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FORM 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

(Mark One)

For the quarterly period ended June 30, 2003

OR

For the transition period from              to             

Commission file number 0-20253

DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

(Exact name of registrant as specified in its charter)

1100 Main Street, Suite 1830, Kansas City, Missouri 64105

(Address of principal executive offices, including zip code)

(816) 421-7444

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Limited Partnership Interests

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

PART 1- FINANCIAL INFORMATION

Item 1. Financial Statements

DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

CONDENSED STATEMENTS OF NET ASSETS AS OF

June 30, 2003 and December 31, 2002

(Liquidation Basis)

(Unaudited)

The accompanying notes are an integral part of these condensed financial statements.

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DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

CONDENSED STATEMENTS OF INCOME (LOSS) AND CHANGES IN NET ASSETS

For the Periods Ended June 30, 2003 (Liquidation Basis),

June 30, 2002 (Liquidation Basis) and June 27, 2002 (Going Concern Basis)

(Unaudited)

The accompanying notes are an integral part of these condensed financial statements.

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DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

CONDENSED STATEMENTS OF CASH FLOWS

For the Periods Ended

June 30, 2003 (Liquidation Basis), June 30, 2002 (Liquidation Basis)

and June 27, 2002 (Going Concern Basis)

(Unaudited)

The accompanying notes are an integral part of these condensed financial statements.

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DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

NOTES TO CONDENSED FINANCIAL STATEMENTS

These unaudited interim condensed financial statements should be read in conjunction with DiVall Income Properties 3 Limited Partnership’s (the “Partnership”) 2002 annual audited financial statements within Form 10-K.

These unaudited condensed financial statements include all adjustments, which are in the opinion of management, necessary to present a fair statement of the Partnership’s financial position as of June 30, 2003, and statements of income (loss) and changes in net assets for the three-month period ended June 30, 2003 and the periods June 28, 2002 through June 30, 2002 and April 1, 2002 through June 27, 2002, and the six-month period ended June 30, 2003 and the periods June 28, 2002 through June 30, 2002 and January 1, 2002 through June 27, 2002 and cash flows for the six-month period ended June 30, 2003 and the periods June 28, 2002 through June 30, 2002 and January 1, 2002 through June 27, 2002.

1. ORGANIZATION AND BASIS OF ACCOUNTING:

DiVall Income Properties 3 Limited Partnership (the “Partnership”) was formed on December 12, 1989, pursuant to the Uniform Limited Partnership Act of the State of Wisconsin. The initial capital, which was contributed during 1989, consisted of $300, representing aggregate capital contributions of $200 by the former general partners and $100 by the Initial Limited Partner.

The Partnership initially offered two classes of Limited Partnership interests for sale: Distribution interests (“D-interests”) and Retention interests (“R-interests”). Each class was offered at a price (before volume discounts) of $1,000 per interest. The Partnership offered the two classes of interests simultaneously up to an aggregate of 25,000 interests.

The minimum offering requirements for the D-interests were met and escrowed subscription funds were released to the Partnership as of July 13, 1990. The offering closed on April 23, 1992, at which point 17,102.52 D-interests had been issued, resulting in aggregate proceeds, net of discounts and offering costs, of $14,408,872.

The minimum offering requirements for R-interests were not met. During 1991, 680.9 R-interests were converted to D-interests and were reflected as Partnership issuances in 1991.

Prior to June 28, 2002, the Partnership was engaged in the business of owning and operating its investment portfolio of commercial real estate properties (the “Properties”). The Properties were leased on a triple net basis to, and operated by, franchisors or franchisees of national, regional and local retail chains under long-term leases. The lessees consisted primarily of fast food, family style, and casual/theme restaurants. At December 31, 2001, the Partnership owned four (4) properties and specialty leasehold improvements for use in all four (4) of the Properties. In June 2002 the Partnership sold all but the vacant Colorado Springs property. In June 2003 the Partnership the Partnership entered into a contract to sell the remaining property. The closing date of the Colorado Springs property was July 14, 2003.

As a result of the Limited Partners’ approval to sell all of the Partnership’s properties and dissolve and liquidate the Partnership, the Partnership’s financial statements for the period subsequent to June 27, 2002 have been prepared on a liquidation basis. Accordingly, assets have been valued at estimated net realizable values and liabilities include estimated costs associated with carrying out the plan of liquidation.

