1. A portion of the gain recognized on the sale or exchange of a partnership interest may be deemed attributable to “unrealized receivables” or “inventory,” and as such this gain will be taxed as ordinary income. (This may also occur with certain nonliquidating distributions where the partnership interest is reduced and also certain disproportionate liquidating distributions.) These properties are known as “Sec. 751 properties,” (sometimes referred to as “hot assets”) and each is defined below.
2. Unrealized Receivables – These amounts include the following:
Any rights to payment to the extent the payment would be received for property other than a capital asset (the most common example would be an accounts receivable of a cash-basis taxpayer).
- Any rights to payment for services rendered or to be rendered that has not been included in income (services receivable of a cash-basis law partnership, for example).
- Other items of potential gain that would be taxed as ordinary income, including:
- Property subject to recapture of depreciation under Sec. 1245 or Sec. 1250
- Mining property for which exploration expenses were deducted
- Stock in a Domestic International Sales Corporation (DISC)
- Certain farm land for which soil and water conservation or land-clearing expenses were deducted
- Franchises, trademarks, or trade names
- Oil, gas, or geothermal properties for which intangible drilling and development costs were deducted
- Stock of certain foreign controlled corporations
- Market discount bonds and short-term obligations
3. Inventory Items – This includes not only inventory in the traditional sense but any property that if sold by the partnership would not be capital gain or Sec. 1231 gain. Note that for a sale or exchange, the inventory does not have to be “substantially appreciated” (20% or more), as is the case with distributions discussed earlier.
4. If Sec. 751 property exists, the portion of the gain attributable to such property must be reported as ordinary income, and not capital gain.
5. There are filing requirements associated with Sec. 751 properties. First, the partnership must file (as an attachment to the Form 1065) a Form 8308 (Report of a Sale or Exchange of Certain Partnership Interests) for the tax year that includes the end of the calendar year of such a sale or exchange. The partnership must furnish a copy of this form to all parties in the exchange. In addition, the partner selling or exchanging such an interest must file a statement with his or her return detailing all the particulars of the transaction.
6. Gain attributable to Sec. 751 properties is determined by comparing the portion of the amount realized attributable to those properties (if no allocation is made, allocate based on relative fair market values) with the partner’s fractional share of the partnership basis in those assets (note – the adjusted basis of uncollected receivables of a cash-basis taxpayer is $0).
7. The Sec. 751 gain should always be determined first, and this amount is fully recognized, even if greater than total gain on the sale. The gain or loss on the remaining non-Sec. 751 assets is whatever is left.
Example – Tim Vertavek’s overall gain on selling his partnership interest is $40,000, and his gain on selling Sec. 1251 assets is $46,000. Tim will report $46,000 of ordinary income related to the Sec. 1251 assets and will report a $6,000 capital loss related to the noncapital assets sold.