The following discussions explain the treatment of gain or loss from the disposition of an interest in a partnership.

Abandoned or worthless partnership interest. A loss incurred from the abandonment or worthlessness of a partnership interest is an ordinary loss only if both of the following tests are met.

• The transaction is not a sale or exchange.
• The partner has not received an actual or deemed distribution from the partnership.

If the partner receives even a de minimis actual or deemed distribution, the entire loss is a capital loss.

Partnership election to adjust basis of partnership property. Generally, a partnership's basis in its assets is not affected by a transfer of an interest in the partnership, whether by sale or exchange or because of the death of a partner. However, the partnership can elect to make an optional adjustment to basis in the year of transfer. See Adjusting the Basis of Partnership Property, later, for information on making the election.

Sale, Exchange, or Other Transfer

The sale or exchange of a partner's interest in a partnership usually results in capital gain or loss. However, see Payments for Unrealized Receivables and Inventory Items, later, for certain exceptions. Gain or loss is the difference between the amount realized and the adjusted basis of the partner's interest in the partnership. If the selling partner is relieved of any partnership liabilities, that partner must include the liability relief as part of the amount realized for his or her interest.

Example 1. Fred became a limited partner in the ABC Partnership by contributing $10,000 in cash on the formation of the partnership. The adjusted basis of his partnership interest at the end of the current year is $20,000, which includes his $15,000 share of partnership liabilities. The partnership has no unrealized receivables or inventory items. Fred sells his interest in the partnership for $10,000 in cash. He had been paid his share of the partnership income for the tax year.

Fred realizes $25,000 from the sale of his partnership interest ($10,000 cash payment + $15,000 liability relief). He reports $5,000 ($25,000 realized - $20,000 basis) as a capital gain.

Example 2. The facts are the same as in Example 1, except that Fred withdraws from the partnership when the adjusted basis of his interest in the partnership is zero. He is considered to have received a distribution of $15,000, his relief of liability. He reports a capital gain of $15,000.

Exchange of partnership interests. An exchange of partnership interests generally does not qualify as a nontaxable exchange of like-kind property. This applies regardless of whether they are general or limited partnership interests or interests in the same or different partnerships. However, under certain circumstances, such an exchange may be treated as a tax-free contribution of property to a partnership. See Contribution of Property under Transactions Between Partnership and Partners, earlier.

An interest in a partnership that has a valid election in effect under section 761(a) of the Internal Revenue Code to be excluded from the partnership rules of the Code is treated as an interest in each of the partnership assets and not as a partnership interest. See Exclusion From Partnership Rules, earlier.

Installment reporting for sale of partnership interest. A partner who sells a partnership interest at a gain may be able to report the sale on the installment method. For requirements and other information on installment sales, see Publication 537, Installment Sales.

The gain from the installment sale is treated as part capital gain and part ordinary income if the partnership's assets included unrealized receivables or inventory items. See Payments for Unrealized Receivables and Inventory Items, later. The gain allocable to unrealized receivables and inventory items is generally ordinary income and must be reported in the year of sale. The gain allocable to the other assets is capital gain and can be reported under the installment method.

Liquidation at Partner's Retirement or Death

Payments made by the partnership to a retiring partner or successor in interest of a deceased partner in return for the partner's entire interest in the partnership may have to be allocated between payments in liquidation of the partner's interest in partnership property and other payments. The partnership's payments include an assumption of the partner's share of partnership liabilities treated as a distribution of money.

For income tax purposes, a retiring partner or successor in interest of a deceased partner is treated as a partner until his or her interest in the partnership has been completely liquidated.

Liquidating payments. Payments made in liquidation of the interest of a retiring or deceased partner in exchange for his or her interest in partnership property are considered a distribution, not a distributive share or guaranteed payment that could give rise to a deduction (or its equivalent) for the partnership.

Unrealized receivables and goodwill. Payments made for the retiring or deceased partner's share of the partnership's unrealized receivables or goodwill are not treated as made in exchange for partnership property if both of the following tests are met.

• Capital is not a material income-producing factor for the partnership. (Whether capital is a material income-producing factor is explained in the discussion under Family Partnership near the beginning of this publication.)
• The retiring or deceased partner was a general partner in the partnership.

However, this rule does not apply to payments for goodwill to the extent that the partnership agreement provides for a reasonable payment to a retiring partner for goodwill.

Payments for unrealized receivables or goodwill are not treated as made in exchange for partnership property under any circumstance if the partner retired or died before January 5, 1993 (or retired on or after that date if a written contract to buy the partner's interest in the partnership was binding on January 4, 1993, and at all times thereafter).