Prior to June 28, 2002, rental revenue from investment properties was recognized on the straight-line basis over the life of the respective lease. Percentage rents were accrued only when the tenant had reached the revenue breakpoint stipulated in the lease.

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The Partnership considered its operations to be in only one segment, the operation of a portfolio of commercial real estate leased on a triple net basis, and therefore no further segment reporting is made.

Prior to June 28, 2002, depreciation of the properties and improvements was provided on a straight-line basis over 31.5 years, which were the estimated useful lives of the buildings and improvements.

Prior to June 28, 2002, deferred fees represented leasing commissions paid when properties were leased and upon the negotiated extension of a lease. Leasing commissions were capitalized and amortized over the original lease term.

Real estate taxes on the Partnership’s investment properties were the responsibility of the tenant. However, when a tenant failed to make the required tax payments or when a property became vacant, the Partnership made the appropriate payment to avoid possible foreclosure of the property. Taxes were accrued in the period for which the liability was incurred.

Cash and cash equivalents include cash on deposit in financial institutions and highly liquid temporary investments with initial maturities of 90 days or less.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities (and disclosure of contingent assets and liabilities) at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

In October 2001, Statement of Financial Accounting Standards No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (FAS 144) was issued. FAS 144 supercedes Statement of Financial Accounting Standards No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of” (FAS 121). FAS 144 develops a single accounting model for long-lived assets to be disposed of, whether previously held and used or newly acquired. The provisions of FAS 144 became effective for fiscal years beginning after December 15, 2001. The Partnership adopted FAS 144 on January 1, 2002 and the result was that assets disposed of or deemed to be classified as held for sale required the reclassification of current and previous years’ operations to discontinued operations.

Prior to June 28, 2002, the Partnership periodically reviewed its long-lived assets, primarily real estate, for impairment whenever events or changes in circumstances indicated that the carrying amount of such assets may not be recoverable. The Partnership’s review involved comparing current and future operating performance of the assets, the most significant of which is undiscounted operating cash flows, to the carrying value of the assets. Based on this analysis, a provision for possible loss was recognized, if any.

During the First Quarter of 2002, Management found a buyer for the Colorado Springs property and anticipated the property to be sold in May 2002. However, the sale was not consummated and the agreement was terminated. Management intends to continue to market the property for sale. Also, during the First Quarter of 2002, Management accepted an offer for the remaining three (3) Partnership properties, which included the Applebee’s- Pittsburgh, Hardee’s- St. Francis and the vacant Oak Creek properties. The General Partner sought the written consent of the Limited Partners to sell all of the Partnership’s Properties and dissolve and liquidate the Partnership. Prior to the sale of the remaining properties, the General Partner had received the written consent of the holders of more than fifty percent (50%) of the Partnership interests authorizing such sales and dissolution and liquidation of the Partnership. All of the Partnership’s properties, except for the vacant Colorado Springs property, were sold in June 2002.

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As a result of the Limited Partners’ approval to sell all of the Partnership’s properties and dissolve and liquidate the Partnership, the Partnership’s financial statements for the period subsequent to June 27, 2002 have been prepared on a liquidation basis. Accordingly, assets have been valued at estimated net realizable values and liabilities include estimated costs associated with carrying out the plan of liquidation.

The net adjustment at June 28, 2002 required to convert from the going concern (historical cost) basis to the liquidation basis of accounting was a net increase in carrying value of net assets of $235,000. The increase in the carrying value of net assets was due to an increase in the value of investment properties to their estimated fair values of $550,000 offset by the recorded estimated liabilities associated with carrying out the liquidation of $315,000, and were included in the statement of net assets as of June 30, 2002. Estimated liabilities associated with carrying out the plan of liquidation were based upon (1) historical costs for similar services, (2) based on agreements currently in place, and (3) estimates provided by service providers. In the Third Quarter of 2002, approximately $34,000 of recorded estimated liabilities associated with carrying out the liquidation were paid. In the Fourth Quarter of 2002, approximately $24,000 of the recorded estimated liabilities associated with carrying out the liquidation were paid. Additionally, during the three month period ended December 31, 2002, the adjustment to liquidation basis was reduced by $103,000 to account for a $19,000 increase in the estimated liabilities associated with carrying out the liquidation based upon updated estimates of total costs and the write down of the remaining asset by $84,000 based upon the ultimate amount realized upon its sale.

