<PAGE>
 
                                   FORM 10-K
               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C.  20549

(Mark One)
[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

     For the fiscal year ended     December  31, 1996
                               ---------------------------------------

                                      OR

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934
     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)

                     WISCONSIN                         39-1660958
          (State or other jurisdiction of           (I.R.S. Employer
           incorporation or organization)          Identification No.)

           101 W. 11th St., Suite 1110, Kansas City, Missouri 64105
         (Address of principal executive offices, including zip code)

                                (816) 421-7444
             (Registrant's telephone number, including area code)

  (Former name, former address and former fiscal year, if changed since last
                                   report.)

     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_________
                                          ---------            

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation  S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]

     The aggregate market value of the voting securities held by nonaffiliates
of the Registrant:  The aggregate market value of limited partnership interests
held by nonaffiliates is not determinable since there is no public trading
market for the limited partnership interests.

                Index to Exhibits located on page:      34 - 35
                                                   ------------------
<PAGE>
 
                                    PART I
ITEM 1.  BUSINESS

BACKGROUND
----------

The Registrant, DiVall Income Properties 3 Limited Partnership (the
"Partnership"), is a limited partnership organized under the Wisconsin Uniform
Limited Partnership Act pursuant to an Agreement of Limited Partnership dated as
of December 12, 1989, and amended as of December 18, 1989, February 19, 1990,
April 9, 1990, February 8, 1993, May 26, 1993, June 1, 1993, and June 30, 1994.
As of December 31, 1996, the Partnership consisted of one General Partner and
1,091 Limited Partners owning an aggregate of 17,102.52 Limited Partnership D-
Interests (the "D-Interests") acquired at a public offering price of $1,000 per
Interest before volume discounts.  The Interests were sold pursuant to a
Registration Statement on Form S-11 filed under the Securities Act of 1933 dated
April 23, 1990.  On April 23, 1992, the Partnership closed the offering at
17,102.52 D-Interests ($17,102,520), providing net proceeds to the Partnership
after volume discounts and offering costs of $14,408,872.

The Partnership is currently engaged in the business of owning and operating its
investment portfolio (the "Properties") of commercial real estate and recovering
the assets misappropriated by the former general partners and their affiliates.
The misappropriation is more fully discussed below in Recent Developments. The
Properties are 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 consist of fast-food, family style, and casual/theme
restaurants.  At December 31, 1996, the Partnership owned seven (7) Properties
and specialty leasehold improvements for use in all seven (7) of the Properties,
as more fully described in Item 2.

Prior to the disposal of the Properties, the Partnership's return on its
investment will be derived principally from rental payments received from its
lessees.  Therefore, the Partnership's return on its investment is largely
dependent, among other factors, upon the business success of its lessees.  The
business success of the Partnership's individual lessees can be adversely
affected on three general levels.  First, the tenants rely heavily on the
management contributions of a few key entrepreneurial owners.  The business
operations of such entrepreneurial tenants can be adversely affected by death,
disability or divorce of a key owner, or by such owner's poor business decisions
such as an undercapitalized business expansion.  Second, changes in a local
market area can adversely affect a lessee's business operation.  A local economy
can suffer a downturn with high unemployment.  Socioeconomic neighborhood
changes can affect retail demand at specific sites and traffic patterns may
change, or stronger competitors may enter a market.  These and other local
market factors can potentially adversely affect the lessees of Partnership
properties.  Finally, despite an individual lessee's solid business plans in a
strong local market, the chain concept itself can suffer reversals or changes in
management policy which can in turn affect the profitability of operations for
Partnership properties. Therefore, there can be no assurance that any specific
lessee will have the ability to pay its rent over the entire term of its lease
with the Partnership.

Since all of the Partnership's investment in properties and equipment involves
restaurant tenants, the restaurant market is the major market segment with a
material impact on Partnership operations.  It would appear that the management
skill and potential operating efficiencies realized by Partnership lessees will
be a major ingredient for their future operating success in a very competitive
restaurant and food service marketplace.

There is no way to determine with any certainty, which, if any, tenants will
succeed or fail in their business operations over the term of their respective
leases with the Partnership. It can be reasonably anticipated that

                                       2
<PAGE>
 
some lessees will default on future lease payments to the Partnership which will
result in the loss of expected lease income for the Partnership. Management will
use its best efforts to vigorously pursue collection of any defaulted amounts
and to protect the Partnership assets and future rental income potential by
trying to re-lease any properties with rental defaults. External events which
could impact the Partnership's liquidity are the entrance of other competitors
into the market areas of our tenants; liquidity and working capital needs of the
leaseholders; and failure or withdrawal of any of the national franchises held
by the Partnership's tenant. Each of these events, alone or in combination,
would affect the liquidity level of leaseholders resulting in possible default
by the tenant. Since the information regarding plans for future liquidity and
expansion of closely held organizations, which are tenants of the Partnership,
tends to be of a private and proprietary nature, anticipation of individual
liquidity problems is difficult, and prediction of future events is nearly
impossible.

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, two of 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.  The aggregate
amount of the misappropriation, related costs and 9% interest accrued since
January 1, 1993, is approximately $14,000,000, net of recoveries, of which
$6,527,000 has been allocated to the Partnership.

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 the responsibility for daily operations and assets
of the Partnerships as well as to develop and execute a plan of restoration to
the Partnerships.  As reported in the Partnership's report on Form 8-K dated May
26, 1993, effective as of that date, the Limited Partners, by written consent of
a majority of interests, elected the Permanent Manager, TPG, as General Partner.
Additional results of the solicitation included the approval of the Permanent
Manager Agreement ("PMA"), the acceptance of the resignations of the former
general partners, amendments to certain provisions of the Partnership Agreement
pertaining to general partner interests and compensation, and an amendment of
the Partnership Agreement providing for an Advisory Board (the "Board").

THE PERMANENT MANAGER AGREEMENT
-------------------------------

The PMA was entered into on February 8, 1993, between the Partnership, DiVall 1,
DiVall 2, the now former general partners DiVall and Magnuson, their controlled
affiliates, and TPG, naming TPG as the Permanent Manager.  The PMA contains
provisions allowing the Permanent Manager to submit the PMA, the issue of
electing the Permanent Manager as General Partner, and the issue of acceptance
of the resignations of the former general partners to a vote of the Limited
Partners through a solicitation of written consents.

TPG, as the new General Partner, has been operating and managing the affairs of
the Partnership in accordance with the provisions of the PMA and the Partnership
Agreement, as amended.

ADVISORY BOARD
--------------

The concept of the Advisory Board was first introduced by TPG during the
solicitation of written consents for the Partnerships, and is the only type of
oversight body known to exist for similar partnerships at this time. The first
Advisory Board was appointed in October 1993, and held its first meeting in
November 1993. The

                                       3
<PAGE>
 
four person Board is empowered to, among other functions, review operational
policies and practices, review extraordinary transactions, and advise and serve
as an audit committee to the Partnership and the General Partner. The Advisory
Board does not have the authority to direct management decisions or policies of
the Partnership or remove the General Partner. The powers of the Board are
advisory only. The Board has full and free access to the Partnership's books and
records, and individual Board members have the right to communicate directly
with the Limited Partners concerning Partnership business. Members of the Board
are compensated $3,000 annually and $1,200 for each quarterly meeting attended.

The Board currently consists of a broker dealer representative, D. Todd
Witthoeft of Nelson Witthoeft Financial; and a Limited Partner from each of the
three Partnerships:  Gerhard Zoller from DiVall 1, Richard Otte from DiVall 2,
and Dr. Albert Eschen from the Partnership.  The position of industry
representative was created for approximately a three (3) year period which ended
January 31, 1996.  For a brief description of each Board member, refer to Item
10, Directors and Executive Officers of the Registrant.

RESTORATION PLAN
----------------

TPG, upon commencement of its management of the Partnerships, developed a
strategy (the "Restoration Plan" or "Plan") for recovering as much of the
amounts misappropriated by the former general partners and their affiliates as
possible.  The Plan focuses on recovery from the following sources:  (a)
personal property, (b) promissory notes, (c) land contracts, (d) litigation, and
(e) PMA savings.

     A.   Personal Property.  DiVall and Magnuson appear to have very few
          -----------------                                              
          unencumbered personal assets which would materially benefit the
          Partnerships. The Partnerships have obtained security interests in
          substantially all of DiVall and Magnuson's assets which have been
          identified. The security interests included a mortgage on DiVall's
          residence and surrounding farm land which was subsequently sold to a
          third party.

     B.   Promissory Notes.  Pursuant to the PMA, DiVall, Magnuson, and entities
          ----------------                                                      
          owned by them, granted the Partnership a security interest in certain
          promissory notes and mortgages due from other DiVall related entities
          (the "Private Partnerships"). Recovery of amounts due under these
          notes is substantially complete, but the amount of such recoveries has
          been substantially discounted because many of the Private Partnerships
          are currently involved in bankruptcy proceedings. See Item 3, Legal
          Proceedings, for additional information regarding the bankruptcy
          proceedings of the Private Partnerships.

     C.   Land Contracts.  The Partnerships were assigned two land contracts
          --------------   
          from the Partnership's former general partners. These contracts were
          not originally identified nor assigned in connection with the PMA and
          settlements have been received on these contracts.

     D.   Litigation.  The Partnerships have initiated lawsuits against the
          ----------                                                       
          Partnership's former auditors, former securities counsel, former
          general partners and a former affiliate. Settlements were received
          during 1996. Refer to Item 3, Legal Proceedings, and Note 11 to the
          financial statements included in Item 8 below for additional
          information concerning the settlement of these lawsuits.

                                       4
<PAGE>
 
     E.   PMA Savings.  Pursuant to the terms of the PMA, The Provo Group, Inc.
          -----------   
          is to account to the former general partners for all of the following
          which are avoided or reduced by implementation of the PMA: (i) Fees
          payable to the general partner or entities controlled by the general
          partner, (ii) brokerage commissions, and (iii) residuals. Under the
          PMA, all such savings shall be credited against the amounts due from
          the former general partners.

Total amounts recovered at December 31, 1996, amounted to $5,161,000, of which
approximately $2,406,000 was allocated to the Partnership.  Currently there are
few potential sources of recovery remaining.

The total amount due the Partnerships from the former general partners and their
affiliates as of December 31, 1996, as a result of the misappropriation of
assets, approximates $14,000,000, net of recoveries, which includes the amount
of the misappropriation discovered to date, related costs, and 9% interest
accrued since January 1, 1993.

ITEM 2.  PROPERTIES

The Partnership's properties are leased under 20 year leases.  All leases are
triple net which require the tenant to pay all property operating costs
including maintenance, repairs, utilities, property taxes, and insurance. All
leases contain percentage rent provisions which require the tenant to pay a
specified percentage (3% to 7%) of gross sales above a threshold amount.

