Module 8

Exchanges


 

Section B...Hot Assets

Required Code & Regulation Readings
 

Please browse the following statutory provisions

 

Code Sections
Regulations

751

1.751-1(a) thru (d)

   

. Sales Containing Hot Assets

Section 741 provides that the gain or loss recognized from the sale or exchange of a partnershipinterest is captial gain except to the extent that 751 applies. Consequently the starting point for characterizing a sale or exchange of a partnership interest begins in 751.

Section 751(a) provides that the consideration received by a selling partner in exchange for all or part of his or her interest in the unrealized receivables or inventory items (a.k.a. "Hot Assets") of the partnership shall be treated as a sale of an ordinary income producing asset. The balance of the sale will be treated as a sale of a capital asset. Thus, understanding the definition of Hot Assets is imperative to properly classifying the sale of a partnership interest.


Unrealized Receivables

One of the hot assets that triggers ordinary income is the unrealized receivable which is defined as the right to payment for past or future sales of goods or services not previously includable in income. This classification is necessary to insure that ordinary income will not be avoided when a partnership is sold with cash basis receivables. With certain exceptions, only partnerships on a cash basis generate income from unrealized receivables upon sale of the partnership interest. IRC Sec. 751(c)(1) and (2).

Example 1

T sells his entire interest in the ST partnership to R for $7,500. T's basis in the partnership is $3,000 and the partnership has the following balance sheet:

Assets
Basis
FMV
Acct. Receivable
$0
$8,000
Investment Land
6,000
7,000

TOTAL

$6,000
$15,000
 
Liab & Capital
Basis
FMV
S Capital
$3,000
$7,500
T Capital
3,000
7,500

TOTAL

$6,000
$15,000

T's total gain is $4,500 ($7,500 - 3,000) of which $4,000 is ordinary income (1/2 * $8,000 accounts receivable) and the remaining $500 is capital gain.

Note that the ST partnership is on a cash basis because the accounts receivable have a zero basis.

The definition of unrealized receivables is not, however, limited to situations involving rights to future payments. The statutory definition includes a host of partnership assets which, if sold, would give rise to ordinary income. IRC Sec. 751(c) Flush Language


Depreciation recapture as an unrealized receivable

One of the most overlooked, yet common, unrealized receivables is depreciable property subject to depreciation recapture under Section 1245 and 1250. If the partnership owns assets which are subject to recapture of depreciation, only the amount of the recapture potential and not the entire gain is considered to be an unrealized receivable on the sale of the partnership interest.

The term Section 1245 property includes all depreciable property other than buildings or their structural components. The term Section 1250 means any real property other than property described in Section 1245. The basis of Section 1245 and 1250 recapture is zero. Regs. Sec. 1.751-1(c)(5)

Example 2

The BC Partnership has the following Balance Sheet:

Assets
Basis
FMV
Accounts Receivable
15,000
15,000
Machine ($8,000 recapture)
33,000
45,000
Total
$48,000
$60,000
A Capital
24,000
30,000
B Capital
24,000
30,000
Total
$48,000
$60,000

If C sells his entire interest for $30,000, he will have a realized gain of $6,000 ($30,000 - $24,000). Of this amount $4,000 will be taxed as ordinary income (1/2 of the $8,000 recapture). The remaining $2,000 is attributable to the Section 1231 gain remaining in the machine and will be taxed to C as a capital gain.

 

Note

Sections 1245 and 1250 recapture must be computed separately for each property. Thus, a selling partner may have to recognize ordinary income even though the aggregate fair market value of all the Section 1245 and 1250 properties produce an overall loss.


Inventory and Substantially Appreciated Inventory

The second category of hot assets that triggers ordinary income attention is the substantially appreciated inventory item. In order for inventory to be a Hot Asset, the 1997 Act eliminated the requirement that inventory be substantially appreciated in order to give rise to ordinary income for sales and exchanges under Sec. 751 (a). Thus, all inventories become Hot Assets.

Note, however, there has been no change with respect to distributions under Sec. 752(b). Thus, the requirement that inventory be substantially appreciated continues to apply to those types of distributions. Substantial appreciation will not be discussed in this module.


Section 751 Bifurcations

In making the necessary computations under Section 751, the basis used for unrealized receivables and for all inventory after August 5, 1997 is the same as the inside basis. Of course, the inside basis for an unrealized receivable for rendering services would generally be zero. The value allocated to the assets in the contract of sale of the partnership will generally be regarded by the IRS as correct, provided those values represent fair market values. Otherwise, competent appraisals may be necessary to ascertain value.