The reserve for liquidation at June 30, 2003 was $201,000 and reflected payments of $29,000 made during the second quarter of 2003 against the estimated costs during the period of liquidation. Payments of $46,000 were made during the first quarter of 2003.

The statement of income (loss) and changes in net assets for the period April 1, 2002 through June 27, 2002 and January 1, 2002 through June 27, 2002 have been prepared on a going concern basis of accounting on which the Partnership had previously reported its financial condition and its results of operations.

No provision for Federal income taxes has been made, as any liability for such taxes would be that of the individual partners rather than the Partnership. At December 31, 2002, the tax basis of the Partnership’s assets exceeded the amounts reported in the accompanying financial statements by approximately $220,499.

2. REGULATORY INVESTIGATION:

A preliminary investigation during 1992 by the Office of the Commissioner of Securities for the State of Wisconsin and the Securities and Exchange Commission (the “Investigation”) revealed that during at least the three years ended December 31, 1992, the former general partners of the Partnership, Gary J. DiVall (“DiVall”) and Paul E. Magnuson (“Magnuson”) had transferred substantial cash assets of the Partnership and two affiliated publicly registered partnerships, DiVall Insured Income Fund Limited Partnership (“DiVall 1”) and DiVall Insured Income Properties 2 Limited Partnership (“DiVall 2”) (collectively the “Partnerships”) to various other entities previously sponsored by or otherwise affiliated with DiVall and Magnuson. The unauthorized transfers were in violation of the respective Partnership Agreements and resulted, in part, from material weaknesses in the internal control system of the Partnerships.

Subsequent to discovery, and in response to the regulatory inquiries, a third-party Permanent Manager, The Provo Group, Inc. (“TPG”), was appointed (effective February 8, 1993) to assume responsibility for daily operations and assets of the Partnerships as well as to develop and execute a plan of restoration for the Partnerships. Effective May 26, 1993, the Limited Partners, by written consent of a majority of interests, elected the Permanent Manager, TPG, as General Partner. TPG terminated the former general partners by accepting their tendered resignations.

In 1993, the current General Partner estimated an aggregate recovery of $3 million for the Partnerships. At that time, an allowance was established against amounts due from former general partners and their affiliates reflecting the estimated $3 million receivable. This net receivable was allocated among the Partnerships based

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on each Partnership’s pro rata share of the total misappropriation. Restoration expenses and recoveries have been allocated based on the same percentages. Through March 31, 2003, $5,813,000 of recoveries have been received which exceeded the original estimate of $3 million. As a result, during 1996, 1997, 1999, 2000, 2001, 2002 and 2003 the Partnership has recognized a total of $1,309,000 as recovery of amounts previously written off on the statements of income, which represents its share of the excess recovery. There were no restoration activities or recoveries in 1998. The current General Partner continues to pursue recoveries of the misappropriated funds, however, no further significant recoveries are anticipated.

3. INVESTMENT PROPERTIES:

The total cost of the investment properties includes the original purchase price plus acquisition fees and other capitalized costs paid to an affiliate of the former general partners adjusted for impairment write-downs.

At December 31, 2001, the Partnership owned four (4) properties comprised of: one (1) Hardee’s restaurant, one (1) Applebee’s restaurant, and two (2) vacant properties (previously operated as a Denny’s restaurant and a Hardee’s restaurant.) During the First Quarter of 2002, Management found a buyer for the vacant Colorado Springs property and anticipated the property to be sold in May 2002. However, the sale was not consummated and the agreement was terminated. Also during the First Quarter of 2002, Management accepted an offer for three (3) of the remaining Partnership properties. Following the receipt of the written consent of Limited Partners holding more than fifty percent (50%) of the partnership interests authorizing such sales, the three (3) properties were sold in June 2002.

The net asset value of the Colorado Springs property was written by $84,000 in December 2002 to the amount ultimately realized upon its sale in 2003.

During the First Quarter of 2002, Management accepted offers for three (3) of the remaining Partnership properties, which included: (i) the Oak Creek property, (ii) the St. Francis property and (iii) the Applebee’s property in Pittsburgh, Pennsylvania. The sales were contingent upon Limited Partner approval to sell the remaining properties and to liquidate and dissolve the Partnership. The net asset value of the Oak Creek property was written-down by $178,000 in the First Quarter of 2002 to reflect the estimated sales price, less costs to sell, of the property at March 31, 2002 of $600,000. The St. Francis property was written-down by $61,000 in the First Quarter of 2002 to reflect the estimated sales price, less costs to sell, of the property at March 31, 2002 of $755,000. The sales were consummated in June 2002 at an aggregate sale price of $2,755,000, as the General Partner received Limited Partner approval.