Unrealized receivables are defined later under Payments for Unrealized Receivables and Inventory Items. However, for this purpose, they do not include the items listed in that discussion under Other items treated as unrealized receivables.

Partners' valuation. Generally, the partners' valuation of a partner's interest in partnership property in an arm's-length agreement will be treated as correct. If the valuation reflects only the partner's net interest in the property (total assets less liabilities), it must be adjusted so that both the value of and the basis for the partner's interest include the partner's share of partnership liabilities.

Gain or loss on distribution. Upon the receipt of the distribution, the retiring partner or successor in interest of a deceased partner will recognize gain only to the extent that any money (and marketable securities treated as money) distributed is more than the partner's adjusted basis in the partnership. The partner will recognize a loss only if the distribution is in money, unrealized receivables, and inventory items. No loss is recognized if any other property is received. See Partner's Gain or Loss under Partnership Distributions, earlier.

Other payments. Payments made by the partnership to a retiring partner or successor in interest of a deceased partner that are not made in exchange for an interest in partnership property are treated as distributive shares of partnership income or guaranteed payments. This rule applies regardless of the time over which the payments are to be made. It applies to payments made for the partner's share of unrealized receivables and goodwill not treated as a distribution.

If the amount is based on partnership income, the payment is taxable as a distributive share of partnership income. The payment retains the same character when reported by the recipient that it would have had if reported by the partnership. For more information, see Partner's Income or Loss, earlier.

If the amount is not based on partnership income, it is treated as a guaranteed payment. The recipient reports guaranteed payments as ordinary income. For additional information on guaranteed payments, see Transactions Between Partnership and Partners, earlier.

These payments are included in income by the recipient for his or her tax year that includes the end of the partnership tax year for which the payments are a distributive share or in which the partnership is entitled to deduct them as guaranteed payments.

Former partners who continue to make guaranteed periodic payments to satisfy the partnership's liability to a retired partner after the partnership is terminated can deduct the payments as a business expense in the year paid.

Payments for Unrealized Receivables and Inventory Items

If a partner receives money or property in exchange for any part of a partnership interest, the amount due to his or her share of the partnership's unrealized receivables or inventory items results in ordinary income or loss. This amount is treated as if it were received for the sale or exchange of property that is not a capital asset.

This treatment applies to the unrealized receivables part of payments to a retiring partner or successor in interest of a deceased partner only if that part is not treated as paid in exchange for partnership property. See Liquidation at Partner's Retirement or Death, earlier.

For a sale or exchange of a partnership interest before August 6, 1997, inventory must be substantially appreciated before it generates ordinary income (rather than capital gain). This also applies to any sale or exchange under a written contract that is in effect on June 8, 1997, and at all times thereafter before the sale or exchange. For the definition of "substantially appreciated," see Certain distributions treated as a sale or exchange under Partnership Distributions, earlier.

Unrealized receivables. Unrealized receivables include any rights to payment not already included in income for the following items.

• Goods delivered or to be delivered to the extent the payment would be treated as received for property other than a capital asset.
• Services rendered or to be rendered.

These rights must have arisen under a contract or agreement that existed at the time of sale or distribution, even though the partnership may not be able to enforce payment until a later date. For example, unrealized receivables include accounts receivable of a cash method partnership and rights to payment for work or goods begun but incomplete at the time of the sale or distribution of the partner's share.

The basis for any unrealized receivables includes all costs or expenses for the receivables that were paid or accrued but not previously taken into account under the partnership's method of accounting.

Other items treated as unrealized receivables. Unrealized receivables include potential gain that would be ordinary income if the following partnership property were sold at its fair market value on the date of the payment.

• Mining property for which exploration expenses were deducted.
• Stock in a Domestic International Sales Corporation (DISC).
• Certain farm land for which expenses for soil and water conservation or land clearing were deducted.
• Franchises, trademarks, or trade names.
• Oil, gas, or geothermal property for which intangible drilling and development costs were deducted.
• Stock of certain controlled foreign corporations.
• Market discount bonds and short-term obligations.
• Property subject to recapture of depreciation under sections 1245 and 1250 of the Internal Revenue Code. Depreciation recapture is discussed in chapter 3 of Publication 544.

Determining value. Generally, the sales price of unrealized receivables, or their value if received in a distribution treated as a sale or exchange, is determined by any arm's-length agreement between the buyer and the seller (or between the partnership and the partner receiving the distribution).

If no agreement exists, the price or value must be determined by taking into account both the estimated cost to complete performance of the contract or agreement and the time between the sale or distribution and the time of payment.

