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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Chapter 21
Dispositions of Partnership Interests and Partnership Distributions
SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] Joey is a 25% owner of Loopy LLC. He no longer wants to be involved in the
business. What options does Joey have to exit the business?
Answer:
Joeys two most common options are to sell or exchange his interest in the LLC to a
third party or to have the LLC liquidate his interest. Joey may also exchange his
interest for corporate stock, give the interest away, or transfer the interest upon his
death.
2. [LO 1] Compare and contrast the aggregate and entity approaches for a sale of a
partnership interest.
Answer:
Under the aggregate approach, the disposition of a partnership interest represents a
sale of the partners share of each of the partnership assets. This approach would
require complex tax rules because the partner would need to allocate the sales proceeds
among the different assets and determine the character of the gain or loss from each
asset.
Under the entity approach, the sale of a partnership interest would be very similar to
the sale of corporate stock. The partner would recognize capital gain or loss on the sale
based on the difference between the sales price and the partners tax basis in the
partnership interest.
3. [LO 1] What restrictions might prevent a partner from selling his partnership interest to a
third party?
Answer:
Partnership agreements may specify whether a partner may voluntarily leave the
partnership. If the agreement does not allow for a voluntary withdrawal, the
partnership may need to be dissolved to effect the termination.
A partnership agreement may also specify whether a partner may assign his interest to
a third party. This will determine if the partner is free to sell his interest to someone
other than the existing partners.

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

4. [LO 1] Explain how a partners debt relief affects his amount realized in a sale of
partnership interest.
Answer:
When a partner sells his partnership interest, often he is relieved of his partnership
debt obligations. As is the case in sales of other assets, debt relief will increase the
amount realized in the sale of a partnership interest. Because the partners outside
basis includes his share of the partnership debt, this negates the effect of debt on the
gain or loss of the partnership interest sale.
5.

[LO 1] Under what circumstances will the gain or loss on the sale of a partnership
interest be characterized as ordinary rather than capital?

Answer:
To the extent that a gain or loss on the sale of a partnership interest is attributable to
certain ordinary income assets held by the partnership, the gain or loss is ordinary.
751(a) defines the assets for which the gain or loss will be treated as ordinary.
6. [LO 1] What are hot assets and why are they important in the sale of a partnership
interest?
Answer:
Hot assets are assets defined in 751 that will re-characterize the portion of a gain or
loss on the sale of a partnership interest as ordinary. The two categories of hot assets
under 751(a) are unrealized receivables and inventory items. Unrealized receivables
include rights to receive payment for goods delivered or to be delivered, rights for
services rendered or to be rendered, and items treated as ordinary income if the
partnership were to sell the item at its fair market value.
Under 751(a) inventory items include property held for sale to customers in the
ordinary course of business and assets that are not capital assets or 1231 assets that
would produce ordinary income if sold by the partnership. To the extent that a seller
realizes any amounts from the sale of his partnership interest that are attributable to
these unrealized receivables or inventory items, the gain or loss will be classified as
ordinary.
7. [LO 1] For an accrual-method partnership, are accounts receivable considered unrealized
receivables? Explain.
Answer:
No. For accrual-method taxpayers, accounts receivable are not considered unrealized
receivables because these amounts have already been realized and recognized as
ordinary income.

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

8. [LO 1] Can a partnership have unrealized receivables if it has no accounts receivable?


Answer:
The definition of unrealized receivables is broad enough to encompass assets other
than accounts receivable. 751(a) also includes assets that are NOT capital assets or
1231 assets that would produce ordinary income if sold by the partnership. Items
such as depreciation recapture are also classified as unrealized receivables. Thus, a
partnership can have unrealized receivables without having accounts receivable.
9. [LO 1] How do hot assets affect the character of gain or loss on the sale of a partnership
interest?
Answer:
Hot assets cause a portion of the gain or loss on the sale of a partnership interest to be
classified as ordinary rather than capital.
10. [LO 1] Under what circumstances can a partner recognize both gain and loss on the sale
of a partnership interest?
Answer:
A partner may recognize both gain and loss on the sale of a partnership interest in the
situation where a partners share of the unrealized gain in hot assets is greater than his
total gain or loss on the sale of his partnership interest.
11. [LO 1] Absent any special elections, what effect does a sale of partnership interest have
on the partnership?
Answer:
When one partner sells his partnership interest, the sale generally has no effect on the
partnership. However, if the partnership interest that is sold is large, the sale may
terminate the partnership for tax purposes.
12. [LO 1] {Research} Generally, a selling partners capital account carries over to the
purchaser of the partnership interest. Under what circumstances will this not be the case?
Answer:
In the case where the selling partner contributed built-in loss property to the
partnership, the buyers capital account will be reduced by the amount of the inherent
loss at the partnership interest sale date. This treatment ensures that only the partner
that contributed the built-in loss property to the partnership benefits from the
inherent loss.
13. [LO 2] What distinguishes operating from liquidating distributions?

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Answer:
Operating or current distributions are made to partners whose interests in the
partnership continue after the distribution. Liquidating distributions terminate a
partners interest in the partnership.
14. [LO 3] Under what circumstances will a partner recognize a gain from an operating
distribution?
Answer:
In general, partners do not recognize gain or loss from operating distributions.
However, when the partnership distributes money that exceeds a partners basis in her
partnership interest, she will recognize a gain equal to the excess. In this situation, the
partner is unable to adjust the basis in property distributed in order to defer the gain.
15. [LO 3] Under what circumstances will a partner recognize a loss from an operating
distribution?
Answer:
A partner never recognizes loss from operating distributions.
16. [LO 3] In general, what effect does an operating distribution have on the partnership?
Answer:
The partnership does not generally recognize gain or loss for tax purposes when
making an operating distribution. This contrasts with the tax treatment of corporate
distributions in which the corporation recognizes gain or loss on distributions of
property other than cash.
17. [LO 3] If a partners outside basis is less than the partnerships inside basis in distributed
assets, how does the partner determine his basis of the distributed assets in an operating
distribution?
Answer:
If only money is distributed, the partner recognizes gain equal to the difference
between the money distributed and the basis in the partnership interest. If the
partnership distributes money and hot assets only, the partner defers gain recognition
by reducing the basis of the hot assets distributed. The partner first allocates basis to
the assets received equal to the partnership basis (allocating to money first). Then, the
partner allocates the required decrease (difference between the partnerships basis in
the distributed assets and the partners outside basis) to the assets with unrealized
depreciation. Finally, the partner allocates any remaining required decrease to the
distributed assets in proportion to their adjusted bases.
If the partnership distributes other property in addition to money and hot assets, the
partner defers gain by reducing the basis in the other property distributed. The
partner first assigns basis to the distributed assets equal to the partnership basis. The
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

partner then allocates the required decrease to property other than money, inventory
and unrealized receivables to the extent of the unrealized depreciation in the assets.
Finally, the partner allocates any remaining required decrease to the other property in
proportion to the assets adjusted bases.
18. [LO 4] Under what conditions will a partner recognize gain in a liquidating distribution?
Answer:
In the situation in which a partnership distributes only money and the amount exceeds
the partners basis in her partnership interest, she will recognize a gain equal to the
excess. In this situation, the partner is unable to adjust the basis in property
distributed in order to defer the gain.
19. [LO 4] Under what conditions will a partner recognize loss in a liquidating distribution?
Answer:
When a distribution includes only cash, unrealized receivables, and inventory and the
partners basis in his partnership interest is greater than the sum of the bases of the
distributed assets, the partner will recognize a loss on a liquidating distribution. The
partner treats the loss as a capital loss.
20. [LO 4] Describe how a partner determines his basis in distributed assets in cases in which
a partnership distributes only money, inventory, and/or unrealized receivables in a
liquidating distribution.
Answer:
If the partners basis in the partnership interest is greater than the basis of the
distributed assets, the partner is unable to defer loss without changing the character of
the loss. Therefore, the partner assigns a basis to the money, inventory, and unrealized
receivables equal to the partnerships basis in the distributed assets. The partner
recognizes a capital loss equal to the remaining outside basis after the distributed
assets have been assigned a carryover basis.
If the partners basis in the partnership interest is less than the basis of the distributed
assets, the partner defers gain recognition by reducing the basis of the hot assets
distributed. The required decrease is equal to the difference between the partnerships
basis in the distributed assets and the partners outside basis. The partner allocates the
required decrease to assets with unrealized depreciation first to eliminate existing
losses in the distributed assets. Then the partner allocates any remaining required
decrease to the distributed assets in proportion to their adjusted bases.
21. [LO 4] How does a partner determine his basis in distributed assets when the partnership
distributes other property in addition to money and hot assets?
Answer:
If the partners basis in the partnership interest is greater than the basis of the
distributed assets, the partner defers loss recognition by increasing the basis of the
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

other property distributed. The required increase equals the difference between the
partners outside basis and the partnership bases in the distributed assets. The partner
first assigns a basis to the distributed assets equal to the partnerships basis. The
partner then allocates the required increase to the other property with unrealized
appreciation. Finally, the partner allocates any remaining required increase to the
other property in proportion to their fair market values.
When the partnership distributes other property in addition to money, inventory, and
unrealized receivables and the partners basis in the partnership interest is less than
the basis of the distributed assets, the partner defers gain by reducing the basis in the
other property distributed. The partner first assigns basis to the distributed assets
equal to the partnership basis. The partner then allocates the required decrease to
property other than money, inventory and unrealized receivables to the extent of the
unrealized depreciation in the assets. Finally, the partner allocates any remaining
required decrease to the other property in proportion to the assets adjusted bases.
22. [LO 5] {Planning} SBT partnership distributes $5,000 cash and a parcel of land with a
fair market value of $40,000 and a $25,000 basis to the partnership to Sam (30% partner).
What factors must Sam and SBT consider in determining the tax treatment of this
distribution?
Answer:
SBT and Sam must determine if the distribution is an operating or a liquidating
distribution. Sam may not recognize a loss if the distribution is an operating
distribution. Sam must also consider whether the distributed cash exceeds her basis in
SBT. If so, she will recognize a gain on the distribution.
SBT and Sam must also consider whether the distribution is a disproportionate
distribution. To the extent that SBT has any hot assets, this distribution to Sam will
represent a disproportionate distribution that can cause both Sam and SBT to recognize
gain or loss on the distribution. Finally, Sam must determine her basis in the distributed
land. Her determination of basis will depend on whether the distribution is an operating
or a liquidating distribution.
23. [LO 5] Discuss the underlying concern to tax policy makers in distributions in which a
partner receives more or less than his share of the partnership hot assets.
Answer:
If a partners share of hot assets is altered from a distribution, the primary concern is
that the partner will convert capital gain or loss to an ordinary gain or loss. Thus if a
partnership has 751 property, the partnership must determine whether any
distribution is proportionate or disproportionate. If the distribution is
disproportionate, the tax rules require the application of a complex set of rules to
ensure that the distributee partner recognizes a proportionate amount of ordinary and
capital gain or loss commiserate to his interest in the partnership.

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Most operating distributions are proportionate and do not require the application of
these rules. However, in cases where a partner is reducing his interest in the
partnership (e.g., from 40% to 25%) or in liquidating distributions, the application of
these rules is more commonplace.
24. [LO 5] In general, how do the disproportionate distribution rules ensure that partners
recognize their share of partnership ordinary income?
Answer:
Basically, the tax rules require partners to treat disproportionate distributions as
though three separate events occur. To illustrate, assume a partners interest in the
partnership hot assets decreases as a result of the distribution. First, the partner is
treated as though a hypothetical current distribution of the hot assets occurs. The
partner is treated as though she receives the fair market value of the decrease in hot
assets as a current distribution.
Next, the rules require the partner to act as though she has sold the hot assets received
in the hypothetical distribution to the partnership for an amount equal to the amount
of the cold assets that her interest increases.
Finally, the last step is to treat the amount of the distribution that is proportionate as a
normal distribution.
25. [LO 6] {Planning} Why would a new partner who pays more for a partnership interest
than the selling partners outside basis want the partnership to elect a special basis
adjustment?
Answer:
An investor who pays more for a partnership interest than the sellers outside basis
essentially has already paid for his share of any appreciation in the partnerships
assets. However, absent a special basis adjustment, the buyer inherits the sellers inside
basis, which does not reflect the gain realized on the sale of the partnership interest.
As the partnership sells the appreciated assets, the partners recognize their share of
the gain from the appreciated assets as a part of their annual distributive share of the
partnership income.
This means that the buyer pays for the appreciation of the assets as part of the
acquisition price of the partnership interest AND recognizes gain again when the
partnership recognizes income from the sale of the appreciated assets. Only upon the
sale of his partnership interest will the over-taxation resolve itself. The special basis
adjustment under 754 eliminates the disparity between a new partners inside and
outside basis.
26. [LO 6] List two common situations that will cause a partners inside and outside basis to
differ.
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Answer:
The most common situations in which discrepancies between inside and outside bases
occur are following sales of partnership interests and following distributions in which
a partner receives more or less than her share of the inside basis in the partnership
property.
27. [LO 6] Explain why a partnership might not want to make a 754 election to allow
special basis adjustments.
Answer:
Once the partnership makes a 754 election, the election is binding for all future sales
and distributions. The election may only be revoked with the consent of the IRS. The
election may not always be advantageous and limits the partnerships and partners
ability to tax plan. For example, if partnership assets decrease in value, an incoming
partner will have a downward basis adjustment.
28. [LO 6] When might a new partner have an upward basis adjustment following the
acquisition of a partnership interest?
Answer:
A new partner will have an overall upward basis adjustment when he purchases an
interest in the partnership for an amount greater than his inside basis immediately
following the acquisition. Although the overall basis adjustment results in an increase
in asset bases, it is possible for some individual asset bases to decrease if the asset has
declined in value while held by the partnership.
29. [LO 6] Are special basis adjustments mandatory? If so, when?
Answer:
Two cases require a mandatory special basis adjustment. First, when a partnership
has a substantial built-in loss at the time of a sale of a partnership interest, the
adjustment is required. A substantial built-in loss occurs when the partnerships
adjusted basis in its assets exceeds the fair market value of the assets by more than
$250,000.
The second case where a mandatory special basis adjustment must be made is for
distributions where there is a substantial basis reduction. A substantial basis reduction
exists if the negative adjustments from a special basis adjustment exceed $250,000.
Recall that negative basis adjustments only occur in liquidating distributions.

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Problems
30. [LO 1] Jerry is a 30% partner in the JJM Partnership when he sells his entire interest to
Lucia for $56,000 cash. At the time of the sale, Jerrys basis in JJM is $32,000. JJM does
not have any debt or hot assets. What is Jerrys gain or loss on the sale of his interest?
Answer:
Jerry will determine his gain or loss as the difference between the amount realized on
the sale and his basis in the partnership interest.
Amount realized
$ 56,000
Less: Adjusted basis
(32,000)
Gain recognized on the sale
$24,000
31. [LO 1] Joy is a 30% partner in the JOM Partnership when she sells her entire interest to
Hope for $72,000 cash. At the time of the sale, Joys basis in JOM is $44,000 (which
includes her $6,000 share of JOM liabilities). JOM does not have any hot assets. What is
Joys gain or loss on the sale of her interest?
Answer:
Joy determines her gain or loss as follows:
Amount realized
Cash
$72,000
Debt relief
6,000
Less: Outside basis in JOM
Gain recognized on the sale

$78,000
(44,000)
$34,000

32. [LO 1] Allison, Keesha, and Steven each own equal interests in KAS partnership, a
calendar year-end, cash-method entity. On January 1 of the current year, Stevens basis in
his partnership interest is $27,000. During January and February, the partnership
generates $30,000 of ordinary income and $4,500 of tax exempt income. On March 1,
Steven sells his partnership interest to Juan for a cash payment of $45,000. The
partnership has the following assets and no liabilities at the sale date:
Cash
Land held for investment
Totals

Basis
$ 30,000
30,000
$ 60,000

FMV
$ 30,000
60,000
$ 90,000

a. Assuming KASs operating agreement provides for an interim closing of the books
when partners interests change during the year, what is Stevens basis in his
partnership interest on March 1 just prior to the sale?
b. What is the amount and character of Stevens recognized gain or loss on the sale?

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

c. What is Juans basis in the partnership interest?


d. What is the partnerships basis in the assets following the sale?
Answer:
a.

Outside basis as of January 1:


Plus: distributive share of income
Ordinary
Tax exempt
Outside basis as of March 1:

$ 27,000

b.

Amount realized:
Less: basis in partnership interest
Capital gain

$ 45,000
(38,500)
$ 6,500

c.

Juans basis in his partnership interest is his cost of $45,000.

d.

The partnership has a basis in its assets equal to the assets before the sale. The sale
does not affect the partnerships basis in its assets.

10,000
1,500
$ 38,500

33. [LO 1] Grace, James, Helen, and Charles each own equal interests in GJHC partnership, a
calendar year-end, cash-method entity. On January 1 of the current year, James basis in
his partnership interest is $62,000. For the taxable year, the partnership generates
$80,000 of ordinary income and $30,000 of dividend income. For the first 5 months of
the year, GJHC generates $25,000 of ordinary income and no dividend income. On June
1, James sells his partnership interest to Robert for a cash payment of $70,000. The
partnership has the following assets and no liabilities at the sale date:
Cash
Land held for investment
Totals

Basis
$ 27,000
80,000
$ 107,000

FMV
$ 27,000
100,000
$ 127,000

a. Assuming GJHCs operating agreement provides that the proration method will be used
to allocate income or loss when partners interests change during the year, what is
James basis in his partnership interest on March 1 just prior to the sale?
b. What is the amount and character of James recognized gain or loss on the sale?
c. If GJHC uses an interim closing of the books, what is the amount and character of
James recognized gain or loss on the sale?

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Answer:
a.

Outside basis as of January 1:


$ 62,000
Plus: distributive share of income
Ordinary ($80,000 x 25% x 5/12) 8,333
Dividend ($30,000 x 25% x 5/12) 3,125
Outside basis as of June 1:
$ 73,458

b.

Amount realized:
Less: basis in partnership interest
Capital loss

$ 70,000
(73,458)
$ (3,458)

c.

Outside basis as of January 1:


Plus: distributive share of income
Ordinary ($25,000 x 25%)
Outside basis as of June 1:

$ 62,000

Amount realized:
Less: basis in partnership interest
Capital gain

$ 70,000
(68,250)
$ 1,750

6,250
$ 68,250

34. [LO 1] At the end of last year, Lisa, a 35% partner in the five-person LAMEC
partnership, has an outside basis of $60,000 including her $30,000 share of LAMEC debt.
On January 1 of the current year, Lisa sells her partnership interest to MaryLynn for a
cash payment of $45,000 and the assumption of her share of LAMECs debt.
a. What is the amount and character of Lisas recognized gain or loss on the sale?
b. If LAMEC has $100,000 of unrealized receivables as of the sale date, what is the
amount and character of Lisas recognized gain or loss?
c. What is MaryLynns basis in the partnership interest?
Answer:
a.

b.

Amount realized:
Cash
Debt relief
Less: basis in partnership interest
Lisas recognized capital gain

$ 45,000
30,000

$75,000
(60,000)
$ 15,000

Lisas share of unrealized receivables is $35,000 ($100,000 unrealized receivables


35% interest). Lisa will recognize $35,000 of ordinary income and a $20,000 capital
loss determined as:

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Total gain
Less: Ordinary income
Lisas recognized capital loss
c.