In connection with the sale of these three (3) properties sales commissions of $164,650 (approximately 6%) were paid in the Second Quarter of 2002. Of such sales commissions, $82,650 was paid to an unaffiliated broker and $82,000 was paid a General Partner affiliate.

During March 2001, Hardee’s Food Systems, Inc. notified Management of its intent to close its restaurant in Oak Creek, Wisconsin. The lease on the property was not set to expire until 2010. In the Second Quarter of 2001, a lease termination agreement was executed and the tenant ceased the payment of rent as of April 30, 2001. Hardee’s Food Systems agreed to pay a lease termination fee of approximately two (2) years rent or $181,000. The payments were received in four (4) equal installments of $45,250. The first payment was received in May 2001 upon the execution of the agreement and the remaining balance of $135,750 represented a Note receivable on the balance sheet. The first and second Note receivable installments were received in August and October 2001. The final installment, which was reflected as a Note receivable on the balance sheet at December 31, 2001, was received in January 2002. During the First Quarter of 2002, Management accepted purchase offers for three (3) of the Partnership properties, which included the Oak Creek property. In the First Quarter of 2002 the net asset value of the property was written-down by $178,000 to reflect the estimated sales price, less costs to sell, of the property at March 31, 2002 of $600,000.

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According to the Partnership Agreement, the former general partners were to commit 82% of the original offering proceeds to the acquisition of investment properties. Upon the close of the offering, approximately 57% of the original offering proceeds was invested in the Partnership’s properties.

4. PARTNERSHIP AGREEMENT:

The Partnership Agreement, prior to an amendment effective May 26, 1993, provided that, for financial reporting and income tax purposes, net profits or losses from operations were allocated 90% to the Limited Partners and 10% to the former general partners. The Partnership Agreement also provided that Net Cash Receipts, as defined, would be distributed 90% to the Limited Partners and 10% to the former general partners, except that distributions to the former general partners in excess of 1% in any calendar year would be subordinated to distributions to the Limited Partners in an amount equal to their Original Property Distribution Preference, as defined.

Net proceeds, as defined, were to be distributed as follows: (a) 1% to the General Partners and 99% to the Limited Partners, until distributions to the Limited Partners equal their Original Capital, as defined, plus their Original Property Liquidation Preference, as defined, and (b) the remainder 90% to the Limited Partners and 10% to the General Partners. Such distributions were to be made as soon as practicable following the sale, financing or refinancing of an original property.

On May 26, 1993, pursuant to the results of a solicitation of written consents from the Limited Partners, the Partnership Agreement was amended to replace the former general partners and amend various sections of the agreement. The former general partners were replaced as General Partner, by The Provo Group, Inc., an Illinois Corporation. Under the terms of the amendment, net profits or losses from operations are allocated 99% to the Limited Partners and 1% to the current General Partner. The amendment also provided for distributions from Net Cash Receipts to be made 99% to the Limited Partners and 1% to its current General Partner. Pursuant to the amendments to the Partnership Agreement effective June 30, 1994, distributions of Net Cash Receipts will not be made to the General Partner unless and until each Limited Partner has received a distribution from Net Cash Receipts in an amount equal to 10% per annum, cumulative simple return on his or her Adjusted Original Capital, as defined, from the Return Calculation Date, as defined, except to the extent needed by the General Partner to pay its federal and state income taxes on the income allocated to it attributable to such year. Distributions paid to the General Partner are based on the estimated tax liability as a result of allocated income. Subsequent to the filing of the General Partner’s income tax returns, a true up of actual distributions is made. Net proceeds as defined, was also amended to be distributed 1% to the current General Partner and 99% to the Limited Partners.

Additionally, as per the amendment of the Partnership Agreement dated May 26, 1993, the total compensation paid to all persons for the sale of the investment properties shall be limited to a competitive real estate commission, not to exceed 6% of the contract price for the sale of the property. The General Partner may receive up to one-half of the competitive real estate commission, not to exceed 3%, provided that the General Partner provides a substantial amount of services in the sales effort. It is further provided that a portion of the amount of such fees payable to the General Partner is subordinated to its success at recovering the funds misappropriated by the former general partners. (See Note 7.)