Example. You are a partner in ABC Partnership. The adjusted basis of your partnership interest at the end of the current year is zero. Your share of potential ordinary income from partnership depreciable property is $5,000. The partnership has no other unrealized receivables or inventory items. You sell your interest in the partnership for $10,000 in cash and you report the entire amount as a gain since your adjusted basis in the partnership is zero. You report as ordinary income your $5,000 share of potential ordinary income from the partnership's depreciable property. The remaining $5,000 gain is a capital gain.

Inventory items. Inventory items are not just stock-in-trade of the partnership. They also include the following property.

• Property that would properly be included in the partnership's inventory if on hand at the end of the tax year or that is held primarily for sale to customers in the normal course of business.
• Property that, if sold or exchanged by the partnership, would not be a capital asset or section 1231 property (real or depreciable business property held more than one year). For example, accounts receivable acquired for services or from the sale of inventory and unrealized receivables are inventory items.
• Property held by the partnership that would be considered inventory if held by the partner selling the partnership interest or receiving the distribution.

Notification required of partner. If a partner exchanges a partnership interest attributable to unrealized receivables or inventory for money or property, he or she must notify the partnership in writing. This must be done within 30 days of the transaction or, if earlier, by January 15 of the calendar year following the calendar year of the exchange. A partner may be subject to a $50 penalty for each failure to notify the partnership about such a transaction, unless the failure was due to reasonable cause and not willful neglect.

Information return required of partnership. When a partnership is notified of an exchange of partnership interests involving unrealized receivables or inventory items, the partnership must file Form 8308, Report of a Sale or Exchange of Certain Partnership Interests. Form 8308 is filed with Form 1065 for the tax year that includes the last day of the calendar year in which the exchange took place. If notified of an exchange after filing Form 1065, the partnership must file Form 8308 separately, within 30 days of the notification.

On Form 8308, the partnership states the date of the exchange and the names, addresses, and taxpayer identification numbers of the partnership filing the return and the transferee and transferor in the exchange. The partnership must also provide a copy of Form 8308 (or a written statement with the same information) to each transferee and transferor by the later of January 31 following the end of the calendar year or 30 days after it receives notice of the exchange.

The partnership may be subject to a penalty of up to $50 for each failure to timely file Form 8308 and a $50 penalty for each failure to furnish a copy of Form 8308 to a transferor or transferee, unless the failure is due to reasonable cause and not willful neglect. If the failure is intentional, a higher penalty may be imposed. See the form instructions for details.

Statement required of partner. If a partner sells or exchanges any part of an interest in a partnership having unrealized receivables or inventory, he or she must file a statement with his or her tax return for the year in which the sale or exchange occurs. The statement must contain the following information.

• The date of the sale or exchange, the partner's adjusted basis for the partnership interest, and the part of the basis that represents the unrealized receivables or inventory items.
• The money and fair market value of any other property the partner received or will receive for the interest in the partnership, and the part for the unrealized receivables or inventory items.
• The statement described earlier in Special adjustment to basis under Partner's Basis for Distributed Property, if the partner computes the basis for the unrealized receivables or inventory items under that provision.
• If the partnership used the optional basis adjustment, the computation described later under Adjusting the Basis of Partnership Property and a list of the partnership properties to which the adjustment has been allocated.

Partner's disposition of distributed unrealized receivables or inventory items. In general, any gain or loss on a sale or exchange of unrealized receivables or inventory items a partner received in a distribution is an ordinary gain or loss. For this purpose, inventory items do not include real or depreciable business property, even if they are not held more than 1 year.

Example. Mike, a distributee partner, received his share of accounts receivable when his law firm dissolved. The partnership used the cash method of accounting, so the receivables had a basis of zero. If Mike later collects the receivables or sells them, the amount he receives will be ordinary income.

Exception for inventory items held more than 5 years. If a distributee partner sells inventory items held for more than 5 years after the distribution, the type of gain or loss depends on how they are being used on the date sold. The gain or loss is capital gain or loss if the property is a capital asset in the partner's hands at the time sold.

Example. Ann receives, through dissolution of her partnership, inventory that has a basis of $19,000. Within 5 years, she sells the inventory for $24,000. The $5,000 gain is taxed as ordinary income. If she had held the inventory for more than 5 years, her gain would have been capital gain, provided the inventory was a capital asset in her hands at the time of sale.

Substituted basis property. If a distributee partner disposes of unrealized receivables or inventory items in a nonrecognition transaction, ordinary gain or loss treatment applies to a later disposition of any substituted basis property resulting from the transaction.

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