The Partnership owned the following properties (including specialty leasehold
improvements) as of December 31, 1996:

<TABLE>
<CAPTION>
                                                                                  Lease
Acquisi-   Property Name                               Purchase       Rental Per  Expiration  Renewal
tion Date  & Address               Lessee              Price (1)      Annum       Date        Options
---------  ---------               ------              ---------      -----       ----        -------
<S>        <C>                     <C>                 <C>            <C>         <C>         <C>
08/07/90   Hardee's                Midland Food        $  802,084(2)    $ 68,280  05/31/2010  (3)
           354 N Chestnut          Systems, Inc.
           Wahoo, NE
         
08/14/90   Hardee's                Hardee's Food        1,648,569(2)      92,000  01/31/2010  None
           2450 E Layton Ave       Systems, Inc.
           St Francis, WI
         
09/11/90   Applebee's              B.T. Woodlipp,       1,297,990(2)     116,040  11/30/2009  None
           2101 Greentree Rd       Inc.
           Pittsburgh, PA
         
02/05/91   Hardee's                Hardee's Food        1,929,472(2)      88,000  05/31/2010  None
           9505 S 13th St          Systems, Inc.
           Oak Creek, WI
         
07/01/91   Denny's                 L&H Restaurants,       424,187(2)      35,880  06/30/2011  None
           9060 Arapahoe Rd        Inc.
           Englewood, CO
         
11/13/91   Denny's                 Cypress              1,479,269(2)     140,340  01/31/2011  None
           3771 Orlando Dr         Restaurants, Inc.
           Sanford, FL
</TABLE> 

                                       5
<PAGE>
 
<TABLE>
<CAPTION>
                                                                                  Lease
Acquisi-   Property Name                               Purchase       Rental Per  Expiration  Renewal
tion Date  & Address               Lessee              Price (1)      Annum       Date        Options
---------  ---------               ------              ---------      -----       ----        -------
<S>        <C>                     <C>                 <C>            <C>         <C>         <C>
04/28/92   Denny's                 L&H Restaurants,       791,159(2)      77,460  05/31/2012  (3)
           4375 Sinton Rd          Inc.
           Colorado Springs, CO
</TABLE> 

Footnotes.

(1) Purchase price includes all costs incurred to acquire the property.
(2) Purchase price includes cost of specialty leasehold improvements.
(3) Renewal options available.

ITEM 3.  LEGAL PROCEEDINGS

On March 16, 1993, the Partnership, along with DiVall 1 and DiVall 2 initiated a
lawsuit against Ernst & Young LLP ("E&Y"), a certified public accounting firm,
in the Circuit Court of Dane County, Wisconsin, in connection with the audits of
the Partnerships performed by E &Y for the years 1989, 1990 and 1991.  The
Partnerships requested the payment of damages in the amount of $9,000,000, plus
interest, attorneys fees and costs, and whatever additional relief the court
deemed just and proper.  The Partnerships hired legal counsel under a contingent
fee arrangement to prosecute all of the Partnerships' claims.  E & Y filed an
Answer denying that it was negligent.

E & Y also filed third-party claims alleging fraud and negligence on the part of
the Partnerships' former securities law firm, Quarles & Brady. The Partnerships
also filed claims against Magnuson, DiVall, DiVall Real Estate Investment
Corporation, David Shea, and Quarles & Brady.

The trial of the case was scheduled to take place in Iowa County, Wisconsin,
beginning on March 20, 1996. Shortly before trial, the Partnerships reached a
resolution of their claims against Quarles & Brady.  A resolution of the claims
against Ernst & Young was reached after opening statements.  As a result of
these settlements, net proceeds to the Partnership, after the payment of
contingent legal fees and related costs, totaled approximately $1,000,000.

As part of the Permanent Manager Agreement, DiVall, Magnuson, and entities owned
by them, granted the Partnership a security interest in certain promissory notes
and mortgages from other DiVall related entities (the "Private Partnerships").
In the aggregate, the face amount of these notes was equal to a minimum of
$8,264,932.  In addition, DiVall, Magnuson, and related entities owned by them,
granted the Partnership a security interest in their general partner interests
in the Private Partnerships.  The foregoing security interests were to secure
the repayment of the funds which were diverted by DiVall and Magnuson from the
Partnership. The Partnership shares such security interests with DiVall 1 and
DiVall 2.  These promissory notes and mortgages are not recorded on the balance
sheets of the Partnerships, but are recorded as recoveries on a cash basis upon
settlement.

On July 23, 1993, nineteen (19) of the Private Partnerships sought the
protection of the Bankruptcy Court in the Eastern District of Wisconsin.  Seven
(7) of these bankruptcies were voluntary and twelve (12) of these bankruptcies
were involuntary.  Several of the Private Partnerships seeking bankruptcy owe
promissory notes to DiVall, Magnuson, or entities owned by them, in which the
Partnership has a security interest.  These cases were subsequently transferred
to the Western District Bankruptcy Court located in Madison, Wisconsin.

                                       6
<PAGE>
 
The Partnership's experience in those bankruptcy cases that have concluded,
either through the approval of Plans of Reorganization, dismissal of the
bankruptcies, settlements or a combination of the foregoing, is that (i) the
value of the obligations of the Private Partnerships assigned to the
Partnerships have been at a significant discount to their face amounts, and (ii)
the General Partner interests in such Private Partnerships often have little
economic value.  The Partnership's recoveries in these bankruptcies have been on
a steeply discounted basis.

Plans of reorganization have been filed in the bankruptcies, and settlement
agreements in all of the Private Partnerships have been reached.  Settlements in
the bankruptcies have resulted in cash payments to the Partnerships of a total
of $720,000 and notes secured by subordinated mortgages in the aggregate amount
of $625,000.  The Partnerships subsequently sold the secured notes for a total
of $175,000.

The Partnerships have been named as defendants in certain foreclosure actions
brought in state courts in Wisconsin.  In each of these actions, the plaintiff
seeks to foreclose on real property owned by one of the Private Partnerships.
The Partnerships were named as subordinate lienholders on the properties.  It is
believed that none of these cases constitute a claim against the individual
Public Partnerships.  However, if the foreclosures are successful, the Private
Partnerships' interest in the underlying real estate may be extinguished,
rendering individual obligations to the Partnerships uncollectible.  Such a
foreclosure has occurred in one instance and is pending in at least one other
situation.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.
                                    PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

(a)  Although some interests have been traded, there is no active public market
     for limited partnership interests and it is not anticipated that an active
     public market for limited partnership interests will develop.

(b)  As of December 31, 1996, there were 1,091 record holders of limited
     partnership interests in the Partnership.

(c)  The Partnership Agreement, as amended, provides for distributable net cash
     receipts of the Partnership to be distributed on a quarterly or monthly
     basis, 99% to the Limited Partners and 1% to the General Partner, subject
     to the limitations on distributions to the General Partner described in the
     Amended Partnership Agreement.  During 1996 and 1995, $1,650,000 and
     $735,000, respectively, were distributed in the aggregate to the Limited
     Partners.  In 1996, the General Partner received aggregate distributions of
     $2,789, and $111 was refunded by the General Partner during 1995.

                                       7
<PAGE>
 
ITEM 6.  SELECTED FINANCIAL DATA

                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
                       (a Wisconsin limited partnership)

                 December 31, 1996, 1995, 1994, 1993, and 1992
                 (not covered by Independent Auditors' Report)

<TABLE>
<CAPTION>
     ------------------------------------------------------------------------------------
                              1996        1995        1994         1993          1992    
     ------------------------------------------------------------------------------------
     <S>                   <C>         <C>         <C>         <C>           <C>         
     Total Revenue         $1,812,164  $  951,189  $1,079,845  $ 1,173,258   $ 1,183,738 
     ------------------------------------------------------------------------------------
     Net Income (Loss)        697,472      20,425     385,971     (128,731)   (2,295,274)
     ------------------------------------------------------------------------------------
     Net Income (Loss)                                                                   
     per Limited                                                                         
     Partner Interest           40.37        1.18       22.34        (7.64)      (126.97)
     ------------------------------------------------------------------------------------
     Total Assets           6,720,437   8,001,587   8,723,385   10,831,833    11,164,563 
     ------------------------------------------------------------------------------------
     Total Partners'                                                                     
     Capital                6,486,045   7,441,362   8,155,826    9,879,128    10,469,512 
     ------------------------------------------------------------------------------------
     Cash Distributions                                                                  
     per Limited                                                                         
     Partnership                                                                         
     Interest                   96.48       42.98      123.24        27.00            (b)
     ------------------------------------------------------------------------------------ 
</TABLE>

(a)  The above selected financial data should be read in conjunction with the
     financial statements and the related notes appearing elsewhere in this
     annual report.

(b)  During 1992, $748,417 was distributed in the aggregate to the Limited
     Partners.  The distributions per limited partnership interest were based
     upon the dates of admittance of the holders of the Interests into the
     Partnership; therefore, presentation of distributions per Interest would
     not be meaningful.

ITEM 7.  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 properties, including equipment held by the Partnership at
December 31, 1996, were originally purchased at a price, including acquisition
costs, of approximately $8,373,000.

Terratron, Inc. the lessee of two (2) Hardee's restaurants has experienced sales
difficulties over the past three years.  Effective December 31, 1995, management
entered into a one-year lease modification with the tenant

                                       8
<PAGE>
 
which reduced base rents for 1996 by approximately $85,000, Additionally,
delinquent rent totaling $46,000 was capitalized into a five (5)-year note
accruing interest at 10% per annum.  The amount of rent capitalized was also
written off as uncollectible.  During the Fourth Quarter of 1996, management
terminated the leases with Terratron and entered into new leases with Hardee's
Food Systems, Inc.  In connection with this transaction, the capitalized rent
was received.  The new leases resulted in annual rents which are $142,000 lower
than Terratron's contract rents and $57,000 lower than 1996 adjusted rents.

The net investment in direct financing leases, which includes the Partnership's
specialty leasehold improvement leases, amounted to $25,000 at December 31,
1996, compared to $976,000 at December 31, 1995.  The decrease of $951,000 was a
result of principal payments received along with the termination of equipment
leases on the three Hardee's properties and sale of the equipment to the
tenants.  These terminations resulted in a loss of $116,000.  These lease
terminations will significantly impact future cash flows to the Partnership and
will therefore impact partner distributions.

OTHER ASSETS
------------

Cash and cash equivalents, including cash restricted for real estate taxes held
by the Partnership, were $1,237,000 at December 31, 1996, compared to $355,000
at December 31, 1995.  The Partnership designated cash of $925,000 to fund the
Fourth Quarter 1996 distributions to Limited Partners paid in February 1997;
$165,000 for the payment of year-end accounts payable and accrued expenses; and
the remainder represents reserves deemed necessary to allow the Partnership to
operate normally.  The increase is primarily due to recoveries received during
the Fourth Quarter of 1996 and cash received from the sale of equipment.  Cash
generated through the operations of the Partnership's investment properties,
sales of investment properties, and any recoveries of misappropriated funds by
the former general partners will provide the sources 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 9 to
the financial statements included in Item 8 of this report.