After the values and bases of all assets have been determined, the assets must be divided into two components;

  1. Section 751 hot assets, and
  2. other assets (i.e., capital and Section 1231 assets).
Example 3

XYZ has the following Balance Sheet:

Assets
Basis
FMV
Cash
$10,000
$10,000
Accounts Receivable
0
13,000
Inventory
12,000
20,000
Equipment*
20,000
28,000
Land
50,000
45,000
Investments
7,000
13,000
Total
$99,000
$129,000
*Includes $6,000 recapture of depreciation

Partner X with a basis of $33,000 sells a one-third interest in XYZ for $43,000. Although it appears X has realized a $10,000 gain, the assets must be divided in order to determine their character.

Assuming all the Section 751 inventory items are hot assets , the assets of the partnership would be split as follows:

Hot (751) Assets
Basis
FMV
Accounts Receivable
0
13,000
Inventory
12,000
20,000
Equipmentn Deprec
- 0 -
6,000
Total
$12,000
$39,000

Other (741) Assets
Basis
FMV
Cash
$10,000
$10,000
Equipment
20,000
22,000
Land
50,000
45,000
Investments
7,000
13,000
Total
$87,000
$90,000

As a result of the sale, Partner X must recognize $9,000 as ordinary income (1/3 * ($39,000 - $12,000)) and $1,000 as capital gain (1/3 * ($90,000 - $87,000)).


Section 751 does not impose a ceiling

Realized gain or loss is ordinarily measured by the difference between the amount realized by a partner and that partners outside basis. However, the existence of hot assets can create a situation where more ordinary income is recognized than the amount of the realized gain (i.e., the ceiling is surpassed). When this happens, the counter-balancing effect is recognition of a capital loss on the sale of the partnership interest.

Example 4

The AB partnership is on the cash basis and has unrealized accounts receivable of $15,000 with a basis of zero. A's proportionate interest in the hot assets is $7,500. A's outside basis is $20,000 and the entire partnership interest is sold for $23,000 resulting in a realized gain of $3,000. A must first allocate $7,500 of the sales price to the unrealized receivables, the basis of which is zero. Thus, $7,500 of ordinary income must be recognized. The remaining $15,500 of the sale price is allocated to the balance of the partnership interest that has a remaining basis of $20,000. Accordingly, A has a $4,500 capital loss on the balance of the partnership interest ($15,500 -$20,000),

Note The amount realized ceiling of $3,000 less the ordinary income of $7,500 provides a counter-balancing capital loss of $4,500.


Study Questions Make your selection by clicking the appropriate response letter.

1.

Which of the following statements concerning the sale of a partnership are true?

 
The amount realized must be bifurcated between the capital assets and the ordinary assets.
 
Hot assets are assets that are taxed as ordinary income.
 
The ordinary income recognized will be the amount realized attributed to the sale of hot assets.
 
The sale of a partnership is taxed under the aggregate theory.

2.
The ABC partnership has the following assets:
  Basis FMV
Cash $ 9,000 $ 9,000
Acct rec. 0 30,000
Investments 6,000 21,000
  $15,000 $60,000

If partner C has an adjusted basis of $5,000 and sells the entire one-third interest to D for $20,000, what is the character and amount of any gain recognized by C?

 
$15,000 capital gain.
 
$10,000 ordinary gain, $5,000 capital gain.
 
$15,000 ordinary gain.
 
$5,000 ordinary gain, $10,000 capital gain.

3.

The ABC partnership has the following assets.

  Basis FMV
Cash $12,000 $12,000
Acct rec. 6,000 6,000
Investments 9,000 21,000
Machine 30,000 51,000
  $57,000 $90,000

If partner C has an adjusted basis of $19,000 and sells the entire one-third interest to D for $30,000, what is the character and amount of any gain recognized by C? (Assume $15,000 depreciation has been taken on the machine.)

 
$ 6,000 capital gain, $5,000 ordinary income.
 
$ 4,000 capital gain, $7,000 ordinary income.
 
$11,000 ordinary income.
 
$11,000 capital gain.

4.

The AB partnership has the following assets.

  Basis FMV
Investments $40,000 $30,000
Inventory 10,000 18,000
Acct rec. - 0 - 12,000
  $50,000 $60,000

If partner B with adjusted basis of $25,000 sells the entire 1/2 interest to C for $30,000, what is the character And amount of any gain recognized by B?

 
$ 5,000 ordinary gain.
 
$ 5,000 capital gain.
 
$ 6,000 ordinary gain, $1,000 capital loss.
 
$10,000 ordinary gain, $5,000 capital loss.

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