7755 / How does a limited partner treat the amount realized on a sale of a partnership interest?

If the amount the partner realizes (see Q 7754) exceeds the partner’s adjusted basis in the partnership interest, the gain is capital gain except that if part of the amount realized (whether it is more or less than the basis) is attributable to a share of certain ordinary income property (i.e., partnership assets which, if sold, would result in ordinary gain), part of the amount realized (not just part of the gain) will generally have to be treated as ordinary income.¹ The IRC uses the terms “unrealized receivables” and “inventory items of the partnership” to identify the kinds of ordinary income property.² These items are also often called “hot assets” or “IRC
Section 751 property.”

In effect, a sale of a partnership interest is treated as two transactions, a sale of “IRC Section 751 property” and a sale of other property.

---

Planning Point: In fact, although this situation is not common, the transaction may have to be further broken up, into as many as four transactions, to the extent the partnership’s assets, if sold, would generate collectibles gain (taxed at a maximum 28 percent rate) and unrecaptured section 1250 gain (taxed at a maximum 25 percent rate), as well as the more traditional capital gain and ordinary income.³

---

In order to determine the gain or loss on each sale, the total amount realized by the partner on sale of the interest and the partner’s adjusted basis in the interest must each be allocated between the share of the partnership’s IRC Section 751 property and the share of other property.⁴

IRC Section 751 property includes much more than the term “unrealized receivables,” on its face, suggests. In order to prevent the conversion of ordinary income on certain items of partnership property to capital gain, Congress has frequently used the term “unrealized receivables” as a catch-all for various items generating ordinary income. Thus, for example, the term includes potential depreciation recapture computed as if the property had been sold by the partnership at its fair market value at the time the partnership interest is sold, and amounts that would be treated as ordinary income attributable to market discount if the partnership had sold market discount bonds (issued after July 18, 1984) or short term obligations it held.⁵ (See Q 7645 regarding market discount bonds, Q 7626 and Q 7628 address short term obligations.) The term “inventory items” includes property held primarily for sale to customers and other property that would not be considered a capital asset or “IRC Section 1231” property.⁶

The amount realized by a partner upon the sale or exchange of an interest in IRC Section 751 property is the amount of income or loss from IRC Section 751 property that would have been allocated to the partner if the partnership had sold all of its property in a taxable transaction in an amount equal to the fair market value of the property immediately before the partner’s transfer of the interest in the partnership. Any gain or loss recognized that is attributable to IRC Section 751 property is ordinary gain or loss. The difference between the amount of capital gain or loss that the partner would realize in the absence of these rules and the amount of ordinary income or loss determined under these rules is the partner’s capital gain or loss on the sale of the partnership interest.⁷ It is possible to have ordinary income attributable to the sale of the interest in IRC Section 751 property and a capital loss attributable to the sale of the interest in the other property.

Example. Partner B sells a one-half interest in partnership AB, when the balance sheet is: