When a partner sells or exchanges his partnership interest, the partner generally recognizes a capital gain or loss on the sale. The exception to this rule is where the amount received by the partner is attributed to unrealized receivables or inventory. If the partnership were to sell these assets, also known as “hot assets,” it would recognize ordinary income or loss on the sale. Therefore, in the sale or exchange of a partnership interest, amounts attributed to the partner’s share of hot assets are generally subject to ordinary income tax treatment. This prevents a partner from transforming ordinary income to capital gain through the sale of the partnership interest.
Because of the special tax treatment reserved for hot assets, it is crucial that practitioners and producers clearly understand which assets fall into these categories of hot assets. This article sets forth general guidelines for identifying and categorizing unrealized receivables and inventory in a farm partnership. It does not attempt to provide a detailed roadmap for this process. Nor does it attempt to address the complex allocation rules accompanying partnership distributions, disproportionate distributions, or liquidations.
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Identifying Unrealized Receivables and Inventory in Farm Partnership Interest Dispositions (PDF)