DUE FROM FORMER AFFILIATES, ALLOWANCE FOR UNCOLLECTIBLE AMOUNTS DUE FROM FORMER
-------------------------------------------------------------------------------
AFFILIATES AND DUE TO AFFILIATED PARTNERSHIPS
---------------------------------------------

Due from former affiliates represented misappropriated assets due from the
former general partners and their affiliates in the amount of $2,017,000 at
December 31, 1996.  The receivable decreased from the prior year due to
$2,067,000 of recoveries received during the year from the former general
partners and their affiliates, including a settlement received from the
Partnerships' former accountants and attorneys.

The Partnership maintains a record of costs incurred in identifying or
recovering the misappropriated assets. These amounts are expensed when incurred,
and then recorded on the balance sheet as a restoration cost receivable with a
corresponding allowance for such receivable deemed uncollectible.  These costs
are considered due from the former general partners and their affiliates.
Interest has been accrued on the

                                       9
<PAGE>
 
misappropriated funds since January 1, 1993, at a rate of 9% per annum and has
been included in the restoration cost receivable.  The receivable increased from
approximately $3,253,000 at December 31, 1995 to $4,509,000 at December 31,
1996, and includes $2,191,000 of cumulative accrued interest.

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 on each Partnership's pro rata share of the total
misappropriation.  Through December 31, 1996, $5,160,000 of recoveries have been
received which exceeded the original estimate of $3 million.  As a result, the
Partnership has recognized $1,000,000 as income, which represents its share of
the excess recovery.  The current General Partner continues to pursue recoveries
of the misappropriated funds, however no further significant recoveries are
anticipated.

The restoration costs are allocated among the Partnerships based on each
Partnership's respective share of the misappropriation as discussed in Note 10
to the financial statements included in Item 8 of this report.  The allocation
is adjusted periodically to reflect any changes in the entire misappropriation.
The Partnership's percentage of the allocation was increased in 1993.
Consequently, the Partnership had not been paying its pro rata share of the
costs.  Accordingly, the Partnership recorded payables at December 31, 1993, in
the amount of $295,000 and $192,000, due to DiVall 1 and DiVall 2, respectively,
with corresponding amounts reflected as professional expenses related to the
Investigation.  Recoveries allocated to the Partnership have been used to  repay
the amounts owed to DiVall 1 and DiVall 2.  During 1996, all amounts due to
DiVall 1 and DiVall 2 were fully repaid.

LIABILITIES
-----------

Accounts payable and accrued expenses at December 31, 1996, in the amount of
$30,000, primarily represented accruals of legal and auditing fees.  The
decrease from December 31, 1995, is a result of the payment of accrued out-of-
pocket costs associated with the litigation against the Partnerships' former
accountants and attorneys.

Due to Current General Partner amounted to $49,000 at December 31, 1996, and
consisted of a true-up of the management fee for the year, leasing commissions
on the leases executed with Hardee's Food Systems, Inc. and the Fourth Quarter
distribution.

Real estate taxes payable increased from $3,000 at December 31, 1995, to $81,000
at December 31, 1996, primarily due to the collection of all 1996 taxes due in
1997 in connection with the Terratron lease termination.

PARTNERS' CAPITAL
-----------------

Net income for the year was allocated between the General Partner and the
Limited Partners, 1% and 99%, respectively, as provided in the Partnership
Agreement and the Amendment to the Partnership Agreement, as discussed more
fully in Note 4 of the 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 12 to the financial
statements included in Item 8 of this report for additional information
regarding the reallocation.

                                       10
<PAGE>
 
Cash distributions paid to the Limited Partners and to the General Partner
during 1996, of $1,650,000 and $2,789, respectively, have also been made in
accordance with the amended Partnership Agreement.  The Fourth Quarter 1996
distribution of $925,000 was paid to the Limited Partners on February 15, 1997.

RESULTS OF OPERATIONS:
----------------------

Management believes that the financial results of 1996 are not indicative of
"normal" Partnership operations. There are many events which occurred since the
discovery of the misappropriations in 1992 which have had a negative impact on
financial results.  Some of these events will continue to have a negative impact
on the Partnership in the future.  However, the settlement of the litigation
against the Partnerships' former accountants and attorneys should result in
operating results which more closely represent "normal" operations.

The Partnership reported  net income for the year ended December 31, 1996, in
the amount of $697,000 compared to net income for the years ended December 31,
1995 and 1994 of $20,000 and $386,000.  Results for all three years were
different than would be expected from "normal" operations, primarily because of
costs associated with misappropriation of assets by the former general partners
and their affiliates.  These costs increased significantly during 1995 and 1996
as the lawsuit against the former general partner accountants and attorneys got
closer to trial as well as the payment of contingent legal fees upon settlement
of the litigation. Additionally, non-cash write-offs of uncollectible rent and
equipment lease losses amounted to $46,000 and $97,000, respectively, in 1995,
and equipment losses totaled $116,000 in 1996.  Additionally, 1996 results were
impacted by the reversal of a portion of the former general partner receivable
write-off.

REVENUES
--------

Total revenues were $1,812,000, $951,000, and $1,080,000, for the years ended
December 31, 1996, 1995, and 1994, respectively.  Revenue in 1996 included a
$1,000,000 reversal of a prior year write-off of the former general partner
receivable.

Total revenues should approximate $600,000 annually, based on leases currently
in place.  Future revenues may decrease with tenant defaults and/or sales of
Partnership properties.  They may also increase with additional rents due from
tenants, if those tenants experience sales levels which require the payment of
additional rent to the Partnership.  The decrease from 1996 to projected 1997
levels is primarily a result of the termination or expiration of the majority of
the Partnership's equipment leases.

EXPENSES
--------

For the years ended December 31, 1996, 1995, and 1994, cash expenses amounted to
approximately 48%, 70%, and 50% of total revenues, respectively.  Total
expenses, including non-cash items, amounted to 62%, 98%, and 64% of total
revenues for the years ended December 31, 1996, 1995, and 1994, respectively.
Items negatively impacting expenses during the last three years are expenses
incurred primarily in relation to the misappropriation of assets by the former
general partners and their affiliates, write-offs of uncollectible rent and
losses on equipment leases.

For the years ended December 31, 1996, 1995, and 1994, expenses incurred in
relation to the misappropriated assets amounted to $609,000, $483,000, and
$264,000, respectively.  Future expenses incurred in relation to the
misappropriation should have a minimal impact on the Partnership.

                                       11
<PAGE>
 
Additional expenses impacting operating results are restoration fees paid on
recoveries received, write-downs of equipment lease residuals, losses on
equipment lease terminations, allowances for uncollectible rent, and losses on
disposition of assets and related selling costs. The losses, write-offs, and
depreciation are non-cash items and do not affect current operating cash flow of
the Partnership or distributions to the Limited Partners.

INFLATION:
----------

Inflation has a minimal effect on operating earnings and related cash flows from
a portfolio of triple net leases. By their nature, such leases actually fix
revenues and are not impacted by rising costs of maintenance, insurance, or real
estate taxes.  Although the Partnership's leases have percentage rent clauses,
percentage rents represented only 2% of total rental income for 1996.  If
inflation causes operating margins to deteriorate for lessees if expenses grow
faster than revenues, then, inflation may well negatively impact the portfolio
through tenant defaults.

It would be misleading to associate inflation with asset appreciation for real
estate, in general, and the Partnership's portfolio, specifically.  Due to the
"triple net" nature of the property leases, asset values generally move
inversely with interest rates.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
                ----------------------------------------------

                       (a Wisconsin limited partnership)
                       ---------------------------------

                  INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
                  -------------------------------------------

<TABLE>
<CAPTION>
                                                         Page
                                                         ----
     <S>                                                 <C>
     Report of Independent Public Accountants.........   13

     Balance Sheets, December 31, 1996 and 1995.......   14 - 15

     Statements of Income for the Years
     Ended December 31, 1996, 1995, and 1994..........   16

     Statement of Partners' Capital for the
     Years Ended December 31, 1996, 1995,
     and 1994.........................................   17

     Statements of Cash Flows for the Years
     Ended December 31, 1996, 1995, and 1994..........   18 - 19

     Notes to Financial Statements....................   20 - 30

     Schedule III--Real Estate and Accumulated
     Depreciation.....................................   36
</TABLE>

                                       12
<PAGE>
 
                              Arthur Andersen LLP


                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors of
Divall Income Properties 3 Limited Partnership:

We have audited the accompanying balance sheets of Divall Income Properties 3 
Limited Partnership (the Partnership) as of December 31, 1996 and 1995, and the 
related statements of income, partners' capital and cash flows for each of the 
three years in the period ended December 31, 1996.  These financial statements 
are the responsibility of the Partnership's management.  Our responsibility is 
to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing 
standards.  Those standards require that we plan and perform the audit to 
obtain reasonable assurance about whether the financial statements are free of 
material misstatement.  An audit includes examining, on a test basis, evidence 
supporting the amounts and disclosures in the financial statements.  An audit 
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement 
presentation.  We believe that our audits provide a reasonable basis for our 
opinion.

In our opinion, the financial statements referred to above present fairly, in 
all material respects, the financial position of Divall Income Properties 3 
Limited Partnership as of December 31, 1996 and 1995, and the results of its 
operations and its cash flows for each of the three years in the period ended 
December 31, 1996, in conformity with generally accepted accounting principles.

Our audit was made for the purpose of forming an opinion on the basic financial 
statements taken as a whole.  The schedule listed in the index of financial 
statements is presented for purposes of complying with the Securities and 
Exchange Commission's rules and is not part of the basic financial statements.  
This schedule has been subjected to the auditing procedures applied in the audit
of the basic financial statements and, in our opinion, fairly states in all 
material respects the financial data required to be set forth therein in 
relation to the basic financial statements taken as a whole.