Effective June 1, 1993, the Partnership Agreement was amended to (i) change the definition of “Distribution Quarter” to be consistent with calendar quarters, and (ii) change the distribution provisions to subordinate the General Partner’s share of distributions from Net Cash Receipts and Net Proceeds, except to the extent necessary for the General Partner to pay its federal and state income taxes on Partnership income allocated to the General Partner. Because these amendments do not adversely affect the rights of the Limited Partners, pursuant to section 10.2 of the Partnership Agreement, the General Partner without a vote of the Limited Partners made these.

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5. LEASES:

Original lease terms for the investment properties were generally 20 years from their inception. The leases had provided for minimum rents and additional rents based upon percentages of gross sales in excess of specified breakpoints. The lessee was responsible for occupancy costs such as maintenance, insurance, real estate taxes, and utilities. Accordingly, these amounts were not reflected in the statements of income, except in circumstances where, in management’s opinion, the Partnership would be required to pay such costs to preserve assets (i.e., payment of past-due real estate taxes). Management has determined that the leases were properly classified as operating leases; therefore, rental income was reported when earned on a straight line basis and the cost of the property, excluding the cost of the land, was depreciated over its estimated useful life.

During the first six months of 2002 the aggregate base lease rental payments received from the Partnership properties, Applebee’s- Pittsburgh, Pennsylvania and Hardee’s- St. Francis, Wisconsin, pursuant to their leases totaled $102,000. These two (2) properties that were generating such lease rental revenue were sold at the end of the Second Quarter of 2002. As of June 30, 2003 the Partnership has only one (1) vacant property remaining and Management does not anticipate any additional leases or leasing income prior to the dissolution of the Partnership.

6. TRANSACTIONS WITH CURRENT GENERAL PARTNER AND ITS AFFILIATES:

Between the three original affiliated Partnerships as provided in the Permanent Management Agreement (“PMA”), the current General Partner receives a fee for managing the Partnership equal to 4% of gross receipts, subject to a minimum of $300,000 per year, and a maximum annual reimbursement for office rent and related overhead of $25,000. The Partnership shall only be responsible for its allocable share of such minimum and maximum amounts as indicated above ($570,000 minimum base fee and $4,750 maximum rent reimbursement.) On May 26, 1993, the Permanent Manager, TPG, replaced the former general partners as the new General Partner, as provided for in an amendment to the Partnership Agreement dated May 26, 1993. Pursuant to amendments to the Partnership Agreement, TPG continues to provide management services for the same fee structure as provided in the PMA mentioned above. TPG is entitled to an annual increase in the minimum base management fee and maximum office overhead reimbursement in an amount not to exceed the percentage increase in the Consumer Price Index (“CPI”) for the immediately preceding calendar year. Effective March 1, 2003, the minimum management fee and the maximum annual reimbursement for office rent and overhead increased by 1.58% representing the allowable annual Consumer Price Index adjustment per the PMA. Therefore, beginning March 1, 2003 the monthly minimum management fee was raised to $6,060. However, due to the sale of three of the properties at the end of the Second Quarter of 2002, Management reduced by seventy-five percent (75%) the Partnership’s monthly management fees due to them. Therefore, beginning July 1, 2002 and until the sale of the final property and the wind-up phase commences, the current monthly minimum management fee is anticipated to be reduced by seventy-five percent (75%). As of March 1, 2003 the reduced minimum monthly management fee was $1,515. Pursuant to the sale of the final property management fees will then resume to the full minimum management fee through the final Partnership wind-up and dissolution period.

For purposes of computing the 4% overall fee, gross receipts includes amounts recovered in connection with the misappropriation of assets by the former general partners and their affiliates. TPG has received fees from the Partnership totaling $88,909 to date on the amounts recovered, which includes $62 in fees received in the First Quarter of 2003. The fees received from the Partnership on the amounts recovered reduce the 4% minimum fee by that same amount.

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Amounts paid and or accrued to the current General Partner and its affiliates during 2003 and 2002, were as follows:

7. CONTINGENT LIABILITIES:

According to the Partnership Agreement, the current General Partner may receive a disposition fee not to exceed 3% of the contract price of the sale of investment properties. Fifty percent (50%) of all such disposition fees earned by the current General Partner are to be in escrow until the aggregate amount of recovery of the funds misappropriated from the Partnerships by the former general partners is greater than $4,500,000. Upon reaching such recovery level, full disposition fees will thereafter be payable and fifty percent (50%) of the previously escrow amounts will be paid to the current General Partner. At such time as the recovery exceeds $6,000,000 in the aggregate, the remaining escrow disposition fees shall be paid to the current General Partner. If such levels of recovery are not achieved, the current General Partner will contribute the amounts in escrow towards the recovery. In lieu of an escrow, 50% of all such disposition fees have been paid directly to the restoration account and then distributed among the three Partnerships. After surpassing the $4,500,000 recovery level during March 1996, 50% of the amounts previously in escrow were refunded to the current General Partner. The General Partner does not expect any future refund, as the possibility of achievement of the $6,000,000 recovery threshold appears remote.

8. PMA INDEMNIFICATION TRUST:

The PMA provides that the Permanent Manager will be indemnified from any claims or expenses arising out of or relating to the Permanent Manager serving in such capacity or as substitute general partner, so long as such claims do not arise from fraudulent or criminal misconduct by the Permanent Manager. The PMA provides that the Partnership fund this indemnification obligation by establishing a reserve of up to $250,000 of Partnership assets which would not be subject to the claims of the Partnership’s creditors. An Indemnification Trust (“Trust”) serving such purposes has been established at United Missouri Bank, N.A. The Trust has been fully funded with Partnership assets as of June 30, 2003. Funds are invested in U.S. Treasury securities. In addition, interest totaling $113,208 has been credited to the Trust as of June 30, 2003. The rights of the Permanent Manager to the Trust shall be terminated upon the earliest to occur of the following events: (i) the written release by the Permanent Manager of any and all interest in the Trust; (ii) the expiration of the longest statute of limitations relating to a potential claim which might be brought against the Permanent Manager and which is subject to indemnification; or (iii) a determination by a court of competent jurisdiction that the Permanent Manager shall have no liability to any person with respect to a claim which is subject to indemnification under the PMA. At such time as the indemnity provisions expire or the full indemnity is paid, any funds remaining in the Trust will revert back to the general funds of the Partnership.

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9. FORMER GENERAL PARTNERS’ CAPITAL ACCOUNTS:

The capital account balance of the former general partners as of May 26, 1993, the date of their removal as general partners pursuant to the results of a solicitation of written consents from the Limited Partners, was a deficit of $265,491. At December 31, 1993, the former general partners’ deficit capital account balance in the amount of $265,491 was reallocated to the Limited Partners.

10. SUBSEQUENT EVENTS:

Subsequent to June 30, 2003, the Partnership sold the remaining Colorado Springs property for a net sales price of $410,000, which represents the carrying value of the property.

On November 14, 2003, the Partnership made its final distribution and was dissolved on December 15, 2003.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Liquidity and Capital Resources:

Investment Properties and Net Investment in Direct Financing Leases

The investment property, including equipment held by the Partnership at June 30, 2003, was originally purchased at a price, including acquisition costs, of approximately $791,000.

At December 31, 2001, the Partnership owned four (4) properties comprised of: one (1) Hardee’s restaurant, one (1) Applebee’s restaurant, and two (2) vacant properties (previously operated as a Denny’s restaurant and a Hardee’s restaurant.) During the First Quarter of 2002, Management found a buyer for the vacant Colorado Springs property and anticipated the property to be sold in May 2002. However, the sale was not consummated and the agreement was terminated. Also during the First Quarter of 2002, Management accepted an offer for three (3) of the remaining Partnership properties. Following the receipt of the written consent of Limited Partners holding more than fifty percent (50%) of the partnership interests authorizing such sales, the three (3) properties were sold in June 2002.

The net asset value of the Colorado Springs property was written by $84,000 in December 2002 to the amount ultimately realized upon its sale in 2003.

