[Mike J]

NINJA Question –

Hello all,

I understand the calculation involved with the following question. But, I’m not sure why, once sold after distributed, that the inventory distributed yields a Ordinary Gain while the land distributed yielded a Capital Loss. Please explain why the inventory is Ordinary.

…

The CSU partnership distributed to each partner cash of $4,000, inventory with a basis of $4,000 and a fair market value (FMV) of $6,000, and land with an adjusted basis of $5,000 and an FMV of $3,000 in a liquidating distribution. Partner Chang had an outside basis in Chang’s partnership interest of $12,000. In the second year after receiving the liquidating distribution, Chang sold the inventory for $5,000 and the land for $3,000. What income must Chang report upon the sale of these assets?

A) $0 gain or loss

B) $0 ordinary gain and $1,000 capital loss

C) $1,000 ordinary gain $1,000 capital loss [correct answer]

D) $1,000 ordinary gain $0 capital loss

…

I know: you take the 12,000 owner/partnership basis and allocate to (1) 4,000 cash; (2) 4,000 A/B inventory; and (3) [plug] Land. Of course, there is no Loss here because you can’t receive any prop other than cash, inventory and A/R.

Subsequent Sale of the distributed Inventory is SP 5000 – Basis (above) 4000 = 1,000 Gain.

Subsequent Sale of the distributed Land is SP 3000 – Basis (plug) 4000 = 1,000 Loss

What I don’t know: Why is the Gain associated with the Inventory is ORDINARY, while the Loss associated with the Land is CAPITAL.

Going forward is there a timing issue, eg. certain assets (not land apparently) that are sold w/i X years of distribution aren’t capital?

I’d appreciate it if you could explain it before my May 10 REG exam. Yes, the best work is left to the last minute.

Thanks again!

AUD - 90
BEC - 79
FAR - 77
REG - 77

They don't trust JUST ANYBODY to count beans

[taxgeek83]

Someone correct me if I'm off-base, but I think it has to do with §751 “Hot Assets,” which are generally unrealized receivables and inventory items. Essentially anything that, if sold within the regular course of business, would give rise to ordinary income.

Hopefully that helps. : )

[Mike J]

@Taxgeek83,

Okay, so basically this: https://tax.cchgroup.com/downloads/files/contemporary-tax-practice/M1-Partnership-Taxation/T7-Sale-Partnership-Interest/C-Sale-Partnership-Interest-With-Sec-751-Properties.asp

According to Tax CChgroup, there are two main categories for ORD G<L> treatment. “Unrealized Receivables” [rights to payment for services not yet included in income; 1245 or 1250 property; certain mining and certain farming land; and intangibles] and “Inventory.”

So, since the land isn't mining/farming/1245/1250 property the resultant loss of the land is capital?

FYI, this site is great for a C-Corp & Pass-thru refresher. The “hot assets” weren't on my radar tho.

Thanks

AUD - 90
BEC - 79
FAR - 77
REG - 77

They don't trust JUST ANYBODY to count beans

[taxgeek83]

Exactly. Aside from the right to payment for services not yet included in income, most of the rest is going to be depreciation/amortization recapture. Mining/farming land produces inventory (i.e. coal, crops, etc.) that would generally give rise to ordinary income if sold, so I'm guessing that's why those two are included. Be careful to note that anytime an item in a list begins with “certain,” you need to do more research as there's likely a caveat somewhere.

Anytime you see distributions like that in a partnership, you always have to bifurcate the distribution between the hot asset portion and the capital asset portion. Hot assets get taxed at ordinary income rates, and capital assets at capital gains rates. This only applies to partnerships though.

For the record, my guess is that hot assets usually aren't on anyone's radar – I had just worked with them on a project in a previous life, so I'm fairly familiar. 🙂

P.S. That site you linked to really is great – I've used it for a lot of projects both professional and personal (including studying for the CPA exam!).

[Mike J]

@taxgeek83,

I used that site to learn what I didn't get to in school. Long story, short I'm changing careers (or trying to) from Print Journalism & Paralegal. I love to write, but there isn't the same security and money in it. Anyway, when I returned to school I only needed Individual Tax to qualify for the CPA exams. Most Accounting Programs require two or three classes. I see why, but I was paying as I went so…

Anyway, I have a follow-up. re: “Anytime you see distributions like that in a partnership, you always have to bifurcate the distribution between the hot asset portion and the capital asset portion. Hot assets get taxed at ordinary income rates, and capital assets at capital gains rates. This only applies to partnerships though.”

So this “hot assets” garbage only applies to Partnership? So I wouldn't have to worry about the same scenario but S-Corp? Going forward, I should immediately look for “hot assets” whenever I sell a partner interest or get a LIQUIDATING distribution?

Thanks again,

–Mike

AUD - 90
BEC - 79
FAR - 77
REG - 77

They don't trust JUST ANYBODY to count beans

[taxgeek83]

Get into public accounting and you'll still have plenty of opportunities to write! Mostly letters, but still…. 🙂

https://www.forbes.com/sites/anthonynitti/2014/05/27/tax-geek-tuesday-hot-assets-and-the-sale-of-partnership-interests/#55b590f07f98

This is a good article on it. But to answer your question, yes, only partnerships deal with the hot asset issue, and yes always look for hot assets in partnership transactions. I believe it's still an issue with current distributions as well, but look into that further. As a side note, when you do get licensed and start needing CPE credits, Tony Nitti has quite a few good courses out there if you need some tax instruction. 🙂

[Author]

Replies