1) Sale or Exchange a) Sec 741 – When a partnership interest is sold, gain or loss shall be recognized to the transferor partner. Such g/l shall be considered a g/l from the sale/exchange of a capital asset, except as otherwise provided in Sec.
751 (hot assets) b) Sec. 751(a) Amount of any money, or the fair market value of any property, received by a transferor partner in exchange for all or part of his interest in the partnership, attributable to unrealized receivables or inventory items of the partnership shall be considered as an amount from the sale/exchange of property other than a capital asset. Note, Unlike 751(b), Sec. 751(a) applies to all inventory, not just substantially appreciated inventory. i) If a partner sells or exchanges his partnership interest, gain/loss, must be allocated between capital and ordinary character.
2) Inside v. Outside basis in a partnership interest when purchased versus obtained through contributions a) Outside basis – Sec 742 - Sections 1011 and following sections. i) Cost basis ii) Interest Acquired by Decedent iii) Interest acquired by gift b) The outside basis for the partnership interest is also increased by the partner’s share of liabilities.

c) When a partner purchases the partnership interest in a partnership from an existing partner, the new partner steps into the shoes of the old partner i) Capital account purchased is identical to the former partner’s capital account, even if new partner paid
FMV for the interest d) Sec. 743 – the basis of partnership property shall not be adjusted as the result of a transfer of interest in a partnership by sale or exchange or on the death of partner unless the election provided by section 754 is in effect with regards to the partnership. e) Sec 743/Sec 754 is used to adjust inside basis to equal outside basis in the partnership. These adjustments can be positive or negative.
3) Calculation of Gain or Loss: Amount realized –
Adjusted Basis a) Amount realized = Cash + FMV of other property received + liabilities relieved b) Adjusted basis = Outside basis (usually tax capital account (if Sec. 754 election is in place) + share of liabilities + pro rata share of income/loss up to the date of sale by the partner. Requires closing of books or estimation of net income through that period.
4) Gain must first be allocated to ordinary income property.
Residual gain is then treated as capital gain/loss a) Gain from ordinary income property is calculated using the following procedure i)
First, determine the partner’s pro-rata share of partnership inventory and unrealized receivables using FMV.

ii)
Second, determine the partner’s pro-rata share of the adjusted basis of partnership inventory and unrealized receivables. iii) Subtract the adjusted basis from the FMV to obtain any ordinary gain that the partner must recognize on the sale/exchange transaction iv) The residual gain/loss is then treated as captial gain/loss as necessary.
5) Hot assets a) Unrealized receivables (defined in Sec. 751(c)) b) Inventory (Sec. 751(d))

Amount Realized: $20 cash
$10 assumption of liabilities
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$30
Adjusted Basis: $10 capital
$10 Liabilities
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$20
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Capital Gain (ST) $10
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Question 2 / part a
Amount Realized: $20 cash
$10 assumption of liabilities
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$30
Adjusted Basis: $10 capital
$10 Liabilities
$ 3 net income (1/3 of $9)
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$23
Capital Gain $ 7
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Reg. 1.706-1(c)(2)(ii) – partnership year closes for partner at date of sale – distributive share of income calculated.
Income is characterized at the partnership level
Could be LT cap gain, ST cap gain, 1231 gain
Income is includible for A’s taxable year in which the sale or exchange took place Sec. 706(c)(2)(A) and Reg. Sec.
1.706-1(c)(2)(ii).
Reg. 1.706-1(c)(2)(ii) if the partners agree, allows the distributive share to be ratable allocated to avoid an interim closing of the partnership books.
Question 2 / part b
Reg. 1.706-1(c)(2)(ii) allows the pro-ration method to be used in this case. As such, the $15 of income would be allocated $2.50 to A (15*1/2*1/3).
Proceeds $30 – Adjusted Basis 22.50 = 7.50 gain
Adjusted basis = 10 (capital) + 10(debt) + 2.50 (inc)

Question 2 / part c
Amount Realized: $10 cash
$ 5 assumption of liabilities
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$15
Adjusted Basis: $ 5 capital
$ 5 Liabilities
$ 1.50 income (1/3*$9*1/2)
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$11.50
Capital Gain $3.50
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Reg. 1.705-1(a)(1) – compute distributive share of income when all or part of a partnership interest is sold.
Problem Area 11
Question 1 (part a)
A/R $25 (0 adjusted basis, $25FMV)
Inventory $ 5 ($20 adj. basis, $25 FMV)
Total $30 / 4 = 7.50

Question 1 (part b)
Amount Realized $70 (25 cash + $45 debt)
Adjusted Basis $55 (10 cap + 45 debt)
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Gain to be allocated $15
Inventory and Accounts Receivable are Sec. 751 assets.
Sec. 751 – requires allocation of part of the purchase price to the Sec. 751 assets
Purchase price allocation for hot assets
$50 (FMV) of hot assets * .25 = 12.50
Basis allocation to hot assets
$20 (Adjusted basis to ptshp) * .25 = 5
Ordinary gain = $7.50
Reg. Sec. 1.751-1(a)(2) – the portion of the partner’s basis for his partnership interest to be allocated to Sec. 751 property shall be an amount equal to the basis such property would have had under Sec. 732 if the selling partner had received his share of such properties in a current distribution.

Sec. 732(a) – A’s basis in the Sec. 751 assets would be his share of the bases of the assets in the hands of the partnership ($20). His share would be 25%.
Remainder of the gain is capital under Sec. 741
Amount realized $57.50 $12.50
Adjusted Basis ($50.00) $ 5.00
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Gain $ 7.50 $ 7.50
Question 1 – Part c
If ABCD were an accrual method taxpayer for all items, the adjusted basis of the accounts receivable would be $25.
Therefore, the only hot asset is inventory.
A/B FMV
A/R 25 25
Inv 20 25
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Total 45 50
However, for Sec. 751(a) purposes, the allocations would be as follows: (25%*25 FMV basis of INV) – (25%*20) a/b of INV) = $1.25 or ordinary income.