Income Tax when You Sell an Interest in a Partnership

When you sell an interest in a partnership, the sale is generally considered the sale of a capital asset for federal income tax purposes. The capital gain or loss on the sale is the difference between the amount you realize on the sale and the adjusted basis of your interest in the partnership. The amount realized on the sale is the cash and the fair market value of any property you receive for your partnership interest. According to the IRS, if you are relieved of any partnership liabilities when you sell your interest, the amount of the debt relief is included in the amount you realize on the sale.

Your adjusted basis in the partnership is your initial investment in the partnership plus your share of the partnership's income minus your share of partnership losses. Your basis would be increased for any additional investments you make in the partnership and would be decreased for any withdrawals you make from the partnership.

As indicated by George Saenz, CPA, in Bankrate.com, you can find the amount in your individual capital account on Schedule K-1 (Form 1065) that the partnership issues at the end of the year. You would have to adjust this amount for any changes in your capital account since the end of the year, including your year-to-date share of partnership income or loss to determine your basis as of the date you sell your interest.

While the sale of an interest in a partnership normally results in a capital gain or loss, a portion of the gain or loss is considered ordinary income if the partnership has net unrealized receivables or inventory. According to the IRS, unrealized receivables include rights to payment for goods already delivered or to be delivered and for services already rendered or to be rendered. Inventory includes the partnership's stock in trade and property that would not be considered a capital asset, real or depreciable property held more than one year if it were sold or exchanged by the partnership.

As pointed out by Harvey Coustan for McGladrey, legislative regulations and judicial decisions have added to the types of items considered unrealized receivables, such as contracts to sell products or to provide services. Therefore, it is important to analyze the partnership's assets to determine whether there are any items that could result in tax as ordinary income for part of the gain on the sale of your partnership interest.

When you sell your partnership interest, the amount that you treat as ordinary income for unrealized receivables and inventory is the amount that would have been allocated to you if the partnership had sold all its assets for cash at fair market value at that time. In this case, you would have to attach a statement to your tax return indicating the date of the sale of your interest, the amount of gain or loss on unrealized receivables and inventory, and the capital gain or loss on the sale. The partnership has to file Form 8308, Report of a Sale or Exchange of Certain Partnership Interests with the Form 1065 filed for that tax year.

Sources:

George Saenz, CPA, Sale of a partnership investment, Bankrate.com

Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, IRS

Harvey Coustan, Sale of a Partnership Interest, McGladrey

Partnership - Audit Technique Guide - Chapter 7 - Dispositions of Partnership Interest (Rev. 3/2008), IRS

Publication 541, Partnerships, IRS