The tax cost of hot assets upon the disposition of a partnership interest.

• Author: Bakale, Anthony S.

Often a partner will negotiate a deal to dispose of his partnership interest without considering the tax implications of hot assets or how to best structure the transaction (as a sale or a redemption). This is because most are unaware that a disposition of a partner's interest in an entity that holds hot assets may convert long-term capital gain to ordinary income or in certain cases may force the partner to recognize ordinary income offset by a nonutilizable capital loss upon the disposition.

Example 1: Partner A owns a 50% interest in ABC Partnership. ABC holds hot assets, otherwise referred to as Sec. 751 property or ordinary income property. A's outside basis of his interest in ABC is $100,000. He sells his interest for $200,000, resulting in an overall gain of $ 100,000. The partnership assets consist of a Sec. 751 asset with a value of $400,000 and a basis of zero and a non-Sec. 751 asset with a value of zero and a basis of $200,000. Since the partnership holds a hot asset, A is treated as having separately sold his 50% share of the Sec. 751 asset for its value of $200,000 ($400,000 x 50%) and will realize $200,000 in ordinary income. The remaining proceeds (zero) are then applied to the remaining basis of $100,000 ($200,000 x 50%), producing a $100,000 capital loss. In this case, rather than recognizing $15,000 in tax on $100,000 of long-term capital gain ($100,000 x 15%), A will incur an immediate tax liability of $70,000 ($200,000 ordinary income x 35%) and a tax benefit of $15,000 ($100,000 x 15%) at the time the capital loss is utilized. The net tax cost of the disposition of A's partnership interest is $55,000 rather than $15,000. In this example, the application of Sec. 751 is important, given the 20% difference in tax rates between ordinary income and long-term capital gain, which is likely to continue to exist after 2010.

In the case of a sale or exchange, Regs. Sec. 1.751-1(a)(1) provides that

To the extent that money or property received by a partner in exchange for all or part of his partnership interest is attributable to his share of the value of partnership unrealized receivables or ... inventory items, the money or fair marker value of the property received shall be considered as an amount realized from the sale or exchange of property other than a capital asset. The remainder of the total amount realized on the sale or exchange of the partnership interest is realized from the sale or exchange of a capital asset under...