During the First Quarter of 2002, Management accepted purchase offers for three (3) of the remaining Partnership properties, which included: (i) the Oak Creek property, (ii) the St. Francis property and (iii) the Applebee’s property in Pittsburgh, Pennsylvania. The sales were contingent upon Limited Partner approval to sell the remaining properties and to liquidate and dissolve the Partnership. The net asset value of the Oak Creek property was written-down by $178,000 in the First Quarter of 2002 to reflect the estimated sales price, less costs to sell, of the property at March 31, 2002 of $600,000. The St. Francis property was written-down by $61,000 in the First Quarter of 2002 to reflect the estimated sales price, less costs to sell, of the property at March 31, 2002 of $755,000. The sales were consummated in June 2002 at a sales price of $2,755,000, as the General Partner received Limited Partner approval.

In connection with the sales of these three (3) properties sales commissions of $164,650 (approximately 6%) were paid in the Second Quarter of 2002. Of such sales commissions, $82,650 was paid to an unaffiliated broker and $82,000 was paid to a General Partner affiliate.

Other Assets

Cash and cash equivalents held by the Partnership, were $461,000 at June 30, 2003, compared to $539,000 at December 31, 2002. The sale of the final Partnership property will provide a source for future fund liquidity and Limited Partner distributions.

The Partnership established an Indemnification Trust (the “Trust”) during the Fourth Quarter of 1993 and deposited $130,000 in the Trust during 1994, $100,000 during 1995 and $20,000 during 1996. The provision to establish the Trust was included in the Permanent Manager Agreement for the indemnification of TPG, in the absence of fraud or gross negligence, from any claims or liabilities that may arise from TPG acting as Permanent Manager. The Trust is owned by the Partnership. For additional information regarding the Trust, refer to Note 8 to the financial statements included in Item 8 of this report.

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Liabilities

Accounts payable and accrued expenses at December 31, 2002 amounted to $7,125 primarily representing accruals of auditing, tax, and data processing fees.

Property taxes payable at December 31, 2002 in the amount of $1,665 represented an accrual of 2002 real estate taxes in relation to the vacant Colorado Springs property.

Payments of estimated liabilities associated with carrying out the plan of liquidation for the three and six- month periods ended June 30, 2003 totaled $29,000 and $75,000, respectively, and were applied against the reserve for estimated costs during the period of liquidation.

Partners’ Capital and Net Assets in Liquidation

Income (loss) from operations for the period was allocated between the General Partner and the Limited Partners, 1% and 99%, respectively, as provided in the Partnership Agreement as discussed more fully in Note 4 of the condensed financial statements included in Item 8 of this report. The former General Partners’ capital account balance was reallocated to the Limited Partners at December 31, 1993. Refer to Note 9 to the condensed financial statements included in Item 8 of this report for additional information regarding the reallocation.

Due to cash deficits during the Fourth Quarter of 2002, there was not a distribution to the Limited Partners on February 15, 2003. In addition, due to the First and Second Quarter 2003 cash deficits a Limited Partner distribution was not made.

Results of Operations

The Partnership reported income from operations for the three-month period ended June 30, 2003 (liquidation basis), in the amount of $3,500 compared to a loss from operations for the period April 1, 2002 through June 27, 2002 (going concern basis) of $38,000. The Partnership reported income from operations for the six-month period ended June 30, 2003 (liquidation basis), in the amount of $7,000 compared to a loss from operations of $299,000 for the period January 1, 2002 through June 27, 2002 (going concern basis). The variance in the loss resulted from: (i) the loss of rental income due to the sale of the Applebee’s- Pittsburgh and Hardee’s- St. Francis properties in the Second Quarter of 2002; (ii) increased expenditures in 2002 due to tenant defaults, lease terminations, and Second Quarter 2002 property sales; and (iii) Management lowering its monthly minimum management fees by 75% beginning in the Third Quarter of 2002.

Revenues

Total revenues were $3,500 for the three-month period ended June 30, 2003 compared to $59,000 for the period April 1, 2002 through June 27, 2002. Total revenues were $7,000 for the six-month period ended June 30, 2003 compared to $118,000 for the period January 1, 2002 through June 27, 2002. Total revenues in 2002 included rental income from the Applebee- Pittsburgh and Hardee’s- St. Francis properties. These two revenue- generating properties were sold as of June 30, 2002.

For the three and six-month period ended June 30, 2003, total rental revenues should approximate zero (0), as the Partnership currently does not own a property with a lease currently in place. The Partnership only owns one (1) vacant property and Management does not anticipate any additional leases or leasing income prior to the dissolution of the Partnership. However, in the Second Quarter of 2003 the Partnership did generate revenues of $3,500. These revenues came from interest earnings and recoveries from former General Partners. Management anticipates that such revenue types may continue to be generated until Partnership dissolution.

