Depreciation Recapture When You Sell a Partnership Interest

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.

A full worked example: splitting the gain

Suppose you own a 25% interest in an LLC (taxed as a partnership) that owns a single apartment building. Your outside basis in the interest is $180,000, and you sell the interest for $450,000, producing a $270,000 total gain. If the sale were pure capital gain, all $270,000 would be long-term capital gain at 0/15/20%. But Section 751 intervenes. The partnership's books show $600,000 of accumulated straight-line depreciation on the building and $80,000 on cost-segregated 5- and 7-year components. Your 25% share of the unrealized recapture is $150,000 of unrecaptured Section 1250 gain (25% max rate) and $20,000 of Section 1245 ordinary recapture.

On the return, that $20,000 is taxed as ordinary income and $150,000 as 25%-rate gain; only the remaining $100,000 ($270,000 − $20,000 − $150,000) is taxed at ordinary long-term capital-gains rates. The character of your gain is reshuffled entirely by the assets inside the partnership — the sale price alone never tells you your tax bill.

Reporting: Form 8308 and the seller's return

The partnership has its own compliance duty. Under Section 6050K, it must file Form 8308 (Report of a Sale or Exchange of Certain Partnership Interests) and furnish a copy to both the transferring partner and the buyer whenever an interest is sold and the partnership holds Section 751 property. Recent versions of the form require the partnership to report the seller's share of ordinary gain and unrecaptured Section 1250 gain — the figures the selling partner needs to split the transaction correctly. The seller reports the overall disposition on Form 8949 and Schedule D, then breaks out the Section 751 ordinary portion as ordinary income (and the unrecaptured 1250 slice on the appropriate worksheet). If the partnership is slow to deliver the figures, the seller should still request the Section 751 statement, because guessing at the split is a common source of amended returns.

Redemptions and liquidating distributions are different

Selling your interest to a third party or to another partner is governed by Sections 741 and 751(a). A redemption — where the partnership itself buys out your interest — runs through Section 736 and the hot-asset distribution rules of Section 751(b) instead, and the mechanics differ. Payments for your share of partnership property (Section 736(b)) are generally treated as a distribution, while certain other payments (Section 736(a)) can be ordinary income or a distributive share. The recapture still cannot be washed into capital gain, but which Code section applies changes the timing and the paperwork. If you are being bought out by the entity rather than by an outside buyer, have the agreement drafted with these rules in mind.

Installment sales don't defer the recapture

Selling a partnership interest on the installment method (payments over more than one year) does not let you stretch the ordinary recapture. Under Section 453(i), depreciation recapture income must be reported in full in the year of sale, even if you collect the price over time — and the Section 751 ordinary component is generally treated the same way. Only the capital-gain portion of the interest sale can be spread under the installment method. So a seller financing a buyout can face a mismatch: ordinary recapture tax is due up front, while the cash trickles in over years. Model the cash flow before agreeing to installment terms.

Death of the partner erases the recapture trap

The step-transaction the recapture rules police at sale largely disappears at death. When a partner dies, the heirs take a stepped-up outside basis in the interest equal to its date-of-death fair market value, and if the partnership has a Section 754 election in place, Section 743(b) also steps up the heirs' share of the inside basis of the assets — wiping out the built-in depreciation recapture for the successor. Unlike a retirement account or other income-in-respect-of-a-decedent item, the embedded 1245/1250 recapture is generally eliminated rather than carried to the heirs. For a long-held, heavily depreciated real estate partnership, holding the interest until death can be dramatically more tax-efficient than selling during life.

The ordinary slice can exceed your overall gain

A counterintuitive result of Section 751: the ordinary-income portion is computed on the partnership's hot assets, not on your net gain — so you can owe ordinary tax even when your economic gain is modest, and in some cases recognize ordinary income offset by a capital loss. The rule works by hypothetically selling the partnership's Section 751 property at fair market value; your share of that ordinary income is fixed regardless of what you sold your interest for. If the partnership's non-hot assets have declined in value, you might report, say, $60,000 of ordinary Section 751 gain and a $15,000 capital loss on the balance of the interest, even though your total gain is only $45,000. Because a capital loss cannot offset ordinary income beyond $3,000 a year, this mismatch can produce a real cash-tax cost that a simple 'gain times capital-gains rate' estimate completely misses. Always ask the partnership for the Section 751 statement before you model the tax on an interest sale.

A checklist before you sell or buy an interest

For the seller: request the partnership's Section 751 hot-asset figures early; confirm whether the buyout is a third-party sale (Sections 741/751(a)) or an entity redemption (Sections 736/751(b)); model the split of the price into Section 1245 ordinary recapture, unrecaptured Section 1250 gain (25%), and residual capital gain before agreeing on price; and check whether the 3.8% net investment income tax and your state's rates apply to each slice. For the buyer: negotiate for a Section 754 election so you receive a Section 743(b) inside-basis step-up that reduces your future depreciation recapture, and confirm the partnership will actually make and maintain the election. For both: make sure the partnership files Form 8308 and furnishes the required statements on time, because the ordinary/capital split reported there drives each party's return. Getting these steps done before closing avoids the most common surprise — a far larger ordinary-income bill than the headline sale price suggested.

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.

What is Form 8308?

It is the report a partnership must file (and furnish to the buyer and seller) when a partnership interest is sold and the partnership holds Section 751 hot assets. Recent versions require the partnership to state the selling partner's share of ordinary gain and unrecaptured Section 1250 gain — the numbers you need to split the sale correctly on your return.

Can I use the installment method to spread the recapture tax?

No. Under Section 453(i), depreciation recapture — and generally the Section 751 ordinary portion — must be recognized in full in the year of sale, even if you collect the sale price over several years. Only the capital-gain portion of the interest can be reported on the installment method.

Does the Section 751 recapture pass to my heirs if I die owning the interest?

Generally no. Heirs take a stepped-up outside basis at date-of-death value, and with a Section 754 election in place the inside basis of the partnership's assets also steps up under Section 743(b), eliminating the built-in depreciation recapture for the successor.

Is a redemption by the partnership taxed the same as a sale to a buyer?

Not exactly. A redemption is governed by Section 736 and the hot-asset distribution rules of Section 751(b), rather than the Section 741/751(a) rules that apply to a sale to a third party. The recapture still cannot be converted to capital gain, but the timing and reporting differ, so the buyout agreement should be drafted accordingly.

Sources

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.