/s/ Arthur Andersen LLP

Chicago, Illinois
March 13, 1997
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                                BALANCE SHEETS

                          DECEMBER 31, 1996 AND 1995
                          --------------------------


                                    ASSETS

<TABLE>
<CAPTION>
                                                                        December 31,   December 31,
                                                                            1996           1995
                                                                        -------------  -------------
<S>                                                                     <C>            <C> 
INVESTMENT PROPERTIES:  (NOTE 3)
     Land                                                                $ 2,085,836    $ 2,085,836
     Buildings and improvements                                            3,762,726      3,766,226
     Accumulated depreciation                                               (761,761)      (644,443)
                                                                         -----------    -----------
       Net investment properties                                           5,086,801      5,207,619
                                                                         -----------    -----------
NET INVESTMENT IN DIRECT FINANCING LEASES: (NOTE 7)                           25,017        976,461
                                                                         -----------    -----------
OTHER ASSETS:
     Cash and cash equivalents                                             1,155,128        312,290
     Cash restricted for real estate taxes                                    81,447         42,799
     Cash held in indemnification trust (NOTE 9)                             276,248        242,725
     Rents and other receivables (net of allowance of $45,730 in 1995)        27,186         27,955
     Due from current General Partner                                              0            792
     Deferred rent receivable                                                 41,108         42,904
     Deferred fees                                                            23,310              0
     Note receivable                                                               0         79,001
     Prepaid assets                                                            4,192          1,902
                                                                         -----------    -----------
       Total other assets                                                  1,608,619        750,368
                                                                         -----------    -----------
DUE FROM FORMER AFFILIATES: (NOTE 2)
     Due from former general partner affiliates                            2,017,488      4,084,424
     Allowance for uncollectible amounts due from former affiliates       (2,017,488)    (3,017,285)
     Restoration cost receivable                                           4,509,417      3,252,676
     Allowance for uncollectible restoration receivable                   (4,509,417)    (3,252,676)
                                                                         -----------    -----------
     
       Due from former affiliates, net                                             0      1,067,139
                                                                         -----------    -----------
       Total assets                     
                                                                         $ 6,720,437    $ 8,001,587
                                                                         ===========    ===========
</TABLE>

       The accompanying notes are an integral part of these statements.

                                       14
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                                BALANCE SHEETS

                          DECEMBER 31, 1996 AND 1995
                          --------------------------

                       LIABILITIES AND PARTNERS' CAPITAL

<TABLE>
<CAPTION>
                                                               December 31   December 31,
                                                                   1996          1995
                                                               ------------  -------------
<S>                                                            <C>           <C> 
LIABILITIES:
     Accounts payable and accrued expenses                     $    30,280    $   251,948
     Due to affiliated partnerships (NOTE 10)                            0        201,912
     Due to current General Partner                                 49,327              0
     Security deposits                                              46,979        103,181
     Real estate taxes payable                                      81,217          3,184
     Unearned rental income                                         26,589              0
                                                               -----------    -----------
       Total liabilities                                           234,392        560,225
                                                               -----------    -----------
CONTINGENT LIABILITIES: (NOTE 8)
 
PARTNERS' CAPITAL: (NOTES 1, 4 AND 12)
     Current General Partner -
       Cumulative net income (loss)                                  9,400          2,425
       Cumulative cash distributions                                (4,222)        (1,433)
                                                               -----------    -----------
 
                                                                     5,178            992
                                                               -----------    -----------
     Limited Partners (17,102.52 interests outstanding)
       Capital contributions, net of offering costs             14,408,872     14,408,872
       Cumulative net loss                                        (824,530)    (1,515,027)
       Cumulative cash distributions                            (6,837,984)    (5,187,984)
       Reallocation of former general partners' deficit capital   (265,491)      (265,491)
                                                               -----------    -----------
                                                                 6,480,867      7,440,370
                                                               -----------    -----------
         Total partners' capital                                 6,486,045      7,441,362
                                                               -----------    -----------
         Total liabilities and partners' capital               $ 6,720,437    $ 8,001,587
                                                               ===========    ===========
</TABLE>

       The accompanying notes are an integral part of these statements.

                                       15
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                             STATEMENTS OF INCOME

             FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
             -----------------------------------------------------

<TABLE>
<CAPTION>
                                                                1996       1995       1994
                                                             ----------  --------  ----------
<S>                                                          <C>         <C>       <C>
REVENUES:
     Rental income                                           $  674,703  $758,852  $  827,136
     Interest income on direct financing leases                  85,204   118,763      98,424
     Interest income                                             51,243    57,163     123,608
     Other income                                                 1,217    16,411      30,677
     Recovery of amounts previously written off (NOTE 11)       999,797         0           0
                                                             ----------  --------  ----------
 
                                                              1,812,164   951,189   1,079,845
                                                             ----------  --------  ----------

EXPENSES:
 
     Management fees (NOTE 6)                                    86,826    56,829      65,436
     Disposition fees (NOTE 6)                                        0         0      20,415
     Disposition fees - Restoration                                   0         0      20,415
     Restoration fees (NOTE 6)                                   63,163     3,028      10,383
     Insurance                                                    5,112     4,843       5,328
     General and administrative                                  43,875    40,092      46,183
     Advisory Board fees and expenses                            16,332    18,603      19,221
     Interest                                                         0     3,293      11,046
     Professional services                                       53,761    53,511      92,735
     Professional services related to Investigation             609,079   483,320     253,222
     Depreciation                                               117,318   117,318     127,595
     Amortization                                                     0     7,566      15,131
     Loss on equipment leases                                   115,726    96,631           0
     Allowance for Uncollectible Rent                                 0    45,730           0
     Write-down of property to net realizable value               3,500         0           0
     Net loss on disposition of assets                                0         0       6,764
                                                             ----------  --------  ----------
                                                              1,114,692   930,764     693,874
                                                             ----------  --------  ----------
NET INCOME                                                   $  697,472  $ 20,425  $  385,971
                                                             ==========  ========  ==========
NET INCOME - CURRENT GENERAL PARTNER                         $    6,975  $    204  $    3,860
NET INCOME  - LIMITED PARTNERS                                  690,497    20,221     382,111
                                                             ----------  --------  ----------
                                                             $  697,472  $ 20,425  $  385,971
                                                             ==========  ========  ==========

NET INCOME  PER LIMITED
  PARTNERSHIP INTEREST, based on 17,102.52
  interests outstanding                                          $40.37     $1.18      $22.34
                                                             ==========  ========  ==========
</TABLE>

       The accompanying notes are an integral part of these statements.

                                       16
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                        STATEMENTS OF PARTNERS' CAPITAL

              FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
              ----------------------------------------------------

<TABLE>
<CAPTION>
                                          Current General Partner                       Limited Partners
                                   -------------------------------------  -------------------------------------------      
                                                                             Capital                                       
                                   Cumulative    Cumulative               Contributions,  Cumulative     Cumulative        
                                   Net Income       Cash                     Net of       Net Income        Cash           
                                   (Loss)       Distributions    Total    Offering Costs   (Loss)       Distributions      
                                   ----------   -------------   --------  --------------  ----------    -------------      
<S>                                <C>          <C>             <C>       <C>             <C>           <C>                
BALANCE AT DECEMBER 31, 1993          $(1,639)        $     0   $(1,639)     $14,408,872  $(1,917,359)    $(2,345,255)     
                                                                                                                           
  Cash Distributions                                                                                                       
    ($123.24 per limited                                                                                                   
     partnership interest                                                                                                   
     outstanding)                                      (1,544)   (1,544)                                   (2,107,729)      
  Net Income                            3,860                     3,860                       382,111                       
                                      -------         -------   -------      -----------  -----------     -----------        
                                                                                                                           
BALANCE AT DECEMBER 31, 1994          $ 2,221         $(1,544)  $   677      $14,408,872  $(1,535,248)    $(4,452,984)     

Cash Distributions                                                                                                         
   ($42.98 per limited                                                                                                     
    partnership interest                                                                                                    
    outstanding)                                          111       111                                      (735,000)      
Net Income                                204                       204                        20,221                       
                                      -------         -------   -------      -----------  -----------     -----------         

BALANCE AT DECEMBER 31, 1995          $ 2,425         $(1,433)  $   992      $14,408,872  $(1,515,027)    $(5,187,984)     

Cash Distributions                                                                                                         
   ($96.48 per limited                                                                                                     
    partnership interest                                                                                                    
    outstanding)                                       (2,789)   (2,789)                                   (1,650,000)      
Net Income                              6,975                     6,975                       690,497                       
                                      -------         -------   -------      -----------  -----------     -----------         

BALANCE AT DECEMBER 31, 1996          $ 9,400         $(4,222)  $ 5,178      $14,408,872  $  (824,530)    $(6,837,984)     
                                      =======         =======   =======      ===========  ===========     ===========       

<CAPTION> 
                                Reallocation        Total           
                                ------------      ----------    
<S>                             <C>               <C>            
BALANCE AT DECEMBER 31, 1993    $(265,491)        $9,880,767     

  Cash Distributions                                             
    ($123.24 per limited                                         
     partnership                                                 
        interest                                                 
         outstanding)                             (2,107,729 
  Net Income                                         382,111 
                                ---------         ---------- 
                                                             
BALANCE AT DECEMBER 31, 1994    $(265,491)        $8,155,149     

Cash Distributions                                               
   ($42.98 per limited                                           
    partnership interest                                         
    outstanding)                                  (7,440,370)   
Net Income                                            20,221 
                                ---------         ---------- 
                                                             
BALANCE AT DECEMBER 31, 1995    $(265,491)        $7,440,370     

Cash Distributions                                           
   ($96.48 per limited                                           
    partnership interest                                         
    outstanding)                                                 
Net Income                                        (1,650,000)    
                                                     690,497 
                                ---------         ---------- 
BALANCE AT DECEMBER 31, 1996    $(265,491)        $6,480,867     
                                =========         ==========  
</TABLE> 
                                                                 
       See accompanying notes are an integral part of these statements. 

                                       17
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
     
                           STATEMENTS OF CASH FLOWS
     
             FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
             -----------------------------------------------------

<TABLE>
<CAPTION>
                                                                                                  1996         1995         1994
                                                                                              ------------  ----------  ------------

<S>                                                                                           <C>           <C>         <C>
CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES:
     Net income                                                                               $   697,472   $  20,425   $   385,971
     Adjustments to reconcile net income to net cash from (used in) operating activities -
          Depreciation and amortization                                                           117,318     124,884       142,726
          Write-down of property to net realizable value                                            3,500           0             0
          Net loss on disposition                                                                       0           0         6,764
          Recovery of amounts previously written off                                             (999,797)          0             0
          Provision for uncollectible rent                                                              0      45,730             0
          Loss on equipment leases                                                                115,726      96,631             0
          Interest applied to Indemnification Trust Account                                       (13,523)    (12,438)         (287)
          (Increase) Decrease in rents, other receivables and prepaid assets                         (729)    (50,408)        3,124
          (Increase)/Decrease in deferred rent receivable                                           1,796      (1,829)      (12,263)
          Deposits (received) applied for real estate taxes                                       (38,648)      8,314        24,232
          Increase/(Decrease) in accounts payable and accrued expenses                           (221,668)    176,024       (23,822)
          Increase/(Decrease) in due to General Partner                                            26,017        (358)         (626)
          (Decrease) in security deposits                                                         (10,614)          0       (16,785)
          Increase/(Decrease) in real estate taxes payable                                         78,033     (47,834)      (24,327)
          Increase/(Decrease) in unearned rental income                                            26,589      (5,690)          638
                                                                                              -----------   ---------   -----------
               Net cash provided from (used in) operating activities                             (218,528)    353,451       485,345
                                                                                              -----------   ---------   ----------- 

                                                                                                                                    

CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:
     Principal payments received on direct financing leases                                       753,954     332,797       293,118
     Deposit to Indemnification Trust Account                                                     (20,000)   (100,000)     (130,000)
     Gross proceeds from sale of Kwik Stop                                                              0           0     1,331,785
     Recoveries from former affiliates                                                          2,066,936      75,697       259,587
     Proceeds from sale of land                                                                    36,176           0             0
     Proceeds from land easement                                                                        0      17,000             0
     Principal receipts from note                                                                  79,001     115,105       112,750
                                                                                              -----------   ---------   -----------
               Net cash provided from investing activities                                      2,916,067     440,599     1,867,240
                                                                                              -----------   ---------   ----------- 

                                                                                                                                    

CASH FLOWS FROM (USED IN) FINANCING ACTIVITIES:
     Principal payments on mortgage note                                                                0     (79,298)      (84,954)
     Payments of amounts due to affiliated partnerships                                          (201,912)    (50,178)     (235,322)
     Cash distributions (to) from General Partner                                                  (2,789)        111        (1,544)
     Cash distributions to Limited Partners                                                    (1,650,000)   (735,000)   (2,107,729)
                                                                                              -----------   ---------   -----------

               Net cash (used in) financing activities                                         (1,854,701)   (864,365)   (2,429,549)
                                                                                              -----------   ---------   ----------- 

                                                                                                                                    

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                              842,838     (70,315)      (76,964)


CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR                                                    312,290     382,605       459,569
                                                                                              -----------   ---------   -----------
CASH AND CASH EQUIVALENTS AT END OF YEAR                                                      $ 1,155,128   $ 312,290   $   382,605
                                                                                              ===========   =========   ===========
SUPPLEMENTAL DISCLOSURE--cash paid for interest                                               $         0   $   3,293   $    11,046
                                                                                              ===========   =========   ===========
</TABLE> 
 
       The accompanying notes are an integral part of these statements.

                                       18
<PAGE>
 
           Supplemental Information to the Statements of Cash Flows
           --------------------------------------------------------

The following significant non-cash transactions occurred during the three years
affecting the Partnership's financial statements:

     1.   During 1994, a parcel of land in Brigham City, Utah was sold in
          exchange for a note receivable in the amount of $225,000.

     2.   During 1996, the Partnership was deeded land with a value of $36,176
          in exchange for a note receivable from a tenant.

     3.   During 1996, security deposits totaling $45,588 were applied as
          equipment lease payments for a tenant.

     4.   During 1996, the Partnership incurred leasing commissions totaling
          $23,310 which were unpaid at year-end.

       The accompanying notes are an integral part of these statements.

                                       19
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                         NOTES TO FINANCIAL STATEMENTS

                       DECEMBER 31, 1996, 1995, AND 1994

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.

The Partnership is currently engaged in the business of owning and operating its
investment portfolio (the "Properties") of commercial real estate and recovering
the assets misappropriated by the former general partners and their affiliates.
The Properties are 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 consist of fast-food, family style, and casual/theme
restaurants.  At December 31, 1996, the Partnership owned seven (7) properties
and specialty leasehold improvements for use in all seven (7) of the Properties.

Rental revenue from investment properties is recognized on the straight-line
basis over the life of the respective lease.  Revenue from direct financing
leases is recognized at level rates of return over the term of the lease.

Depreciation of the properties is provided on a straight-line basis over 31.5
years, which is the estimated useful lives of the buildings and improvements.

Deferred charges represent leasing commissions paid when properties are leased
to tenants other than the original tenant.  Leasing commissions are capitalized
and amorized over the life of the lease.

Real estate taxes on the Partnership's investment properties are the
responsibility of the tenant.  However, when a tenant fails to make the required
tax payments or when a property becomes vacant, the Partnership makes the
appropriate payment to avoid possible foreclosure of the property.  Taxes are
accrued in the period for which the liability is incurred.

                                       20
<PAGE>
 
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 generally accepted
accounting principles 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.

During 1996, the Partnership adopted Statement of Financial Accounting Standards
No.121 ("SFAS 121"), Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed of, which requires that all long-lived assets
be reviewed for impairment in value whenever changes in circumstances indicate
that the carrying amount of an asset may not be recoverable.  The adoption of
SFAS 121 had no impact on the Partnership's financial statements in 1996.

The Partnership will be dissolved on December 1, 2015, or earlier upon the prior
occurrence of any of the following events:  (a)  the disposition of all
interests in real estate and other Partnership assets; (b)  the decision by
Majority Vote of the Limited Partners to dissolve the Partnership or to compel
the sale of all or substantially all of the Partnership's assets; (c)  the
failure to elect a successor General Partner within six months after removal of
the last remaining General Partner; or (d) the date of the death or the
effective date of dissolution, removal, withdrawal, bankruptcy, or incompetency
of the last remaining General Partner, unless the Partnership is continued by
vote of all Limited Partners and a replacement General Partner is previously
elected by a majority of the Limited Partners.

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, 1996, the tax basis of the Partnership's assets exceeded the
amounts reported in the accompanying financial statements by approximately
$2,800,000.

The following represents a reconciliation of net income as stated on the
Partnership's statements of income to net income for tax reporting purposes:

<TABLE>
<CAPTION>
                                                        1996       1995        1994   
                                                     ----------  ---------  ----------
     <S>                                             <C>         <C>        <C>      
     Net income (loss), per statements of income     $ 647,472   $ 20,425   $ 385,971
     Book to tax depreciation difference                 8,491      8,525       9,501
     Straight line rent adjustment                      (1,796)    (1,829)    (12,263)
     Allowance for receivables                         (45,730)    45,730           0
     Loss on equipment leases                          (53,228)    90,822           0
     Affiliate receivable basis adjustment                   0          0    (109,310)
     Other, net                                       (168,552)    (5,510)     19,036
                                                     ---------   --------   ---------
     Net income (loss) for tax reporting purposes    $ 436,597   $158,163   $ 292,935
                                                     =========   ========   ========= 
</TABLE>

                                       21
<PAGE>
 
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.  The aggregate amount of the misappropriation, related costs, and
9% interest accrued since January 1, 1993, is approximately $14,000,000, of
which approximately $6,527,000 has been attributed to the Partnership and is
reflected as due from former affiliates on the balance sheet at December 31,
1996.  The 9% interest accrued as of December 31, 1996, amounted to
approximately $2,191,000 and is not reflected in the accompanying income
statement.  As of December 31, 1995, $7,337,000 was reflected as due from former
affiliates based on an estimated overall misappropriation and related costs of
$15,700,000.

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 on each Partnership's pro rata share of the total
misappropriation.  Through December 31, 1996, $5,160,000 of recoveries have been
received which exceeded the original estimate of $3 million.  As a result, the
Partnership has recognized $1,000,000 as income, which represents its share of
the excess recovery.  The current General Partner continues to pursue recoveries
of the misappropriated funds, however no further significant recoveries are
anticipated.


3.  INVESTMENT PROPERTIES:
    ----------------------

As of December 31, 1996, the Partnership owned seven (7) fast-food restaurants
comprised of:  three (3) Hardee's restaurants, one (1) Applebee's restaurant,
and three (3) Denny's restaurants.  The seven (7) properties are located in five
(5) states.

During 1994, the Partnership sold undeveloped land which was located in Brigham
City, Utah, and was originally purchased by an affiliate of the former general
partners in 1990 in contemplation of constructing and leasing a Hardee's
restaurant.  The Partnership originally entered into the purchase and lease
agreement, but subsequently assigned its rights to the affiliate.  The
construction never commenced, and in April 1992, the affiliate sold the parcel
to the Partnership for the original cost plus excess fees and interest in the
amount of $331,084.  The fees and a portion of the interest are reflected as due
from former affiliates and the land was 

                                       22
<PAGE>
 
being carried by the Partnership at an estimated net realizable value of
$225,000 at December 31, 1993. Under the terms of the Partnership Agreement, the
Partnership is prohibited from purchasing non-earning, unimproved land. In 1994,
management entered into a contract to sell the land to the guarantor of the
lease for the amount of $225,000. A note receivable from the purchaser in the
amount of $79,001 remained outstanding at December 31, 1995 and was repaid in
full during 1996.

Terratron, Inc. the lessee of two (2) Hardee's restaurants has experienced sales
difficulties over the past three years.  Effective December 31, 1995, management
entered into a one-year lease modification with the tenant which reduced base
rents for 1996 by approximately $85,000.  Additionally, delinquent rent totaling
$46,000 was capitalized into a five (5)-year note accruing interest at 10% per
anum.  The amount of rent capitalized was also written off as uncollectible.

During the Fourth Quarter of 1996, management terminated the leases with
Terratron and entered into new leases with Hardee's Food Systems, Inc.  In
connection with this transaction, the capitalized rent was received. The new
leases resulted in annual rents which are $142,000 lower than Terratron's
contract rents and $57,000 lower than 1996 adjusted rents.  In connection with
the transaction, Terratron terminated their equipment leases and the equipment
was sold to the new tenant for $380,000, resulting in a loss to the Partnership
of $93,000.

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.

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.

The Current General Partner receives a fee for managing the Partnership equal to
4% of gross receipts, with a maximum reimbursement for office rent and related
office overhead of $25,000 between the three affiliated Partnerships.  Effective
March 1, 1996, the minimum management fee and the maximum reimbursement for
office rent and overhead increased by 2.8% representing the allowable annual
Consumer Price Index adjustment per the Permanent Manger Agreement ("PMA").  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 $76,574 to date on the amounts recovered,  which has been
offset against the 4% minimum fee.

Several of the Partnership's property leases contain purchase option provisions
with stated purchase prices in excess of the original cost of the properties.
The current General Partner is unaware of any unfavorable purchase options in
relation to original cost.

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

                                       23
<PAGE>
 
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 incomes 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 8.)

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 amendments were made by the
General Partner without a vote of the Limited Partners.

5.  LEASES:
    -------

Lease terms for the investment properties are 20 years from their inception.
The leases provide for minimum rents and additional rents based upon percentages
of gross sales in excess of specified breakpoints.  The lessee is responsible
for occupancy costs such as maintenance, insurance, real estate taxes, and
utilities.

                                       24
<PAGE>
 
Accordingly, these amounts are not reflected in the statements of income, except
in circumstances where, in management's opinion, the Partnership will be
required to pay such costs to preserve assets (i.e., payment of past-due real
estate taxes).  Management has determined that the leases are properly
classified as operating leases; therefore, rental income is reported when earned
and the cost of the property, excluding the cost of the land, is depreciated
over its estimated useful life.

Aggregate minimum lease payments to be received under the leases for the
Partnership's properties are as follows:

<TABLE>
<CAPTION>
      Year ending
      December 31,
      <S>                                              <C>           
             1997                                      $  618,000
             1998                                         618,000
             1999                                         618,000
             2000                                         618,000
             2001                                         618,000
      Thereafter                                        5,400,163
                                                       ----------
                                                       $8,490,163
                                                       ========== 
</TABLE>

Percentage rentals included in rental income in 1996, 1995, and 1994 were
$13,399, $18,923, and $21,690, respectively.

