The hot-asset rule: Section 751
When you sell a partnership interest, the default tax treatment would be capital gain (or loss). Congress did not want taxpayers to convert what would be ordinary income — or 25% recapture — into lower-taxed capital gain simply by putting the property inside a partnership. Section 751 solves this with the hot-asset rule.
Hot assets include unrealized receivables and inventory items. For real estate, the critical hot assets are the embedded depreciation recapture potential: Section 1245 gain (ordinary income recapture on personal property) and Section 1250 unrecaptured gain (the 25% rate on real property). Your allocable share of these embedded gains in the partnership's assets is recognized as ordinary income (or 25% gain) when you sell your interest, even though you are technically selling a partnership interest and not the underlying real property.
How the calculation works
The partnership computes the total unrealized recapture gain in all its assets at the time of the sale. Your share of that amount (based on your partnership interest percentage and the allocations in the partnership agreement) is recharacterized from capital gain into 751 ordinary income or 1250 gain. Example: you own 30% of a partnership that holds a rental building with $400,000 of accumulated depreciation (Section 1250 potential). Your share of 1250 gain is $120,000. Regardless of the price you sell your interest for, you recognize $120,000 of 25% gain, not capital gain.
The partnership must file Form 8308 whenever a partnership interest is sold and Section 751 assets are present.
Buyer protections: Section 754 election
A buyer who purchases a partnership interest typically does not get a stepped-up basis in the partnership's underlying assets — they inherit the existing inside basis. If the partnership has a Section 754 election in place (or agrees to make one), the buyer receives an inside-basis adjustment (Section 743(b)) equal to the difference between the purchase price and their share of the partnership's inside basis. This reduces the buyer's future depreciation recapture exposure. Buyers acquiring significant interests in real estate partnerships should request a 754 election as part of the purchase negotiations.
Frequently asked questions
Is selling a partnership interest a capital gain?
Mostly yes, but the portion attributable to Section 751 hot assets — including embedded depreciation recapture — is taxed as ordinary income (Section 1245 recapture) or at the 25% rate (Section 1250 gain), not as capital gain.
What is Section 751 and how does it affect partnership sales?
Section 751 requires that the gain attributable to the partnership's hot assets (including unrealized depreciation recapture potential) be recognized as ordinary income or 25% gain when a partner sells their interest — preventing the conversion of recapture into capital gain.
What is a Section 754 election?
A 754 election allows a partnership to adjust the inside basis of its assets when a partnership interest changes hands, giving the buyer a basis that reflects what they paid — reducing their future depreciation recapture exposure.
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
- IRS Publication 946 — How to Depreciate Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.