$ 15,000
(35,000)
$ (20,000)

MaryLynns basis in her partnership interest is $75,000 (cash of $45,000 plus her
$30,000 share of LAMECs debt).
35. [LO 1] Marco, Jaclyn, and Carrie formed Daxing partnership (a calendar year-end entity)
by contributing cash 10 years ago. Each partner owns an equal interest in the partnership.
Marco, Jaclyn, and Carrie each have an outside basis in his/her partnership interest of
$104,000. On January 1 of the current year, Marco sells his partnership interest to Ryan
for a cash payment of $137,000. The partnership has the following assets and no
liabilities as of the sale date:
Cash
Accounts receivable
Inventory
Equipment
Stock investment
Totals

Basis
$ 18,000
-069,000
180,000
45,000
$ 312,000

Fair Market Value


$ 18,000
12,000
81,000
225,000
75,000
$ 411,000

The equipment was purchased for $240,000 and the partnership has taken $60,000 of
depreciation. The stock was purchased 7 years ago.
a. What are the hot assets (751(a)) for this sale?
b. What is Marcos gain or loss on the sale of his partnership interest?
c. What is the character of Marcos gain or loss?
d. What is Ryans inside and outside bases in the partnership on the date of the sale?
Answer:
a.

The hot assets include the potential depreciation recapture in the equipment
($45,000), the accounts receivable, and the inventory.

b.

Amount realized:
$ 137,000
Less: basis in partnership interest
(104,000)
Marcos realized and recognized gain $ 33,000

c.

To the extent Marco realizes any amounts attributable to hot assets, his gain will be
classified as ordinary. If Daxing sold its assets for their fair market value at the sale
date, the ordinary gain would be as follows:
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Accounts receivable
Inventory
Equipment

Tax basis
$ -069,000
180,000

Total gain
Less: ordinary gain
Capital gain

$ 33,000
(23,000)
$10,000

FMV
$ 12,000
81,000
225,000

Gain/Loss Marks share


$ 12,000
$4,000
12,000
4,000
45,000
15,000
$ 69,000
$ 23,000

Marco recognizes $23,000 of ordinary income and $10,000 capital gain from the sale
of his interest in Daxing.
d.

Ryan has an outside basis equal to his cost of the partnership interest: $137,000. His
inside basis is equal to Marcos inside basis before the sale: $104,000.

Note: The partnership in problem 35 uses the cash method of accounting under Rev Proc
2001-10, which permits certain small businesses to treat inventory items as nonincidental materials and supplies.
36. [LO 1] Franklin, Jefferson, and Washington formed the Independence Partnership (a
calendar-year-end) by contributing cash 10 years ago. Each partner owns an equal interest
in the partnership. Franklin, Jefferson, and Washington each have an outside basis in his
partnership interest of $104,000. On January 1 of the current year, Franklin sells his
partnership interest to Adams for a cash payment of $122,000. The partnership has the
following assets and no liabilities as of the sale date:
Cash
Accounts receivable
Inventory
Equipment
Stock investment
Totals

Basis
$ 18,000
-069,000
180,000
45,000
$ 312,000

Fair Market Value


$ 18,000
12,000
81,000
225,000
30,000
$ 366,000

The equipment was purchased for $240,000 and the partnership has taken $60,000 of
depreciation. The stock was purchased 7 years ago.
a. What is Franklins overall gain or loss on the sale of his partnership interest?
b. What is the character of Franklins gain or loss?
Answer:
a.

Amount realized:
Less: basis in partnership interest
Franklins realized and recognized gain

$ 122,000
(104,000)
$ 18,000

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

b.

To the extent Franklin realizes any amounts attributable to hot assets, his gain will
be classified as ordinary. If Independence sold its assets for their fair market value
at the sale date, the ordinary gain would be as follows:
Accounts receivable
Inventory
Equipment

Tax basis
$ -069,000
180,000

Total gain
Less: ordinary gain
Capital loss

$ 18,000
(23,000)
$(5,000)

FMV Gain/Loss Franklins share


$ 12,000
$ 12,000
$4,000
81,000
12,000
4,000
225,000
45,000
15,000
$ 69,000
$ 23,000

Franklin recognizes $23,000 of ordinary income and a $5,000 capital loss from the
sale of his interest in Independence.
Note: The partnership in problem 36 uses the cash method of accounting under Rev Proc
2001-10, which permits certain small businesses to treat inventory items as nonincidental materials and supplies.
37. [LO 1] Travis and Alix Weber are equal partners in the Tralix partnership, which does not
have a 754 election in place. Alix sells one-half of her interest (25%) to Michael Tomei
for $30,000 cash. Just before the sale, Alixs basis in her entire partnership interest is
$75,000 including her $30,000 share of the partnership liabilities. Tralixs assets on the
sale date are as follows:
Cash
Inventory
Land held for investment
Totals

Basis
$ 40,000
30,000
80,000
$ 150,000

Fair Market Value


$ 40,000
90,000
50,000
$ 180,000

a. What is the amount and character of Alixs recognized gain or loss on the sale?
b. What is Alixs basis in her remaining partnership interest?
c. What is Michaels basis in his partnership interest?
d. What is the effect of the sale on the partnerships basis in the assets?
Answer:
a.

Amount realized:
Cash
$ 30,000
Debt relief (1/2 of $30,000)
15,000
Less: basis in partnership interest (1/2 of $75,000)
Alixs realized and recognized gain

$ 45,000
(37,500)
$ 7,500

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

To the extent Alix realizes any amounts attributable to hot assets, her gain will be
classified as ordinary. If Tralix sold its assets for their fair market value at the sale
date, the ordinary gain would be as follows:
Inventory

Tax basis
$ 30,000

Total gain
Less: ordinary gain
Capital loss

$ 7,500
(15,000)
$(7,500)

FMV
$ 90,000

Gain/Loss
$ 60,000

Alixs 25%
$ 15,000

Alix recognizes $15,000 of ordinary income and a $7,500 capital loss from the sale of
half of her interest in Tralix.
b.

Alix has a remaining basis in Tralix of $37,500.

c.

Michael has an outside basis in his 25% interest in Tralix equal to his $30,000 cash
payment plus his share of Tralix's debt $15,000 ($30,000 x 50%) for a total basis of
$45,000".

d.

The sale has no effect on Tralixs basis in its assets.


38. [LO 1] Newton is a one-third owner of ProRite Partnership. Newton has decided to sell
his interest in the business to Betty for $50,000 cash plus the assumption of his share of
ProRites liabilities. Assume Newtons inside and outside basis in ProRite are equal.
ProRite shows the following balance sheet as of the sale date:
Assets:
Cash
Receivables
Inventory
Land
Totals
Liabilities and capital:
Liabilities
Capital Newton
Barbara
Liz
Totals

Basis
$ 80,000
25,000
40,000
30,000
$ 175,000

FMV
$ 80,000
25,000
85,000
20,000
$ 210,000

$ 60,000
38,333
38,334
38,333
$ 175,000

What is the amount and character of Newtons recognized gain or loss?


Answer:
Amount realized:
Cash
Debt relief (1/3 of $60,000)

$ 50,000
20,000

$ 70,000

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Less: basis in partnership interest (including liabilities)(58,333)


Newtons realized and recognized gain
$11,667
To the extent Newton realizes any amounts attributable to hot assets, his gain will be
classified as ordinary. If ProRite sold its assets for their fair market value at the sale
date, the ordinary gain would be as follows:
Inventory

Tax basis
$ 40,000

Total gain
Less: ordinary gain
Capital loss

$ 11,667
(15,000)
$(3,333)

FMV
$ 85,000

Gain/Loss
$ 45,000

Newtons 1/3
$ 15,000

Newton recognizes $15,000 of ordinary income and a $3,333 capital loss from the
sale of his interest in ProRite.
39. [LO 3] Coy and Matt are equal partners in the Matcoy Partnership. Each partner has a
basis in his partnership interest of $28,000 at the end of the current year, prior to any
distribution. On December 31, they each receive an operating distribution. Coy receives
$10,000 cash. Matt receives $3,000 cash and a parcel of land with a $7,000 fair market
value and a $4,000 basis to the partnership. Matcoy has no debt or hot assets.
a. What is Coys recognized gain or loss? What is the character of any gain or loss?
b. What is Coys ending basis in his partnership interest?
c. What is Matts recognized gain or loss? What is the character of any gain or loss?
d. What is Matts basis in the distributed property?
e. What is Matts ending basis in his partnership interest?
Answer:
a.

Coy does not recognize any gain or loss on the current distribution.

b.

Coy reallocates his basis in Matcoy to the cash in an amount equal to the
distribution, $10,000. His remaining basis in Matcoy is $18,000 ($28,000 - 10,000).
Basis before distribution
Less: Amount allocated to cash
Equals: basis in partnership interest

c.

$ 28,000
(10,000)
$ 18,000

Matt does not recognize any gain or loss on the current distribution.

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

d.

Matt takes a carryover basis in the distributed property. The cash has a basis equal
to $3,000 and the land has a basis equal to $4,000 (Matcoys basis in the land).

e.

Matt reallocates his basis in Matcoy to the cash in an amount equal to the
distribution, $3,000. Matt takes a carryover basis in the land and allocates $4,000 of
his Matcoy basis to the land. His remaining basis in Matcoy is $21,000 ($28,000 3,000 4,000).
Basis before distribution
Less: Amount allocated to cash
Amount allocated to land
Equals: basis in partnership interest

$ 28,000
(3,000)
25,000
(4,000)
$ 21,000

40. [LO 3] Justin and Lauren are equal partners in the PJenn Partnership. The partners
formed the partnership seven years ago by contributing cash. Prior to any distributions,
the partners have the following bases in their partnership interests:
Partner
Justin
Lauren

Outside Basis
$ 22,000
22,000

On December 31 of the current year, the partnership makes a pro-rata operating


distribution of:
Partner
Justin
Lauren
Property

Distribution
Cash $ 25,000
Cash 18,000
7,000 (FMV) ($2,000 basis to partnership)

a. What is the amount and character of Justins recognized gain or loss?


b. What is Justins remaining basis in his partnership interest?
c. What is the amount and character of Laurens recognized gain or loss?
d. What is Laurens basis in the distributed assets?
e. What is Laurens remaining basis in her partnership interest?
Answer:
a.

Because Justin receives only money in the distribution and the distribution exceeds
his basis in the partnership, he must recognize a gain on the current distribution.
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Justin calculates his gain as the difference between his basis in the partnership and
the distribution.
Distribution of money
Less: Basis in PJenn
Gain (capital)

$ 25,000
(22,000)
$3,000

b.

Justin allocates his entire outside basis to the basis in the money received and
therefore he has a zero basis remaining in his partnership interest.

c.

Lauren does not recognize any gain or loss on the current distribution.

d.

Lauren takes a carryover basis in the assets distributed. She receives $18,000 cash so
she reduces her basis in PJenn by this amount. This leaves an outside basis of $4,000
($22,000 18,000). Lauren assigns a basis of $2,000 to the property distributed as
this is PJenns basis.

e.

Laurens basis in PJenn following the distribution is $2,000, determined as follows:


Basis in PJenn
Less: Cash distribution
Property
Remaining basis in PJenn

$22,000
(18,000)
(2,000)
$2,000

41. [LO 3] Adam and Alyssa are equal partners in the PartiPilo Partnership. The partners
formed the partnership three years ago by contributing cash. Prior to any distributions,
the partners have the following bases in their partnership interests:
Partner
Adam
Alyssa

Outside Basis
$ 12,000
12,000

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

On December 31 of the current year, the partnership makes a pro-rata operating


distribution of:
Partner
Adam
Alyssa

Distribution
Cash $ 16,000
Cash
Property

8,000
8,000 (FMV) ($6,000 basis to partnership)

a. What is the amount and character of Adams recognized gain or loss?


b. What is Adams remaining basis in his partnership interest?
c. What is the amount and character of Alyssas recognized gain or loss?
d. What is Alyssas basis in the distributed assets?
e. What is Alyssas remaining basis in her partnership interest?
Answer:
a.

Because Adam receives only money in the distribution and the distribution exceeds
his basis in PartiPilo, he must recognize a gain on the current distribution. Adam
calculates his gain as the difference between his basis in the partnership and the
distribution.
Distribution of money
Less: Basis in Partipilo
Gain (capital)

$ 16,000
(12,000)
$4,000

b.

Adam allocates his entire outside basis to the basis in the money received and
therefore he has a zero basis remaining in his partnership interest.

c.

Alyssa does not recognize any gain or loss on the current distribution.

d.

Alyssa reduces her basis in PartiPilo by $8,000 for the cash distribution, which
leaves her with a basis of $4,000. Alyssa assigns a $4,000 basis to the property (a
reduction of $2,000).

e.

Alyssa reduces her basis in Partipilo to $-0- after the distribution.


Basis in PartiPilo
Less: Cash distribution
Property
Remaining basis in PartiPilo

$12,000
(8,000)
(4,000)
$-0-

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

42. [LO 3] Karen has a $68,000 basis in her 50% partnership interest in the KD Partnership
before receiving a current distribution of $6,000 cash and land with a fair market value of
$35,000 and a basis to the partnership of $18,000.
a. What is the amount and character of Karens recognized gain or loss?
b. What is Karens basis in the land?
c. What is Karens remaining basis in her partnership interest?
Answer:
a.

Karen does not recognize any gain or loss on the current distribution.

b.

Karen takes a carryover basis in the land equal to $18,000.

c.

Karens outside basis in the partnership after the distribution is as follows:


Basis in KD
Less: Distributions
Cash
Land
Remaining basis in KD

$68,000

(6,000)
(18,000)

(24,000)
$44,000

43. [LO 3] Pam has a $27,000 basis (including her share of debt) in her 50% partnership
interest in the Meddoc partnership before receiving any distributions. This year Meddoc
makes a current distribution to Pam of a parcel of land with a $40,000 fair market value
and a $32,000 basis to the partnership. The land is encumbered with a $15,000 mortgage
(the partnerships only liability).
a. What is the amount and character of Pams recognized gain or loss?
b. What is Pams basis in the land?
c. What is Pams remaining basis in her partnership interest?

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Answer:
a.

Pam must consider the effects of debt changes before determining the effects of the
distribution. Pam is treated as making a net contribution of cash to the partnership
of $7,500, the difference between the full mortgage of $15,000 and her allocated
share of the debt of $7,500. This deemed contribution increases Pams basis in
Meddoc from $27,000 to $34,500. Pam does not recognize any gain or loss on the
current distribution.

b.

Pam takes a carryover basis in the land equal to $32,000.

c.

Pams outside basis in the partnership after the distribution is as follows:


Basis in Meddoc
Plus: Deemed contribution
Less: Land
Remaining basis in Meddoc

$27,000
7,500
(32,000)
$2,500

44. [LO 3] {Research} Two years ago, Kimberly became a 30% partner in the KST
Partnership with a contribution of investment land with a $10,000 basis and $16,000 fair
market value. On January 2 of this year, Kimberly has a $15,000 basis in her partnership
interest and none of her pre-contribution gain has been recognized. On January 2,
Kimberly receives an operating distribution of a tract of land (not the contributed land)
with a $12,000 basis and an $18,000 fair market value.
a. What is the amount and character of Kimberlys recognized gain or loss on the
distribution?
b. What is Kimberlys remaining basis in KST after the distribution?

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

c. What is KSTs basis in the land Kimberly contributed after Kimberly receives this
distribution?
Answer:
a.

Kimberly recognizes $3,000 capital gain as a result of the distribution. Under 737,
Kimberly must recognize her pre-contribution gain to the extent that the fair
market value of the distributed property exceeds her partnership interest before the
distribution (but after reduction for any money distributions). Kimberly recognizes
the lesser of her unrecognized pre-contribution gain ($6,000) or the excess of the fair
market value of the distributed land over her pre-distribution outside basis ($3,000;
$18,000 FMV 15,000 outside basis).

b.

If a partner recognizes a pre-contribution gain under 737, the recognized gain


increases the partners outside basis. Kimberlys outside basis in the partnership
after the distribution is as follows:
Basis in KST
Plus: 737 gain
Less: Carryover basis in land
Remaining basis in KST

c.

$15,000
3,000
(12,000)
$6,000

KSTs basis in the land that Kimberly originally contributed is $13,000 determined
as follows:
KST basis upon contribution
Plus: Kimberlys 737 gain
KSTs basis in land

$ 10,000
3,000
$13,000

Kimberlys recognized gain under 737 increases the partnerships basis in the
property that originated the pre-contribution gain.
45. [LO 4] Rufus is a one-quarter partner in the Adventure partnership. On January 1 of the
current year, Adventure distributes $13,000 cash to Rufus in complete liquidation of his
interest. Adventure has only capital assets and no liabilities at the date of the distribution.
Rufus basis in his partnership interest is $18,500.
a. What is the amount and character of Rufus recognized gain or loss?
b. What is the amount and character of Adventures recognized gain or loss?
c. If Rufus basis is $10,000 at the distribution date rather than $18,500, what is the
amount and character of Rufus recognized gain or loss?
Answer:
a.

Rufus recognizes a capital loss on the distribution of $5,500 representing the


difference between his basis in Adventure of $18,500 and the cash distribution of
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

$13,000. He must recognize a loss because he receives only cash in the distribution
and the cash is less than his basis in his partnership interest.
b.

Adventure does not recognize any gain or loss on the distribution.

c.

If Rufus outside basis is $10,000 prior to the distribution, he must recognize a


capital gain of $3,000 on the distribution as follows:
Cash distribution
Less: Basis in Adventure
Equals: Gain (capital)

$13,000
(10,000)
$3,000

46. [LO 4] The Taurin Partnership (calendar-year-end) has the following assets as of
December 31 of the current year:
Cash
Accounts receivable
Inventory
Totals

Basis
$ 45,000
15,000
81,000
$ 141,000

FMV
$ 45,000
30,000
120,000
$ 195,000

On December 31, Taurin distributes $15,000 of cash, $10,000 (FMV) of accounts


receivable, and $40,000 (FMV) of inventory to Emma (a 1/3 partner) in termination of
her partnership interest. Emmas basis in her partnership interest immediately prior to the
distribution is $40,000.
a. What is the amount and character of Emmas recognized gain or loss on the
distribution?
b. What is Emmas basis in the distributed assets?
c. If Emmas basis before the distribution was $55,000 rather than $40,000, what is
Emmas recognized gain or loss and what is her basis in the distributed assets?
Answer:
a.

Emma does not recognize any gain or loss on the distribution.

b.

Because Taurin distributes only cash, accounts receivable, and inventory, and the
adjusted bases of the property distributed is greater than her basis in the
partnership, Emma will simply reduce the bases of the hot assets. Emma uses a
three step process to allocate her basis to the distributed property.
1. Emma assigns a basis of $15,000 (1/3 of $45,000) to the cash, $5,000 to the
accounts receivable (1/3 of 15,000) and $27,000 (1/3 of $81,000) to the inventory.
Since the sum ($47,000) exceeds her basis in Taurin, she has a required decrease
of $7,000 ($47,000 40,000).

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

2. Emma allocates the required decrease to the assets with unrealized depreciation.
Since there are no distributed assets with unrealized depreciation, Emma skips
this step.
3. Emma decreases the basis of the assets in proportion to their relative adjusted
bases.
Accounts receivable: Basis allocation = $7,000 ($5,000/$32,000) = $1,094
Inventory: Basis allocation = $7,000 ($27,000/$32,000) = $5,906
After completing the allocation Emmas basis in the distributed assets are:
Cash
$15,000
Accounts receivable ($5,000 - $1,094) 3,906
Inventory ($27,000 - $5,906)
21,094
c.

If Emmas basis in Taurin were $55,000 rather than $40,000, she recognizes a capital
loss on the distribution. Emma calculates her loss of $8,000 as the difference
between her basis in her partnership interest ($55,000) and the sum of the adjusted
bases of the distributed assets ($47,000).
Her basis in the distributed assets is equal to the partnerships basis in the assets.
Cash
Accounts receivable
Inventory

$15,000
5,000
27,000

The carryover bases allow Emma to retain the character of the inherent gains in the
accounts receivable and inventory she receives in the liquidating distribution.
47. [LO 4] Melissa, Nicole, and Ben are equal partners in the Opto partnership (calendar
year-end). Melissa decides she wants to exit the partnership and receives a proportionate
distribution to liquidate her partnership interest on January 1. The partnership has no
liabilities and holds the following assets as of January 1:
Cash
Accounts receivable
Stock investment
Land
Totals

Basis
$ 18,000
-07,500
30,000
$ 55,500

FMV
$ 18,000
24,000
12,000
36,000
$ 90,000

Melissa receives one-third of each of the partnership assets. She has a basis in her
partnership interest of $25,000.
a. What is the amount and character of any recognized gain or loss to Melissa?
b. What is Melissas basis in the distributed assets?
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

c. What are the tax implications (amount and character of gain or loss and basis of assets)
to Melissa if her outside basis is $11,000 rather than $25,000?
d. What is the amount and character of any recognized gain or loss from the distribution
to Opto?
Answer:
a.

Melissa does not recognize any gain or loss on the distribution. Rather, she will
adjust the basis of the distributed assets.

b.

Melissa uses a three step process to determine her basis in the distributed property.
1. Melissa assigns a basis of $6,000 (1/3 of $18,000) to the cash, $-0- to the accounts
receivable, $2,500 (1/3 of $7,500) to the stock investment, and $10,000 (1/3 of
$30,000) to the land. The sum ($18,500) of the inside basis is less than her outside
basis so she will need to allocate the excess basis to the basis in the distributed
assets other than 751(a) property. Melissa has a remaining basis of $6,500 to
allocate ($25,000 - $18,500) among the distributed capital assets.
2. Melissa allocates the required increase to the capital assets with unrealized
appreciation to the extent of the appreciation. Melissa allocates $1,500 ($4,000
{1/3 x $12,000} - $2,500 {1/3 x $7,500}) to the stock investment and $2,000
($12,000 {1/3 x $36,000} - $10,000 {1/3 x $10,000}) to the land to bring the bases
of these assets to their fair market value. This leaves $3,000 remaining to be
allocated.
3. Melissa increases the basis of the capital assets in proportion to their relative fair
market values.
Stock investment: Basis allocation = $3,000 ($4,000/$16,000) = $750
Land: Basis allocation = $3,000 ($12,000/$16,000) = $2,250
After completing the allocation Melissas basis in the distributed assets are:
Cash
Accounts receivable
Stock investment ($2,500 + $1,500 + $750)
Land ($10,000 + $2,000 + $2,250)

c.

$6,000
-04,750
14,250

If Melissas basis in Opto were $11,000 rather than $25,000, she will need to
decrease the basis in the stock investment and land she receives in liquidation of her
partnership interest. She will calculate her basis in the distributed assets as follows:
1. First she assigns a carryover basis to the distributed assets.
Cash
Accounts receivable
Stock investment
Land

$6,000
-02,500
10,000
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Since the sum of the adjusted bases of the distributed assets ($18,500) is greater
than her basis in Opto ($11,000), she has a required decrease of $7,500.
2. Melissa allocates her required decrease to the other property with unrealized
depreciation. Since none of the distributed assets have any unrealized
depreciation, Melissa skips this step.
3. In the final step, Melissa allocates the required decrease to the capital assets in
proportion to their adjusted bases.
Stock investment: Basis allocation = $7,500 ($2,500/$12,500) = $1,500
Land: Basis allocation = $7,500 ($10,000/$12,500) = $6,000
After completing the allocation Melissas basis in the distributed assets are:
Cash
Accounts receivable
Stock investment ($2,500 - $1,500)
Land ($10,000 - $6,000)
d.

$6,000
-01,000
4,000

Opto does not recognize any gain or loss on the liquidating distribution.
48. [LO 4] {Planning} Lonnie Davis has been a general partner in the Highland Partnership
for many years and is also a sole proprietor in a separate business. To spend more time
focusing on his sole proprietorship, he plans to leave Highland and will receive a
liquidating distribution of $50,000 in cash and land with a fair market value of $100,000
(tax basis of $120,000). Immediately before the distribution, Lonnies basis in his
partnership interest is $350,000 which includes his $50,000 share of partnership debt.
The Highland Partnership does not hold any hot assets.
a. What is the amount and character of any gain or loss to Lonnie?
b. What is Lonnies basis in the land?
c. What is the amount and character of Lonnies gain or loss if he holds the land for
thirteen months as investment property and then sells it for $100,000?
d. What is the amount and character of Lonnies gain or loss if he places the land into
service in his sole proprietorship and then sells it thirteen months later for $100,000?
e. Do your answers to parts c. and d. above suggest a course of action that would help
Lonnie to achieve a more favorable tax outcome?

Answer:
a. Lonnie does not recognize a gain because the $50,000 of actual cash he receives and
debt relief of $50,000 are not greater than the tax basis in his interest of $350,000.
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Further, Lonnie does not recognize a loss on the liquidating distribution because he
receives assets other than cash and/or hot assets in the distribution (i.e. the land).
b. Lonnies basis in the land is equal to his basis in his partnership interest of $350,000
reduced by the actual cash distribution of $50,000 and the deemed cash distribution
of $50,000 from debt relief leaving a basis of $250,000 in the land.
c. Lonnie will recognize a long-term capital loss of $150,000 or $100,000 less his
$250,000 substituted basis in the land. The loss is a long-term capital loss because
Lonnie held the land as a capital asset for more than one year.
d. Lonnie will recognize a Section 1231 loss of $150,000 ($100,000 less his $250,000
substituted basis in the land). The loss is a Section 1231 loss because Lonnie held
the land as a trade or business asset for more than one year making the land Section
1231 property. Losses from the sale or exchange of Section 1231 property are treated
as ordinary assuming there are no gains from the sale of other Section 1231 in the
same tax year.
e. Given the choice, Lonnie should consider holding the land as a trade or business
asset rather than as a capital asset. In doing so, he will convert what would have
otherwise been a capital loss into an ordinary loss if he also avoids selling other
trade or business property at a gain in the same tax year. Note that if Lonnie had
simply received an all cash liquidating distribution, he would also have recognized a
$150,000 capital loss at the time of the distribution.
49. [LO 4] AJ is a 30% partner in the Trane partnership, a calendar year end entity. On
January 1, AJ has an outside basis in his interest in Trane of $73,000, which includes his
share of the $50,000 of partnership liabilities. Trane generates $42,000 of income during
the year and does not make any changes to its liabilities. On December 31, Trane makes a
proportionate distribution of the following assets to AJ to terminate his partnership
interest:

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Inventory
Land
Totals

Basis
$ 55,000
30,000
$ 85,000

FMV
$ 65,000
25,000
$90,000

a. What are the tax consequences (gain or loss, basis adjustments) of the distribution to
Trane?
b. What is the amount and character of any recognized gain or loss to AJ?
c. What is AJs basis in the distributed assets?
d. If AJ sells the inventory four years after the distribution for $70,000, what is the
amount and character of his recognized gain or loss?
Answer:
a.

Trane does not recognize any gain or loss on the distribution. The liquidation is of a
30% partner and as such does not trigger a technical termination of the
partnership. Tranes basis in its remaining property is unaffected by the distribution
since there is no 754 election in effect.

b.

First, AJ must determine his basis in Trane as of the distribution. At the beginning
of the year, his basis is $73,000. Trane earns $42,000 during the period of which 30%
is allocable to AJ. He increases his basis by his $12,600 ($42,000 30%) share of
Tranes income. Thus, as of the distribution, AJs basis in Trane is $85,600 ($73,000
+ $12,600). Next, AJ accounts for the deemed cash distribution relating to his
reduction of Trane debt. His 30% share of Tranes $50,000 debt is $15,000. AJ
reduces his outside basis by the $15,000 leaving a basis of $70,600 to allocate to the
distributed assets. He does not recognize any gain or loss on the distribution because
the deemed cash distribution does not exceed his basis in Trane.

c.

AJ calculates his basis in the distributed assets as follows:


1. First he assigns a carryover basis to the distributed assets.
Inventory
Land

$55,000
30,000

Since the sum of the adjusted bases of the distributed assets ($85,000) is greater
than his basis in Trane after the deemed cash distribution ($70,600), he has a
required decrease of $14,400.

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

2. AJ allocates his required decrease to the other property with unrealized


depreciation. Since the distributed land has an inherent loss of $5,000, AJ
allocates this amount of the required decrease to the land. Thus at the end of this
step, the basis in the land is $25,000.
3. In the final step, AJ allocates the remaining required decrease $9,400 ($14,400 $5,000) to the land. After completing the allocation his basis in the distributed
assets are:
Inventory
Land ($25,000 in step 2 - $9,400)
d.

$55,000
15,600

AJ calculates the gain or loss on the subsequent sale of inventory as


Amount realized
Less: Adjusted basis
Equals: Gain on sale of inventory

$70,000
(55,000)
$15,000

The gain is an ordinary gain under 735(a)(2) because AJ sells the inventory within
five years of the distribution.

50. [LO 4] Davids basis in the Jimsoo Partnership is $53,000. In a proportionate liquidating
distribution, David receives cash of $7,000 and two capital assets: land one with a fair
market value of $20,000 and a basis to Jimsoo of $16,000 and land two with a fair market
value of $10,000 and a basis to Jimsoo of $16,000. Jimsoo has no liabilities.
a. How much gain or loss will David recognize on the distribution? What is the character
of any recognized gain or loss?
b. What is Davids basis in the distributed assets?
c. If the two parcels of land had been inventory to Jimsoo, what are the tax consequences
to David (amount and character of gain or loss and basis in distributed assets)?

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Answer:
a.

David does not recognize any gain or loss on the distribution.

b.

Since Jimsoos basis of the distributed assets is less than Davids outside basis and
David receives other property in the distribution, David must adjust the basis of the
land in order to defer his loss. He follows a three step process to adjust the bases:
1. David assigns a basis of $7,000 to the cash, $16,000 to the first parcel of land, and
$16,000 to the second parcel of land. The sum ($39,000) of the bases is less than
Davids basis in Jimsoo so he will need to allocate the excess outside basis to the
basis in the distributed assets. David has a remaining outside basis of $14,000
(required increase) to allocate ($53,000 - $39,000) among the two parcels of land.
2. David allocates the required increase to the land with unrealized appreciation to
the extent of the appreciation. David therefore increases the basis of the first
parcel land by $4,000 to $20,000. This leaves $10,000 remaining to be allocated.
3. David increases the basis of the two parcels of land in proportion to their relative
fair market values.
Land 1: Basis allocation = $10,000 ($20,000/$30,000) = $6,667
Land 2: Basis allocation = $10,000 ($10,000/$30,000) = $3,333
After completing the allocation Davids bases in the distributed assets are:
Cash
Land 1 ($16,000 + $4,000 + $6,667)
Land 2 ($16,000 + $3,333)

c.

$7,000
26,667
19,333

If the land were inventory to Jimsoo, David would not be allowed to increase the
basis of the distributed land. Instead, David would recognize a capital loss of
$14,000 on the distribution. David would have a basis of $16,000 in each parcel of
land (carryover basis).

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

51. [LO 4] Megan and Matthew are equal partners in the J & J partnership (calendar-year-end
entity). On January 1 of the current year, they decide to liquidate the partnership.
Megans basis in her partnership interest is $100,000 and Matthews is $35,000. The two
partners receive identical distributions with each receiving the following assets:
Cash
Inventory
Land
Totals

Basis
$ 30,000
5,000
500
$ 35,500

FMV
$ 30,000
6,000
1,000
$37,000

a. What is the amount and character of Megans recognized gain or loss?


b. What is Megans basis in the distributed assets?
c. What is the amount and character of Matthews recognized gain or loss?
d. What is Matthews basis in the distributed assets?
Answer:
a.

Megan does not recognize any gain or loss on the distribution although she realizes a
loss on the distribution.

b.

Megan uses a three step process to determine her basis in the distributed property.
1. Megan assigns a carryover basis of $30,000 to the cash, $5,000 to the inventory,
and $500 to the land. The sum ($35,500) of the basis is less than her basis in J &
J so she will need to allocate the excess basis to the basis in the distributed assets
other than 751(a) property (i.e., the land). Megan has a remaining basis of
$64,500 to allocate ($100,000 - $35,500) among the cold assets.
2. Megan allocates the required increase to the cold assets with unrealized
appreciation to the extent of the appreciation. Therefore, Megan increases the
basis of the land by $500 to$1,000. This leaves $64,000 remaining to be allocated.
3. Since Megan only receives one cold asset in the distribution, all of the required
increase must increase the basis of the land. Megan increases the basis of the
land by the remaining $64,000 required increase.
After completing the allocation, Megans bases in the distributed assets are:
Cash
Inventory
Land

$30,000
5,000
65,000

The application of these rules demonstrates the sometimes strange results from
the allocation process. In this case Megan now has a parcel of land with a basis
of $65,000 even though its fair market value is only $1,000. When she sells the
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

land, she will recognize a capital loss equal to the difference between the sale
price and her extremely large basis.
c.

Matthew does not recognize any gain or loss on the distribution although he realizes
a gain on the distribution.

d.

Matthew defers his gain through a basis decrease to the land he receives in
liquidation of his partnership interest. He calculates his basis in the distributed
assets as follows:
1. First he assigns a carryover basis to the distributed assets.
Cash
Inventory
Land

$30,000
5,000
500

Since the sum of the adjusted bases of the distributed assets ($35,500) is greater
than his basis in J & J ($35,000), Matthew has a required decrease of $500.
2. Matthew allocates his required decrease to the cold assets property with
unrealized depreciation. Since none of the distributed assets have unrealized
depreciation, Matthew skips this step.
3. In the final step, Matthew allocates the entire $500 required decrease to the land.
After completing the allocation, Matthews bases in the distributed assets are:
Cash
Inventory
Land

$30,000
5,000
-0-

52. [LO 4] Bryces basis in the Markit Partnership is $58,000. In a proportionate liquidating
distribution, Bryce receives the following assets:
Cash
Land A
Land B

Basis
$8,000
20,000
20,000

FMV
$8,000
45,000
25,000

a. How much gain or loss will Bryce recognize on the distribution? What is the character
of any recognized gain or loss?
b. What is Bryces basis in the distributed assets?

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Answer:
a.

Bryce does not recognize any gain or loss on the distribution.

b.

Since Markits basis of the distributed assets is less than Bryces outside basis and
Bryce receives other property in the distribution, Bryce must adjust the basis of the
land in order to defer his loss. He follows a three step process to adjust the bases.
1. Bryce assigns a basis of $8,000 to the cash, $20,000 to land A, and $20,000 to land
B. The sum ($48,000) of the bases is less than Bryces basis in Markit so he will
need to allocate the excess outside basis to the basis in the distributed assets.
Bryce has a remaining outside basis of $10,000 (required increase) to allocate
($58,000 - $48,000) among the two parcels of land.
2. Bryce allocates the required increase to the land with unrealized appreciation to
the extent of the appreciation. The combined appreciation in the two parcels of
land is $30,000 ($25,000 for land A and $5,000 for land B). This exceeds Bryces
required increase ($10,000). Therefore in this step Bryce must allocate the
required increase to the two parcels of land based on their relative appreciation.
Land A: Basis allocation = $10,000 ($25,000/$30,000) = $ 8,333
Land B: Basis allocation = $10,000 ($5,000/$30,000) = $ 1,667
3. All of Bryces outside basis has been allocated in Step 2, so he does not need to
use Step 3 of the allocation process. After completing the allocation Bryces bases
in the distributed assets are:
Land A ($20,000 + 8,333)
Land B ($20,000 + 1,667)

$ 28,333
$ 21,667

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

53. [LO 4] {Planning} Danner Inc. has a $395,000 capital loss carryover that will expire at
the end of the current tax year if it is not used. Also, Danner Inc. has been a general
partner in the Talisman Partnership for three years and plans to end its involvement with
the partnership by receiving a liquidating distribution. Initially, all parties agreed that
Danner Inc.s liquidating distribution would include $50,000 in cash and land with a fair
market value of $400,000 (tax basis of $120,000). Immediately before the distribution,
Danners basis in its partnership interest is $150,000 which includes its $100,000 share of
partnership debt. The Talisman Partnership does not hold any hot assets.
a. What is the amount and character of any gain or loss to Danner Inc.?
b. What is Danner Inc.s basis in the land?
c. Can you suggest a course of action that would help Danner Inc. to avoid the expiration
of its capital loss carryover?

Answer:
a. Because Danner Inc.s actual cash distribution of $50,000 and deemed cash
distribution of $100,000 from the relief of debt do not exceed Danner Inc.s tax basis
of $150,000 prior to the distribution, it does not recognize any gain. Further, it does
not recognize any loss because it received property other than cash and/or hot assets
in the distribution.
b. Danner Inc.s basis in the land is zero because the $50,000 of actual cash and
$100,000 deemed cash distributed reduce its tax basis in Talisman from $150,000 to
zero.
c. Danner Inc. could ensure that it fully utilizes its capital loss carryover prior to
expiration by selling the land it receives in the distribution for $400,000 and
recognizing a capital gain of $400,000 ($400,000 selling price for the land less the
zero basis in land). If Danner Inc. needs land for its business operations, it could
take the proceeds from the land sale and purchase a different piece of land suitable
for its needs. Alternatively, Danner Inc. could suggest that the partnership
distribute $400,000 of additional cash in lieu of the land if the partnership has the
cash available. Under this scenario, Danner Inc.s actual cash proceeds of $450,000
and deemed cash proceeds of $100,000 would again trigger a capital gain of
$400,000 since the actual and deemed cash distributed would exceed Danner Inc.s
$150,000 basis in Talisman by $400,000.
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

54. [LO 1, 5] {Planning} Bella Partnership is an equal partnership in which each of the
partners has a basis in his partnership interest of $10,000. Bella reports the following
balance sheet:
Assets:
Inventory
Land
Totals
Liabilities and capital:
Capital Toby
Kaelin
Andrew
Totals

Basis
$ 20,000
10,000
$ 30,000

FMV
$ 30,000
15,000
$ 45,000

10,000
10,000
10,000
$ 30,000

a. Identify the hot assets if Toby decides to sell his partnership interest. Are these assets
hot for purposes of distributions?
b. If Bella distributes the land to Toby in complete liquidation of his partnership interest,
what tax issues should be considered?
Answer:
a.

Hot assets under 751(a) for purposes of sales or exchanges of partnership interests
include unrealized receivables and inventory items. Bellas hot assets include the
inventory with a basis of $20,000 and fair market value of $30,000. For purposes of
distributions, 751(b) defines hot assets as substantially appreciated inventory and
unrealized receivables. Inventory is considered substantially appreciated if its fair
market value exceeds its basis by more than 120%. The value of Bellas inventory
does exceed its basis by more than 120% (100 $30,000/$20,000 = 150%) and is
thus considered hot asset for purposes of distributions.

b.

If Bella distributes the land to Toby in complete liquidation of his partnership


interest, the distribution would be a disproportionate distribution because Toby
receives more than his share of the cold assets. In this case, Toby would be treated as
having sold his share of hot assets to Bella in exchange for cold assets. The deemed
sale would generate ordinary income to Toby.

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

55. [LO 1, 6] Michelle pays $120,000 cash for Brittanys one-third interest in the Westlake
Partnership. Just prior to the sale, Brittanys basis in Westlake is $96,000. Westlake
reports the following balance sheet:
Assets:
Cash
Land
Totals

Basis
$ 96,000
192,000
$ 288,000

Liabilities and capital:


Capital Amy
Brittany
Ben
Totals

96,000
96,000
96,000
$ 288,000

FMV
$ 96,000
264,000
$ 360,000

a. What is the amount and character of Brittanys recognized gain or loss on the sale?
b. What is Michelles basis in her partnership interest? What is Michelles inside basis?
c. If Westlake were to sell the land for $264,000 shortly after the sale of Brittanys
partnership interest, how much gain or loss would the partnership recognize?
d. How much gain or loss would Michelle recognize?
e. Suppose Westlake has a 754 election in place. What is Michelles special basis
adjustment? How much gain or loss would Michelle recognize on a subsequent sale of
the land in this situation?

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Answer:
a.

Amount realized:
Cash
Less: basis in partnership interest
Brittanys realized and recognized gain

$ 120,000
(96,000)
$ 24,000

Brittanys gain will be capital because Westlake has no hot assets.


b.

Michelle has an outside basis in her interest in Westlake equal to her $120,000 cash
payment. Michelle steps into Brittanys shoes and takes an inside basis of $96,000.

c.

Westlake would realize and recognize the following on the sale of the land:
Amount realized
Less: adjusted basis in land
Westlakes realized and recognized gain

$ 264,000
(192,000)
$ 72,000

d.

Michelle would recognize a one-third share of the partnership gain on the sale of the
land: 1/3 $72,000 = $24,000. Because a 754 election was not in effect, Michelle
must recognize her full share of the gain on the sale of the land despite having paid
fair value for her interest in the partnership. Her basis will increase when she
recognizes the gain and only when she sells her Westlake interest will she recognize
an offsetting loss.

Michelles special basis adjustment is the difference between her outside basis and
inside basis in Westlake and is calculated as follows:
Initial interest in Westlake
Minus: Michelles inside basis
Special basis adjustment

$ 120,000
96,000
$ 24,000

The entire special basis adjustment relates to the appreciated land. Michelle would
not recognize any gain on the subsequent sale of the land if Westlake has a 754
election in effect when she purchased her interest.
56. [LO 4, 6] Cliffs basis in his Aero partnership interest is $11,000. Cliff receives a
distribution of $22,000 cash from Aero in complete liquidation of his interest. Aero is an
equal partnership with the following balance sheet:
Assets:
Cash
Investment
Land
Totals
Liabilities and capital:
Capital Chris
Cliff

Basis
$ 22,000
8,800
2,200
$ 33,000

FMV
$ 22,000
8,800
35,200
$ 66,000

11,000
11,000
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Cooper
Totals

11,000
$ 33,000

a. What is the amount and character of Cliffs recognized gain or loss? What is the effect
on the partnership assets?
b. If Aero has a 754 election in place, what is the amount of the special basis
adjustment?
Answer:
a.

Cliff receives only money in the distribution and the amount exceeds his outside
basis, so Cliff will recognize a capital gain on the liquidation of $11,000. Aero does
not recognize any gain or loss and the distribution does not affect Aeros basis in its
assets.

b.

If Aero has a 754 election in effect at the time of the distribution, Aero will have a
special basis adjustment. The adjustment will be $11,000 basis increase since Cliff
recognized a gain on the liquidating distribution.
57. [LO 4, 6] Erins basis in her Kiybron partnership interest is $3,300. Erin receives a
distribution of $2,200 cash from Kiybron in complete liquidation of her interest. Kiybron
is an equal partnership with the following balance sheet:
Assets:
Cash
Stock (investment)
Land
Totals

Basis
$ 2,200
1,100
6,600
$ 9,900

Liabilities and capital:


Capital Erin
Carl
Grace
Totals

3,300
3,300
3,300
$ 9,900

FMV
$ 2,200
2,200
2,200
$ 6,600

a. What is the amount and character of Erins recognized gain or loss? What is the effect
on the partnership assets?
b. If Kiybron has a 754 election in place, what is the amount of the special basis
adjustment?
Answer:
a.

Erin receives only money in the distribution and the amount is less than her outside
basis, so Erin will recognize a capital loss on the liquidation of $1,100. Kiybron does
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

not recognize any gain or loss and the distribution does not affect Kiybrons basis in
its assets.
b.

If Kiybron has a 754 election in effect at the time of the distribution, Kiybron will
have a special basis adjustment. The adjustment will be $1,100 and will be a basis
decrease because Erin recognized a loss on the liquidating distribution.
58. [LO 4, 6] Helens basis in Haywood partnership is $270,000. Haywood distributes all the
land to Helen in complete liquidation of her partnership interest. The partnership reports
the following balance sheet just before the distribution:
Assets:
Cash
Stock (investment)
Land
Totals

Basis
$ 220,000
480,000
110,000
$ 810,000

Liabilities and capital:


Capital Charles
Esther
Helen
Totals

$ 270,000
270,000
270,000
$ 810,000

FMV
$ 220,000
220,000
220,000
$ 660,000

a. What is the amount and character of Helens recognized gain or loss? What is the effect
on the partnership assets?
b. If Haywood has a 754 election in place, what is the amount of the special basis
adjustment?
Answer:
a.

Helen does not recognize any gain or loss on the distribution. Instead, she will
simply adjust the basis in the distributed property to defer recognition of any gain
or loss. Helen increases the basis in the land to $270,000. Haywood does not
recognize any gain or loss and the distribution does not affect Haywoods basis in its
assets.

b.

If Haywood has a 754 election in effect at the time of the distribution, Haywood
will have a special basis adjustment. The adjustment will equal $160,000 ($270,000 $110,000) and will be a basis decrease because the basis of the property distributed
to Helen was increased.

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Comprehensive Problems
59. [LO 2, 3, 4] Simon is a 30% partner in the SBD partnership, a calendar-year-end entity.
As of the end of this year, Simon has an outside basis in his interest in SBD of $188,000,
which includes his share of the $60,000 of partnership liabilities. On December 31, SBD
makes a proportionate distribution of the following assets to Simon:
Cash
Inventory
Land
Totals

Basis
$ 40,000
55,000
30,000
$ 125,000

FMV
$40,000
65,000
45,000
$150,000

a. What are the tax consequences (amount and character of recognized gain or loss, basis
in distributed assets) of the distribution to Simon if the distribution is an operating
distribution?
b. What are the tax consequences (amount and character of recognized gain or loss, basis
in distributed assets) of the distribution to Simon if the distribution is a liquidating
distribution?
c. Compare and contrast the results from parts a. and b.
Answer:
a.

This distribution falls in the category of operating distributions that include


property other than money. As such, Simon must allocate his outside basis to the
distributed assets. First, Simon assigns basis ($40,000) to the money distributed.
Next, he assigns basis equal to the inside basis ($55,000) of the inventory (hot asset).
Finally, Simon assigns basis to the distributed land equal to the inside basis
($30,000). Simon does not recognize any gain or loss on the distribution because the
cash distribution does not exceed his basis in SBD. His remaining outside basis is:
Pre-distribution outside basis
Less: Distributions
Cash
$ (40,000)
Inventory
(55,000)
Land
(30,000)
Post-distribution outside basis

b.

$ 188,000

(125,000)
$ 63,000

Simon does not recognize a gain or loss if the distribution is a liquidating


distribution. To determine the asset bases, Simon must first determine his allocable
basis by considering the deemed cash distribution from the reduction of his debt:
Pre-distribution basis
Debt relief ($60,000 x 30%)
Allocable basis

$ 188,000
(18,000)
$ 170,000
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Simon calculates his basis in the distributed assets as follows:


1. First he assigns a carryover basis to the distributed assets.
Cash
Inventory
Land

$40,000
$55,000
30,000

Since the sum of the adjusted bases of the distributed assets ($125,000) is less
than his basis in SBD after the deemed cash distribution ($170,000), he has a
required increase of $45,000.
2. Simon allocates his required increase to the other property with unrealized
appreciation. Since the distributed land has unrealized appreciation of $15,000,
Simon allocates this amount of the required increase to the land. Thus at the end
of this step, the basis in the land is $45,000.
3. In the final step, Simon allocates the remaining required increase $30,000
($45,000 - $15,000) to the land. After completing the allocation Simons bases in
the distributed assets are:
Cash
$40,000
Inventory
55,000
Land ($30,000 + $15,000 + $30,000) 75,000
c.

Similar to the operating distribution result, Simon does not recognize a gain or loss
if the distribution is a liquidating distribution. The determination of the bases of the
distributed assets differs however between the operating and liquidating
distributions:
Operating Distribution
Inventory
Land

$ 55,000
30,000

Liquidating Distribution
$ 55,000
75,000

Simons basis in the inventory remains the same for both types of distributions
because the tax rules prohibit any increases to hot assets in order to prevent the
conversion of ordinary gain to capital gain. However, in the liquidating distribution,
Simon must allocate his entire outside basis to the distributed assets resulting in a
substantial increase to the basis of the other assets (land).
60. [LO 1, 4] {Planning} Paolo is a 50% partner in the Capri partnership and has decided to
terminate his partnership interest. Paolo is considering two options as potential exit
strategies. The first is to sell his partnership interest to the two remaining 25% partners,
Giuseppe and Isabella, for $105,000 cash and the assumption of Paolos share of Capris
liabilities. Under this option, Giuseppe and Isabella would each pay $52,500 for half of
Paolos interest. The second option is to have Capri liquidate his partnership interest with
a proportionate distribution of the partnership assets. Paolos basis in his partnership
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

interest is $110,000, including Paolos share of Capris liabilities. Capri reports the
following balance sheet as of the termination date:
Assets:
Cash
Receivables
Inventory
Land
Totals
Liabilities and capital:
Liabilities
Capital Paolo
Giuseppe
Isabella
Totals

Basis
$ 80,000
40,000
50,000
50,000
$ 220,000

FMV
$ 80,000
40,000
80,000
60,000
$ 260,000

$ 50,000
85,000
42,500
42,500
$ 220,000

a. If Paolo sells his partnership interest to Giuseppe and Isabella for $105,000, what is the
amount and character of Paolos recognized gain or loss?
b. Giuseppe and Isabella each have a basis in Capri of $55,000 before any purchase of
Paolos interest. What are Giuseppe and Isabellas basis in their partnership interests
following the purchase of Paolos interest?
c. If Capri liquidates Paolos partnership interest with a proportionate distribution of the
partnership assets ($25,000 deemed cash from debt relief, $15,000 of actual cash, and
half of the remaining assets), what is the amount and character of Paolos recognized
gain or loss?
d. If Capri liquidates Paolos interest, what is Paolos basis in the distributed assets?
e. Compare and contrast Paolos options for terminating his partnership interest. Assume
that Paolos marginal tax rate is 35%, and his capital gains rate is 15 percent.