Three (3) of the Partnership's properties are leased to a Denny's franchise.
Base rent from these properties amounted to approximately 38% of total base rent
in 1996.

Two (2) of the Partnership's properties are leased to a Hardee's franchise.
Base rent from these properties is approximately 29% of total base rents.

The original offering document required the Partnership to lease its properties
to a single tenant as long as the properties so leased do not constitute; in the
aggregate, more than 20% of the aggregate gross proceeds of the offering.  As of
December 31, 1995, and 1994, the Partnership had leased two of its properties to
Terratron, Inc., which constitute 21% of the aggregate gross proceeds.  Due to
sales difficulties in the stores leased by Terratron, a one (1)-year lease
modification was entered into with the tenant, reducing 1996 base rents by
approximately $85,000.  Additionally, delinquent rents totaling $46,000 were
capitalized into a five (5)-year note accruing interest at 10% per annum.  The
amount of the rent capitalized was written off as uncollectible at December 31,
1995.  During the Fourth Quarter of 1996, the leases with Terratron were
terminated and new leases were entered into for the properties with Hardee's
Food Systems, Inc.  In connection with this transaction, the capitalized rent
was received.  The new leases resulted in annual rents which are $142,000 lower
than Terratron's contract rents and $57,000 lower than 1996 adjusted rents.

                                       25
<PAGE>
 
6. TRANSACTIONS WITH CURRENT GENERAL PARTNER:
   ------------------------------------------


 
Amounts incurred to the current General Partner for the years ended
December 31, 1996, 1995, and 1994,
are as follows

<TABLE>  
<CAPTION>  
Current General Partner                                                 Incurred            Incurred        Incurred for the
-----------------------                                           for the year ended  for the year ended      year ended
                                                                   December 31, 1996    December 31, 1995   December 31, 1994
                                                                  ------------------  -------------------  ------------------
<S>                                                               <C>                 <C>                  <C>
Management fees                                                              $ 86,826             $56,829            $ 65,436
Disposition fees                                                                    0                   0              20,415
Restoration fees                                                               63,163               3,028              10,383
Leasing commissions                                                            23,310                   0                   0
Cash distribution                                                               2,789                (111)              1,544
Overhead allowance                                                              5,127               4,988               4,856
Reimbursement for out-of-pocket expenses                                        9,118              10,542               6,424
                                                                             --------             -------            --------
                                                                             $190,333             $75,276            $109,058
                                                                             ========             =======            ========
</TABLE>

7.  NET INVESTMENT IN DIRECT FINANCING LEASES:
    ------------------------------------------

The net investment in direct financing leases, which includes the Partnership's
specialty leasehold improvement leases, is comprised of the following as of
December 31, 1996:

<TABLE>
                    <S>                                                              <C>      
                    Minimum lease payments receivable                                $ 1,407  
                    Estimated residual values of leased                                       
                      property (non-recourse)                                         25,318  
                    Less - Unearned income                                            (1,708) 
                                                                                     -------  
                         Net investment in direct financing leases                   $25,017  
                                                                                     =======  
                                                                                              
                    Scheduled future minimum lease payments are as follows:                   
                                                                                              
                         Year ending December 31, 1997                               $26,725  
                                                                                     =======   
</TABLE>

During 1995, it was determined that the residual amounts of the leases were
overstated.  Accordingly a write-down of residual amounts to their estimated net
realizable values was recorded.  The total amount of the write-down was
approximately $96,000.

During 1996, Terratron, Inc. the tenant of two (2) Hardee's restaurants
terminated their equipment leases and purchased the equipment from the
Partnership, resulting in a loss of $93,000. Also during 1996, the tenant of the
Partnership's other Hardee's restaurant (Midland Food Systems) terminated its
equipment lease and purchased the equipment, resulting in a loss of $26,000.
Future cash flows from equipment leases will be significantly reduced as a
result of these terminations.

8.  CONTINGENT LIABILITIES:
    ---------------------- 

According to the Partnership Agreement, as amended, 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 is to be escrowed until the aggregate
amount of recovery of the funds misappropriated from the Partnerships by the
former general partners is greater than $4,500,000. 

                                       26
<PAGE>
 
Upon reaching such recovery level, full disposition fees will thereafter be
payable and fifty percent (50%) of the previously escrowed amounts will be paid
to the current General Partner. At such time as the recovery exceeds $6,000,000
in the aggregate, the remaining escrowed 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 escrowed 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. Fifty percent (50%) of the total amount paid to the recovery was
refunded to the current General Partner during 1996, after exceeding the
$4,500,000 recovery level. The remaining amount allocated to the Partnerships
may be owed to the current General Partner if the $6,000,000 recovery level is
met. As of December 31, 1996, the Partnership may owe the current General
Partner $18,862, which is currently reflected as a recovery, if the $6,000,000
recovery level is achieved.

If an affiliated partnership, DiVall 1, loses in litigation over a promissory
note dispute, the Partnership could be liable for its portion of the default
interest on the note.  (See Note 10.)

9.  PMA INDEMNIFICATION TRUST:
    --------------------------

The Permanent Manager Agreement ("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 December 31, 1996.  Funds are invested in U.S. Treasury
securities.  In addition, interest totaling $26,248 has been credited to the
Trust as of December 31, 1996.  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.

10. RESTORATION TRUST ACCOUNT; EXPENSE ALLOCATIONS; AND RELATED INTER-
    ----------------------------------------------------------- -----
    PARTNERSHIP RECEIVABLES:
    ------------------------

Restoration costs represent expenses incurred by the Partnership associated with
the misappropriated assets by the former general partners and their affiliates.
These costs are allocated among the Partnerships based on each partnership's
respective share of the entire misappropriation, as currently quantified.  The
amount of misappropriation for each partnership is adjusted annually to reflect
new discoveries and more accurate quantification of amounts based on the
continuing Investigation.  Such adjustments may result in periodic adjustments
to prior allocations of recovery costs to reflect updated information.
Consequently, previous payments for restoration expenses may not be consistent
with modified allocations.  Based on modified allocations adjusted as of
December 31, 1993, the Partnership owed $295,053 and $192,359 to DiVall 1 and

                                       27
<PAGE>
 
DiVall 2, respectively, for amounts paid on its behalf. Amounts recovered from
former general partner affiliates have been used to repay the amounts due to
DiVall 1 and DiVall 2. As of December 31, 1996, the amounts due to DiVall 1 and
DiVall 2 have been fully repaid.

Recoveries realized by the Partnerships are being distributed to each respective
partnership on the same basis as the restoration costs are currently being
allocated, adjusted for any future changes in the entire misappropriation, as a
result of the continuing investigation.  Any available recovery funds are being
utilized first to satisfy amounts due other partnerships for amounts advanced
under prior allocation methods.  As of December 31, 1996, the Partnerships
recovered a total of approximately $5,120,365 from the former general partners
and their affiliates.  Of this amount, the Partnership received its pro-rata
share in the amount of $2,387,589.  Additionally, $40,347, representing 50% of
all previously escrowed disposition fees earned by the General Partner, have
been paid to the recovery.  Of that amount, $18,867 was allocated to the
Partnership and is contingently payable to the General Partner upon achievement
of certain recovery levels as described in Note 8.

The PMA contemplated that the Permanent Manager could establish a separate and
distinct Restoration Trust Fund which would hold all recoveries until a final
independent adjudication by a court of competent jurisdiction or vote of the
Limited Partners ratified the allocation of proceeds to each respective
partnership.  Management has concluded that a fair and reasonable interim
accounting for recovery proceeds can be accomplished at the partnership level in
a manner similar to restoration costs which are paid directly by the
Partnerships. Management reserves the right to cause the final allocation of
such costs and recoveries to be determined either by a vote of the Limited
Partners or a court of competent jurisdiction.  Potential sources of recoveries
include third party litigation, promissory notes, land contracts, and personal
assets of the former general partners and their affiliates.

On March 24, 1994, an affiliated partnership, DiVall 1, filed a complaint in the
United States District Court for the Western District of Missouri against
Boatmen's First National Bank of Kansas City ("Boatmen's) seeking a declaratory
judgment that Boatmen's has no right or interest in a promissory note executed
in the name of DiVall 1 by the former general partners (the "Note") secured by
mortgages on five DiVall 1 properties, and further seeking an injunction against
foreclosure proceedings instituted against a DiVall 1 property located in
Dallas, Texas under a first deed of trust and security agreement given to secure
the Note (the "Foreclosure").  The former general partners borrowed $600,000
during or before 1991 from Metro North State Bank (now Boatmen's).  The proceeds
of the Note were not received by DiVall 1.  As of December 31, 1996, DiVall 1
had not paid debt service on the Note.  DiVall 1 received a notice of default on
the Note in October 1993, and the Foreclosure Action was filed in February,
1994.  As of December 31, 1996, interest in the amount of $226,000 had accrued
but was unpaid on the Note.  Interest is accrued at the face rate of the note.
If DiVall 1 loses the case against Boatmen's, additional interest totaling
approximately $246,000, representing the default rate of interest as of December
31, 1996, may be due.  Of the $246,000, approximately $115,000 would be paid by
the Partnership.  Boatmen's has agreed to stay its foreclosure proceedings
pending the outcome of the litigation.  Boatmen's answered the complaint and
filed a motion for summary judgment to which DiVall 1 responded.  The District
Court granted Boatmen's motion for summary judgement.  DiVall 1 appealed and the
Eighth Circuit Court of Appeals reversed the District Court's ruling. The case
was sent back to the District Court for further discovery and trial.  Trial of
the case is scheduled to begin on June 23, 1997.  Pursuant to the Restoration
Trust Account procedures described above, all of the Partnerships are sharing
the expenses of this litigation and any recoveries resulting effectively from
the partial or full cancellation of the alleged indebtedness will be allocated
among the three Partnerships on the same basis as the restoration costs are
currently being allocated.

                                       28
<PAGE>
 
11.  LITIGATION:
     -----------

On March 16, 1993, the Partnership, along with DiVall 1 and DiVall 2 initiated a
lawsuit against Ernst & Young LLP ("E & Y"), a certified public accounting firm,
in the Circuit Court of Dane County, Wisconsin in connection with the audits of
the Partnerships performed by E & Y for the years 1989, 1990 and 1991.  The
Partnerships requested the payment of damages in the amount of $9,000,000, plus
interest, attorneys fees and costs, and whatever additional relief the court
deemed just and proper.   The Partnerships hired legal counsel under a
contingent fee arrangement to prosecute all of the Partnerships' claims.  E & Y
filed an Answer denying that it was negligent.

E & Y also filed third-party claims alleging fraud and negligence on the part of
the Partnerships' former law firm, Quarles & Brady.  The Partnerships also filed
claims against Magnuson, DiVall, DiVall Real Estate Investment Corporation,
David Shea, and Quarles & Brady.

The trial of the case was scheduled to take place in Iowa County, Wisconsin,
beginning on March 20, 1996. Shortly before trial, the Partnerships reached a
resolution of their claims against Quarles & Brady.  A resolution of the claims
against Ernst & Young was reached after opening statements.  As a result of
these settlements, net proceeds to the Partnership, after the payment of
contingent legal fees and related costs, totaled approximately $1,000,000.

As part of the Permanent Manager Agreement, DiVall, Magnuson, and entities owned
by them, granted the Partnership a security interest in certain promissory notes
and mortgages from other DiVall related entities (the "Private Partnerships").
In the aggregate, the face amount of these notes were equal to a minimum of
$8,264,932.  In addition, DiVall, Magnuson, and related entities owned by them,
granted the Partnership a security interest in their general partner interests
in the Private Partnerships.  The foregoing security interests were to secure
the repayment of the funds which were diverted by DiVall and Magnuson from the
Partnership. The Partnership shares such security interests with DiVall 1 and
DiVall 2.  These promissory notes and mortgages are not recorded on the balance
sheets of the Partnerships, but are recorded as recoveries on a cash basis upon
settlement.

On July 23, 1993, nineteen (19) of the Private Partnerships sought the
protection of the Bankruptcy Court in the Eastern District of Wisconsin.  Seven
(7) of these bankruptcies were voluntary and twelve (12) of these bankruptcies
were involuntary.  Several of the Private Partnerships seeking bankruptcy owe
promissory notes to DiVall, Magnuson, or entities owned by them, in which the
Partnership has a security interest.  These cases were subsequently transferred
to the Western District Bankruptcy Court located in Madison, Wisconsin.

The Partnership's experience in those bankruptcy cases that have concluded,
either through the approval of Plans of Reorganization, dismissal of the
bankruptcies, settlements or a combination of the foregoing, is that (i) the
value of the obligations of the Private Partnerships assigned to the Partnership
has been at a significant discount to their face amounts, and (ii) the General
Partner interests in such Private Partnerships often have little economic value.
The Partnership's recoveries in these bankruptcies have been on a steeply
discounted basis.

Plans of reorganization have been filed in the bankruptcies, and settlement
agreements in all of the Private Partnerships have been reached.  Settlements in
the bankruptcies have resulted in cash payments to the Partnerships of a total
of $720,000 and notes secured by subordinated mortgages in the aggregate amount
of $625,000.  The Partnerships subsequently sold the secured notes for a total
of $175,000.

                                       29
<PAGE>
 
12.  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.

13.  SUBSEQUENT EVENTS:
     ------------------

In February 1997, the Partnership made a distribution to the Limited Partners
from operations for the Fourth Quarter 1996 of $925,000 amounting to $54.09 per
limited partnership interest.

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE

Not applicable.

                                   PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The General Partner of the Partnership is The Provo Group, Inc., an Illinois
corporation ("TPG") with its principal office at 101 West 11th Street, Suite
1110, Kansas City, Missouri 64105.  TPG was elected General Partner by vote of
the Limited Partners effective May 26, 1993.  TPG had been managing the
Partnership since February 8, 1993, under the terms of the Permanent Manager
Agreement ("PMA"), which remains in effect.  TPG also serves as the corporate
general partner for DiVall 1 and DiVall 2.  See Items 1 and 13 hereof for
additional information about the PMA and the election of TPG as the General
Partner.

The executive officers and director of the General Partner who control the
affairs of the Partnership are as follows:

     BRUCE A. PROVO, AGE 46 - PRESIDENT, FOUNDER AND DIRECTOR.   Mr. Provo has
     been involved in the management of real estate and other asset portfolios
     since 1979.  Since he founded the company in 1985, Mr. Provo has been
     President of TPG.  From 1982 to 1986, Mr. Provo served as President and
     Chief Operating Officer of the North Kansas City Development Company
     ("NKCDC"), North Kansas City, Missouri.  NKCDC was founded in 1903 and the
     assets of the company were sold in December, 1985 for $102,500,000.  NKCDC
     owned commercial and industrial properties, including an office park and a
     retail district, as well as apartment complexes, motels, recreational
     facilities, fast food restaurants, and other properties.  NKCDC's holdings
     consisted of over 100 separate properties and constituted approximately 20%
     of the privately held real property in North Kansas City, Missouri (a four
     square mile municipality).  Following the sale of the company's real
     estate, Mr. Provo served as the President and Chief Executive Officer and
     Liquidating Trustee of NKCDC from 1986 to 1991.

                                       30
<PAGE>
 
     Mr. Provo graduated from the Miami University, Oxford, Ohio in 1972 with a
     B.S. in Accounting.  He became a Certified Public Accountant in 1974 and
     was a manager in the banking and financial services division of Arthur
     Andersen LLP prior to joining Rubloff Development Corporation in 1979.
     From 1979 through 1985, Mr. Provo served as Vice President - Finance and
     then as President of Rubloff Development Corporation.  Mr. Provo has
     previously served on the Board of Directors of the National Realty
     Committee, a legislative "watchdog" organization for the commercial real
     estate industry headquartered in Washington, DC.

     KRISTIN J. ATKINSON, AGE 34 - VICE PRESIDENT - FINANCE AND ADMINISTRATION.
     Ms. Atkinson joined The Provo Group, Inc. in September 1994, to provide
     management expertise in the areas of financial controls and management
     accounting services for four limited partnerships managed by TPG.  Prior to
     joining TPG, Ms. Atkinson was Manager of Financial Reporting for Farm &
     Home Savings Association, a $4 billion savings and loan association, for
     nine years where she was responsible for supervision of the preparation of
     internal and external financial documentation, including regulatory filings
     for the savings association and its parent company.  Ms. Atkinson graduated
     Magna Cum Laude with a B.S. in Accounting from Missouri Southern State
     College in Joplin, Missouri and worked as an accountant for James P. Arthur
     and Company for one year before joining Farm & Home Savings Association.

     BRENDA BLOESCH, AGE 35 - DIRECTOR OF INVESTOR RELATIONS.  Ms. Bloesch
     joined The Provo Group, Inc. in March 1993, to oversee and provide various
     levels of client support for more than 8,000 broker dealers, registered
     representatives, custodians and investors.  Primarily responsible for all
     communications regarding four limited partnerships managed by TPG, Ms.
     Bloesch is also involved with database management and partnership
     compliance issues.  Prior to joining TPG, Ms. Bloesch was Manager of
     Investment Services at DiVall Real Estate Investment Corporation ("DREIC")
     for four years and Publisher Services Manager at NewsNet, Inc. for five
     years.  Her role at DREIC allowed Ms. Bloesch to obtain extensive knowledge
     of limited partnerships and gain familiarity with the broker and investor
     communities.  Ms. Bloesch is a graduate of Lock Haven University in Lock
     Haven, Pennsylvania, where she received her B.A. in Journalism and Media
     Studies.

The Advisory Board, although its members are not "Directors" or "Executive
Officers" of the Partnership, provides advisory oversight to management of the
Partnership and consists of:

     D. TODD WITTHOEFT - VICE PRESIDENT OF NELSON WITTHOEFT FINANCIAL.
     Mr.Witthoeft has been an investment broker for over ten (10) years and was
     one of the original founders of Calton and Associates.  Mr. Witthoeft
     serves as part of the firm's due diligence committee which reviews the
     structure of public and private limited partnerships prior to offering to
     clients. Mr. Witthoeft has over 400 clients and has taught personal
     financial planning courses.  Mr. Witthoeft holds the following securities
     licenses:  Options Principal, Licensed Life Insurance Agent - series 4;
     General Securities Representative - series 7; General Securities Principal
     - series 24; and State Agent - series 63.

     GERHARD ZOLLER - ADVISOR.  Mr. Zoller is currently involved in special
     training projects at J.H. Findorff & Son, Inc., a leading construction firm
     in Wisconsin.  Mr. Zoller has worked for this company for 27 years and
     served as both President and then Chairman of the Board in more recent
     years.  Prior business background and experience include positions as
     Project 

                                       31
<PAGE>
 
     Manager, Estimator and Chief Executive.  Mr. Zoller has also been
     actively managing personal investments for over 25 years including several
     real estate limited partnerships.  Mr. Zoller is a Limited Partner in
     DiVall 1.

     RICHARD W. OTTE - EDITORIAL WRITER.  Mr. Otte is in his sixth year as an
     Editorial Board Member and editorial writer for The Volusion, a DeLand,
     Florida, subsidiary of the News-Journal Corporation in Daytona Beach,
     Florida.  Mr. Otte retired in 1988 after 34 years with the Dispatch
     Printing Co., serving his last eight years as Managing Editor of the
     Columbus Dispatch and as a member of its Operating Committee.  He
     previously was the executive sports editor of the newspaper in Ohio's
     capital city.  Mr. Otte's 49 years in professional journalism also include
     news reporting, editing and sports assignments with the Daytona Journal
     Herald and Springfield News-Sun.  Mr. Otte is a Limited Partner in DiVall
     2.

     ALBERT H. ESCHEN - OPTOMETRIST.  Dr. Eschen has been an optometrist for 46
     years and is also employed by New York City's Department of Health.  Prior
     business experience include partnerships or personal investments in Crown
     Nursing Home; Coronet Nursing Home; and Sands Hotel & Casino.  Dr. Eschen
     is currently a member of the American Optometry Association and is a member
     of the Board of Directors Illinois College Alumni Association. Dr. Eschen
     was past-President of the Brooklyn Optometric Society and was the first
     optometrist to be appointed to New York City's Department of Health.  Dr.
     Eschen is a Limited Partner in DiVall 3.

ITEM 11.  EXECUTIVE COMPENSATION

The Partnership has not paid any "executive compensation" to the corporate
General Partner or to the directors and officers of the General Partner.  The
General Partner's participation in the income of the Partnership is set forth in
the Agreement of Limited Partnership and amendments thereto, which are filed as
Exhibits 3.1, 3.2, 3.3, 3.4 and 3.5 hereto.  The current General Partner
received management fees and expense reimbursements during the year.

See Item 13 below, and Note 6 to the financial statements in Item 8 hereof, for
further discussion of payments by the Partnership to the General Partner and
former general partners.


ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

(a)  As of December 31, 1996, the following entity is known to beneficially own
5% or more of the outstanding Limited Partnership Interests as follows:

<TABLE>
<CAPTION>
                                                             Interests      Percentage of   
Title of                     Name and Address of            Beneficially     Interests of   
  Class                        Beneficial Owner                Owned         Outstanding    
--------                     -------------------            ------------    -------------   
<S>                    <C>                                  <C>             <C>             
Limited Partnership    The Engineers Joint Pension Fund         1,500         8.77%          
Interests              4325 S. Salina Street
                       Syracuse, NY 13205
</TABLE>

                                       32
<PAGE>
 
(b)  As of December 31, 1996, neither the General Partner nor any of its
affiliates owned any Limited Partnership Interests in the Partnership.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The compensation to be paid to TPG is governed by the Partnership Agreement, as
amended by vote of the Limited Partners to reflect the terms of the PMA.  TPG's
compensation includes a base fee equal to 4% of the Partnership's gross
collected receipts, subject to a minimum of $57,000 per year.  For this purpose,
"gross collected receipts" means all cash revenues arising from operations and
reserves of the Partnerships, including any proceeds recovered with respect to
the obligations of the former general partners.  The portion of such fee
resulting from recoveries from former general partners is designated as
restoration fees.  TPG is also entitled to reimbursement for office rent and
utilities not to exceed $4,750 per year.  TPG is entitled to reimbursement of
reasonable direct costs and expenses, such as travel, lodging, overnight
delivery and postage, but has no right to be reimbursed for administrative
expenses such as payroll, payroll taxes, insurance, retirement and other
benefits, base phone and fax charges, office furniture and equipment, copier
rent, and the like.  Between the three Partnerships, TPG is entitled to an
aggregate minimum base management fee of $300,000 per year and reimbursement for
office rent in the maximum amount of $25,000 per year.  The Partnership shall
only be responsible for its allocable share of such minimum and maximum amounts
as indicated above ($57,000 minimum base fee and $4,750 maximum rent
reimbursement).  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, 1996, the minimum
management fee and the maximum reimbursement for office rent and overhead
increased by 2.8% representing the allowable annual CPI adjustment.
Additionally, TPG is allowed up to one-half of the Competitive Real Estate
Commission, not to exceed 3% upon the disposition of assets.  The payment of a
portion of such fees is subordinated to TPG's success at recovering the funds
misappropriated by the former general partners.

The PMA has an expiration date of December 31, 2002, but may be terminated
earlier (a) by a vote at any time by a majority in interest of the Limited
Partners, (b) upon the dissolution and winding up of the Partnership, (c) upon
the entry of an order of a court finding that the Permanent Manager has engaged
in fraud or other like misconduct or has shown itself to be incompetent in
carrying out its duties under the Partnership Agreement, or (d) upon sixty (60)
days written notice from the Permanent Manager to the Limited Partners of the
Partnership.  Upon termination of the PMA, other than by the voluntary action of
TPG, TPG shall be paid a termination fee of one month's Base Fee allocable to
the Partnership, subject to a minimum of $4,750. In the event that TPG is
terminated by action of a substitute general partner, TPG shall also receive, as
part of this termination fee, 4% of any proceeds recovered with respect to the
obligations of the former general partners, whenever such proceeds are
collected.

Under the PMA, TPG shall be indemnified by the Partnership, DiVall and Magnuson,
and their controlled affiliates, and shall be held harmless from all claims of
any party to the Partnership Agreement and from any third party including,
without limitation, the Limited Partners of the Partnership, for any and all
liabilities, damages, costs, and expenses, including reasonable attorneys' fees,
arising from or related to claims relating to or arising from the PMA or its
status as Permanent Manager.  The indemnification does not extend to claims
arising from fraud or criminal misconduct of TPG as established by court
findings.  To the extent possible, the Partnership is to provide TPG with
appropriate errors and omissions, officers liability or similar insurance
coverage, at no cost to TPG.  In addition, TPG is granted the right to establish
and segregate Partnership assets in an amount not to exceed $250,000, solely for
the purpose of funding such indemnification obligations (the 

                                       33
<PAGE>
 
"Indemnification Trust"). Once a determination has been made that no such claims
can or will be made against TPG, the balance of the Indemnification Trust will
become unrestricted cash of the Partnership. As of December 31, 1996, the
Partnership had fully funded to the Indemnification Trust.

The following fees and reimbursements from the Partnership were incurred to
management in 1996:

<TABLE>
<CAPTION>
The Provo Group, Inc.
---------------------
<S>                                          <C>
 
  Management Fees                            $ 86,826
  Restoration Fees                             63,163
  Leasing Commissions                          23,310
  Office Overhead Allowance                     5,127
  Direct Cost Reimbursements                    9,118
                                             --------
 
       1996 Total                            $187,544
                                             ========
</TABLE>

                                    PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
 
(a)    1.    Financial Statements

             The following financial statements of DiVall Income Properties 3
             Limited Partnership are included in Part II, Item 8:

             Report of Independent Public Accountants

             Balance Sheets, December 31, 1996 and 1995

             Statements of Income for the Years Ended December 31, 1996, 1995
             and 1994

             Statements of Partners' Capital for the Years Ended December 31,
             1996, 1995 and 1994

             Statements of Cash Flows for the Years Ended December 31, 1996,
             1995 and 1994

             Notes to Financial Statements

        2.   Financial Statement Schedules

             Schedule III - Real Estate and Accumulated Depreciation

        All other schedules for which provision is made in the applicable
        accounting regulation of the Securities and Exchange Commission are not
        required under the related instruction or are inapplicable and,
        therefore, have been omitted.

                                       34
<PAGE>
 
        3.   Listing of Exhibits

             3.1    Agreement of Limited Partnership dated as of December 12,
                    1989, and amended as of December 18, 1989, February 19,
                    1990, and April 9, 1990, filed as Exhibit 3A to Amendment
                    No.2 to the Partnership's Registration Statement on Form S-
                    11 dated April 23, 1990, incorporated herein by reference.

             3.2    Amendment to Amended Agreement of Limited Partnership dated
                    as of February 8, 1993, filed as Exhibit 3.3 to the
                    Partnership's 10-K for the year ended December 31, 1992, and
                    incorporated herein by reference.

             3.3    Amendment to Amended Agreement of Limited Partnership dated
                    as of May 26, 1993, filed as Exhibit 3.3 to the
                    Partnership's 10-K for the year ended December 31, 1993, and
                    incorporated herein by reference.

             3.4    Amendment to Amended Agreement of Limited Partnership dated
                    as of June 1, 1993, filed as Exhibit 3.4 to the
                    Partnership's 10-K for the year ended December 31, 1993, and
                    incorporated herein by reference.

             3.5    Amendment to Amended Agreement of Limited Partnership dated
                    as of June 30, 1994, filed as Exhibit 3.5 to the
                    Partnership's 10-K for the year ended December 31, 1994, and
                    incorporated herein by reference.

            10.0    Permanent Manager Agreement filed as an exhibit to the
                    Current Report on Form 8-K dated January 22, 1993,
                    incorporated herein by reference.

            28.0    Correspondence to the Limited Partners dated February 15,
                    1997, regarding the Fourth Quarter 1996 distribution.

(b)    Report on Form 8-K:

       The Registrant filed no reports on Form 8-K during the fourth quarter of
       fiscal year 1996.

                                       35
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
            SCHEDULE III - REAL ESTATE AND ACCUMULATED DEPRECIATION
                               DECEMBER 31, 1996

<TABLE>
<CAPTION>
                                                                                                Gross amount at which              
                                               Initial cost to Partnership                    carried at  end of year (A)      
                                               ---------------------------                    ---------------------------
                                                       Building                  Building                                          
                                                         and                       and                    Accumulated     Date of   
     Property              Encumbrances     Land      Improvements     Land    Improvements      Total    depreciation  construction
------------------------------------------------------------------------------------------------------------------------------------
<S>                        <C>             <C>        <C>            <C>       <C>             <C>        <C>           <C>     
Pittsburgh, Pennsylvania    $       -      $  274,467    $  616,866  $  274,467    $  616,866  $  891,333      $137,887      1990   
Wahoo, Nebraska                     -          54,854       456,762      54,854       453,262     508,116       103,119         -  
St. Francis, Wisconsin              -         485,354       709,028     468,354       709,028   1,177,382       160,793      1990  
Oak Creek, Wisconsin                -         496,505       845,400     496,505       845,400   1,341,905       171,743      1991  
Englewood, Colorado                 -               -       213,210           -       213,210     213,210        38,859      1991 
Sanford, Florida                    -         477,302       659,131     477,302       659,131   1,136,433       109,977      1991  
Colorado Springs, Colorado          -         314,354       265,829     314,354       265,829     580,183        39,383         -  

                           -----------------------------------------------------------------------------------------------
                                                                                                                              
                            $       0      $2,102,836    $3,766,226  $2,085,836    $3,762,726  $5,848,562     $ 761,761         
                           ===============================================================================================
 <CAPTION> 
                                              Life on which 
                                              depreciation 
                                               in latest  
                                               statement      
                                             of operations    
                               Date           is computed     
  Property                   acquired           (years)   
----------------------------------------------------------  
<S>                          <C>             <C>                            
Pittsburgh, Pennsylvania      9/11/90             31.5 
Wahoo, Nebraska                8/7/90             31.5 
St. Francis, Wisconsin        8/14/90             31.5 
Oak Creek, Wisconsin           2/5/91             31.5 
Englewood, Colorado            7/1/91             31.5 
Sanford, Florida             11/13/91             31.5 
Colorado Springs, Colorado    4/28/92             31.5  
</TABLE> 
        

(A) Represents aggregate costs for federal income tax purposes.

(B) Reconciliation of "Real Estate and Accumulated Depreciation":

<TABLE>
<CAPTION>
                                 Year ended          Year ended                 
Investments in Real Estate   December 31, 1996   December 31, 1995              
---------------------------------------------------------------------
<S>                          <C>                 <C>                            
Balance at beginning of year        $5,852,062          $5,869,062              
                                                                                
Property write-down                     (3,500)                  0              
                                                                                
                                                                                
                                                                                
Land Easement                                0             (17,000)             
                           ------------------------------------------              
                                                                                
Balance at end of year              $5,848,562          $5,852,062              
                           ==========================================              
</TABLE> 

<TABLE> 
<CAPTION> 
                                   Year ended           Year ended            
  Accumulated Depreciation      December 31, 1996    December 31, 1995   
-------------------------------------------------------------------------   
<S>                             <C>                  <C>                 
Balance at beginning of year          $644,443               $527,125       
                                                                        
Additions charged to costs                                               
 and expenses                          117,318                117,318         
                                                    
                         ------------------------------------------------                       
                                                       
                                                    
                                                   
Balance at end of year                $761,761               $644,443          
                         ================================================   
</TABLE> 

                                       36
<PAGE>
 
                                  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


By:  The Provo Group, Inc., General Partner



By:  /s/ Bruce A. Provo
     ----------------------------------
     Bruce A. Provo, President


Date:  March 28, 1997


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.



By:  The Provo Group, Inc., General Partner



By: /s/Bruce A. Provo 
    -----------------------------------
    Bruce A. Provo, President


Date:  March 28, 1997



By: /s/ Kristin J. Atkinson 
    -----------------------------------
    Kristin J. Atkinson
    Vice President - Finance and Administration


Date:  March 28, 1997

                                       37