.

The depreciation a real estate deal wants to steer to a specific partner is largely nonrecourse deduction, so steering it validly requires the full 704(b) machinery, not just a simple allocation clause.

The bottom line

• Section 704(b) governs whether the IRS respects how a partnership allocates income and loss.
• An allocation with substantial economic effect stands; one without it is reallocated by ownership.
• Losses funded by nonrecourse debt cannot have ordinary economic effect, so a separate regime applies.
• Nonrecourse deductions are respected through rules anchored by a minimum gain chargeback.
• Steering leveraged real estate depreciation to a specific partner requires the full 704(b) machinery, carefully drafted.

For the allocations this rulebook governs, read special allocations and substantial economic effect. For the ledger underneath, see capital accounts. For the full picture, start at the entity and LLC tax strategies hub.

Last verified August 2026.