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Expenses

Total expenses for the three-month period ended April 1, 2002 through June 27, 2002 were $96,000 and expenses for the period January 1, 2002 through June 27, 2002 were 416,000. The decrease in total expenses in 2003 is due primarily to the property write-downs in the First Quarter of 2002, and the 2002 increase in legal fees and property expenditures in connection with maintenance, tenant default, lease terminations, property sales and Partnership dissolution. Also, beginning in the Third Quarter of 2002, Management reduced its management fees by seventy-five percent (75 %) due to the property sales at the end of the Second Quarter of 2002.

Recent Accounting Pronouncement

In October 2001, Statement of Financial Accounting Standards No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (FAS 144) was issued. FAS 144 supercedes Statement of Financial Accounting Standards No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of” (FAS 121). FAS 144 develops a single accounting model for long-lived assets to be disposed of, whether previously held and used or newly acquired. The provisions of FAS 144 became effective for fiscal years beginning after December 15, 2001.

Critical Accounting Policies

The Partnership believes that its most significant accounting policies deal with:

The Partnership reviews its estimates of costs to carry out the liquidation on a quarterly basis and adjusts its estimates accordingly. These estimates are influenced by the anticipated time to dispose of the remaining asset and the ultimate sale price to be realized upon such disposition.

The Partnership periodically reviews its long-lived assets, primarily real estate, for impairment whenever events or changes in circumstances indicate that the current liquidation value may not be realizable. The Partnership’s review involves comparing the current carrying value to the estimated selling price of the asset. Based on this analysis, the carrying value will be adjusted accordingly.

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Item 3. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

Although the Partnership’s previous independent auditors, Arthur Andersen LLP (“Arthur Andersen”), never informed the Partnership that it was unable to continue as its independent auditors, as a result of the press reports of the wind-down of Arthur Andersen’s business, the Partnership treated Arthur Andersen as having constructively resigned. Effective August 26, 2002 the Partnership dismissed Arthur Andersen as its independent auditors. The dismissal was disclosed in the Partnership’s Form 8-K dated August 14, 2002.

Prior to the wind-down of Arthur Andersen’s business, its report on the Partnership’s financial statements for either of the past two-years did not contain an adverse opinion or a disclaimer opinion, or was qualified or modified as to uncertainty, audit scope or accounting principles. In addition, during the Partnership’s two most recent fiscal years and the interim period following the wind-down of Arthur Andersen’s business, there were no disagreements with Arthur Andersen on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Arthur Andersen, would have caused it to make reference to the subject matter of the disagreement in connection with the report.

The Partnership engaged Deloitte & Touche LLP (“D&T”) as its new independent auditors on December 19, 2002. The engagement was disclosed in the Partnership’s Form 8-K dated January 2, 2003.

During the two most recent fiscal years and the interim period up to and including the date of engagement, neither the Partnership nor anyone on behalf of the Partnership had consulted with D&T regarding (i) either the application of accounting principles to a specific transaction, either completed or proposed; or the type of audit opinion that might be rendered on the Partnership’s financial statements; or (ii) any matter that was either the subject of a disagreement, or a reportable event, with the Partnership’s former auditors Arthur Andersen.

Item 4. Quantitative and Qualitative Disclosure About Market Risk

The Partnership is not subject to market risk.

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PART II- OTHER INFORMATION

Items 1-4.

Not Applicable.

Item 5. Controls and Procedures

As of the end of the period covered by this report, the Partnership carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (“CEO”)/Financial Officer (“CFO”), of the effectiveness of the design and operation of the Partnership’s disclosure controls and procedures. Based on that evaluation, the CEO/CFO has concluded that the Partnership’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Partnership in the reports it files under the Securities and Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the securities and Exchange Commission rules and forms. There have been no significant changes in the Partnership’s internal controls or in other factors that could significantly affect internal controls subsequent to the date of the evaluation period covered by this report referred to above.

Item 6. Exhibits and Reports on Form 8-K

(a) Listing of Exhibits

The Registrant filed Form 8-K on January 6, 2003.

The Registrant filed Form 8-K/A on January 17, 2003.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

Date: 11/22/04

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Date: 11/22/04

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