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

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.

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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

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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:

Assets			Liabilities and Capital
	basis	market value		book value	market value
Cash	$ 3,000	$ 3,000	Liabilities	$ 2,000	$ 2,000
Capital			Capital
Assets	17,000	15,000	A	9,000	15,000
Unrealized
receivables	0	14,000	B	9,000	15,000
	$20,000	$32,000		$20,000	$32,000

B receives $16,000 for his one-half interest ($15,000 in cash and $1,000 in reduction of partnership liabilities). B’s interest in partnership property includes his one-half interest in unrealized receivables worth $7,000. Thus, $7,000 of the $16,000 realized is considered received in exchange for his interest in unrealized receivables and is therefore ordinary income. B’s basis for his partnership interest is $10,000. The difference between the amount of capital gain or loss that the partner would realize in the absence of IRC Section 751 ($16,000 - $10,000 = $6,000) and the amount of ordinary income or loss determined above ($7,000) is B’s capital gain or loss on the sale of its partnership interest. In this case, B will recognize a $1,000 capital loss.⁸

On sale of an interest in an upper tier partnership, a proportionate share of the lower tier partnership’s “unrealized receivables” and “inventory items” will be deemed sold.⁹

Regulations require a statement relating to the sale.¹⁰

The partner’s distributive shares of partnership gains and losses are included in the return for the year of sale, and are not part of the sale proceeds (see Q 7753). Any such income increases basis. If the partner fails to consider this when selling the partnership interest, the partner may realize ordinary income from operations instead of gain on the sale.

Gain or loss from sale of a partnership interest is generally treated as passive for purposes of the “passive loss” rules (see Q 8010 through Q 8021) if the activity is passive with respect to the partner (see Q 8011).

Partnership interests in different partnerships are not eligible for non-recognition treatment under the like-kind exchange rules.¹¹ (See Q 710 regarding the like-kind exchange rules generally, and Q 7839 to Q 7840 regarding like-kind exchanges of real estate. Note that like-kind exchange treatment under IRC Section 1031 is now only available for exchanges of real
property.)

The installment sales rules (see Q 667) are applied to the sale of a partnership interest in the same manner that the rules would be applied to a direct sale of the underlying assets. Thus, for example, the installment method cannot be used to report income from the sale of a partnership interest to the extent that the sales proceeds represent income attributable to the partnership’s inventory items, which would not qualify for installment treatment if sold directly.¹² Similarly, the installment method cannot be used to report gain on the sale of a partnership interest attributable to depreciation recapture, which is an unrealized receivable for these purposes,¹³ and it is generally assumed that the same rule applies to gain attributable to any other unrealized receivable as well. The underlying principle is that the installment method can be used to defer recognition of capital gain, but not of ordinary income.