Certain partnership assets produce ordinary income when sold or exchanged. These assets are known as hot assets and include unrealized receivables and inventory. When a partner sells a partnership interest, receives certain retirement payments, or receives a disproportionate distribution, the portion of gain tied to hot assets is treated as ordinary income.
Unrealized Receivables
Unrealized receivables are rights to receive ordinary income that have not yet been included in income under the partnership’s accounting method.
The basis of unrealized receivables includes costs or expenses that were paid or accrued but not yet taken into account. For partnerships using the cash method, the basis of unrealized receivables is zero because income is recognized only when received.
Unrealized receivables include rights to payment for goods or services that are not capital assets. They also include items that would generate ordinary income if sold at fair market value.
Examples include:
- Goods delivered where payment would be ordinary income
- Services rendered or to be rendered
- Mining property with deducted exploration costs
- DISC stock
- Farmland with deducted soil or land‑clearing costs
- Franchises, trademarks, trade names
- Oil or gas property with deducted intangible drilling costs
- Stock of certain controlled foreign corporations
- Market discount bonds and short‑term obligations
- Depreciation recapture property under §§1245 and 1250
Unrealized receivables also include potential depreciation recapture, even if the property has not yet been sold.
Inventory Items
Inventory includes property held for sale to customers or property that would be included in inventory if on hand at year‑end. It also includes property that would not be a capital asset or Section 1231 property if sold by the partnership.
Inventory also includes property that would be considered inventory if held directly by the partner selling the partnership interest or receiving the distribution.
Inventory is substantially appreciated when its fair market value exceeds 120% of the partnership’s adjusted basis in the inventory at the time of distribution.
Substantially appreciated inventory triggers special ordinary‑income rules when a partner receives a disproportionate distribution or sells a partnership interest.
Why Section 751 Matters
Section 751 prevents the conversion of ordinary income into capital gain. When a partner sells an interest or receives certain distributions, the portion of gain tied to unrealized receivables and inventory is treated as ordinary income, not capital gain.
This rule applies to:
- Sale or exchange of a partnership interest
- Retirement payments for property under §736
- Disproportionate distributions
Section 751 ensures that income that would have been ordinary inside the partnership remains ordinary when transferred.