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Answer:
a.

Amount realized:
Cash
Debt relief (1/2 of $50,000)
Less: basis in partnership interest
Paolos realized and recognized gain

$ 105,000
25,000

$130,000
(110,000)
$ 20,000

To the extent Paolo realizes any amounts attributable to hot assets, his gain will be
classified as ordinary. If Capri sold its assets for their fair market value at the sale
date, the ordinary gain would be as follows:
Receivables
Inventory

Tax basis
$40,000
50,000

FMV
$ 40,000
80,000

Gain/Loss Paolos share


$ -0$-030,000
15,000
$ 30,000

Total gain
Less: ordinary gain
Capital gain

$ 15,000

$ 20,000
(15,000)
$5,000

Paolo recognizes $15,000 of ordinary income and $5,000 capital gain from the sale of
his interest in Capri.
b.

Giuseppe and Isabella will increase their bases in Capri by the cost of Paolos
interest plus their increase in Capris allocable liabilities. Each partner will have an
outside basis in Capri equal to $120,000 ($55,000 original basis + $52,500 additional
investment + $12,500 additional debt).

c.

Paolo does not recognize any gain or loss on the distribution. Rather he adjusts the
basis in the distributed assets. See answer d.

d.

In a proportionate distribution, Paolo will receive $25,000 of deemed cash from


relief of his share of partnership debt, $15,000 of actual cash, and half of the
remaining partnership assets. Paolo first reduces his basis for the deemed cash
distribution relating to his reduction in Capri debt ($25,000) leaving an outside basis
of $85,000 ($110,000 - $25,000). He determines his basis in the distributed assets as
follows:

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

1. He assigns a carryover basis to the distributed assets.


Cash
Receivables
Inventory
Land

$ 15,000
20,000
25,000
25,000

Since the sum of the adjusted bases of the distributed assets ($85,000) is equal to
his basis in Capri ($85,000), the distributed assets take a carryover basis.
e.

Under option 1 (sale of Paolos interest in Capri), Paolo must immediately recognize
a gain of $20,000: $15,000 is ordinary income and $5,000 is capital gain. He has no
future tax liability related to the transaction. The capital gain will be taxed at a
maximum of 15%. Given Paolos ordinary marginal tax rate of 35%, he would have
cash after tax of $99,000 [$105,000 (15% $5,000) (35% $15,000)] to invest in
other projects as he wishes.
Under option 2 (liquidation of Paolos interest), Paolo is able to defer any gain on
the liquidation because he takes a carryover basis in the distributed assets. As he
sells the assets, he will recognize gain or loss. If he holds onto the inventory for
more than five years, Paolo will recognize a capital gain on the sale of the inventory
rather than an ordinary gain. The potential downside is that Paolo only receives
$15,000 actual cash in the distribution. His other proceeds are in the form of
receivables (which bear some risk of default), inventory, and land. If Paolo were to
immediately sell the distributed assets following the distribution, he would recognize
$15,000 of ordinary income on the sale of the inventory and $5,000 capital gain on
the sale of the land. He may incur additional costs to sell or collect on these assets.
This option would leave Paolo with $99,000 after tax cash as follows:
Cash
Receivables
Inventory
*
Land

Tax basis
$15,000
20,000
25,000
25,000

FMV
$15,000
20,000
40,000

30,000

Gain/Loss After-tax Cash


-0$15,000
-020,000
15,000
34, 750
5,000
29,250 **
$ 20,000
$ 99,000

*(35% x $15,000 = $5,250; $40,000 - $5,250 = $34,750 )


** (15% x $5,000 = $750; $30,000 - $750 = $29,250 )
Note that under option 2, Paolo has the same after tax cash as under option 1 if he
decides to sell the distributed assets immediately after the distribution.

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

61. Carrie DLake, Reed A. Green, and Doug A. Divot share a passion for golf and decide to
go into the golf club manufacturing business together. On January 2, 2013, DLake,
Green, and Divot form the Slicenhook Partnership, a general partnership. Slicenhooks
main product will be a perimeter-weighted titanium driver with a patented graphite shaft.
All three partners plan to actively participate in the business. The partners contribute the
following property to form Slicenhook:
Partner
Carrie DLake
Reed A. Green
Doug A. Divot

Contribution
Land, FMV $460,000
Basis $460,000, Mortgage $60,000
$400,000
$400,000

Carrie had recently acquired the land with the idea that she would contribute it to the
newly formed partnership. The partners agree to share in profits and losses equally.
Slicenhook elects a calendar year end and the accrual method of accounting.
In addition, Slicenhook borrows $1,500,000 from BigBank at the time the contributions
were made. Slicenhook uses the proceeds from the loan and the cash contributions to
build a state-of-the-art manufacturing facility ($1,200,000), purchase equipment
($600,000), and produce inventory ($400,000). With the remaining cash, Slicenhook
invests $45,000 in the stock of a privately owned graphite research company and retains
$55,000 as working cash.
Slicenhook operates on a just-in-time inventory system so it sells all inventory and
collects all sales immediately. That means that at the end of the year, Slicenhook does
not carry any inventory or accounts receivable balances. During 2013, Slicenhook has
the following operating results:

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Sales
$ 1,126,000
Cost of goods sold
400,000
Interest income from tax-exempt bonds
900
Qualified dividend income from stock
1,500
Operating expenses
126,000
Depreciation (tax)
179 on equipment
$39,000
Equipment
81,000
Building
24,000
144,000
Interest expense on debt
120,000
The partnership is very successful in its first year. The success allows Slicenhook to use
excess cash from operations to purchase $15,000 of tax-exempt bonds (you can see the
interest income already reflected in the operating results). The partnership also makes a
principal payment on its loan in the amount of $300,000 and a distribution of $100,000 to
each of the partners on December 31, 2013.
The partnership continues its success in 2014 with the following operating results:
Sales
$ 1,200,000
Cost of goods sold
420,000
Interest income from tax-exempt bonds
900
Qualified dividend income from stock
1,500
Operating expenses
132,000
Depreciation (tax)
Equipment
147,000
Building
30,000
177,000
Interest expense on debt
96,000
The operating expenses include a $1,800 trucking fine that one of their drivers incurred
for reckless driving and speeding and meals and entertainment expense of $6,000.
By the end of 2014, Reed has had a falling out with Carrie and Doug and has decided to
leave the partnership. He has located a potential buyer for his partnership interest, Indie
Ruff. Indie has agreed to purchase Reeds interest in Slicenhook for $730,000 in cash
and the assumption of Reeds share of Slicenhooks debt. Carrie and Doug, however, are
not certain that admitting Indie to the partnership is such a good idea. They want at least
to consider having Slicenhook liquidate Reeds interest on January 1, 2015. As of January
1, 2015, Slicenhook has the following assets:

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Tax Basis
$ 876,800
15,000
45,000
333,000
1,146,000
460,000
$ 2,875,800

Cash
Investment - Tax Exempts
Investment Stock
Equipment - net of dep.
Building - net of dep.
Land
Total

FMV
$ 876,800
18,000
45,000
600,000
1,440,000
510,000
$ 3,489,800

Carrie and Doug propose that Slicenhook distribute the following to Reed in complete
liquidation of his partnership interest:
Tax Basis
$ 485,000
45,000
111,000
$ 641,000

Cash
Investment Stock
Equipment - net of dep.
Total

FMV
$ 485,000
45,000
200,000
$ 730,000

Slicenhook has not purchased or sold any equipment since its original purchase just after
formation.
a. Determine each partners recognized gain or loss upon formation of Slicenhook.
b. What is each partners initial tax basis in Slicenhook on January 2, 2013?
c. Prepare Slicenhooks opening tax basis balance sheet as of January 2, 2013.
d. Using the operating results, what are Slicenhooks ordinary income and separately
stated items for 2013 and 2014? What amount of Slicenhooks income for each
period would each of the partners receive?
e. Using the information provided, prepare Slicenhooks page 1 and Schedule K to be
included with its Form 1065 for 2013. Also, prepare a Schedule K-1 for Carrie.
f. What are Carries, Reeds, and Dougs bases in their partnership interest at the end of
2013 and 2014?
g. If Reed sells his interest in Slicenhook to Indie Ruff, what is the amount and character
of his recognized gain or loss? What is Indies basis in the partnership interest?
h. What is Indies inside basis in Slicenhook? What effect would a 754 election have
on Indies inside basis?

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

i. If Slicenhook distributes the assets proposed by Carrie and Doug in complete


liquidation of Reeds partnership interest, what is the amount and character of Reeds
recognized gain or loss? What is Reeds basis in the distributed assets?
j. Compare and contrast Reeds options for terminating his partnership interest. Assume
that Reeds marginal tax rate is 35 percent, and his capital gains rate is 15 percent.
Answer:
a.
Recognized gain or loss on
formation of Slicenhook

D'Lake
$ -0-

Green
$ -0-

Divot
$ -0-

b.
D'Lake
Cash contributed
Basis in contributed land
Share of Debt {1/3 x ($60,000

$460,000

mtg + $1,500,000 loan)}

520,000
(60,000)
920,000

Debt relief
Initial tax basis in Slicenhook

Green
Divot
$400,000 $400,000

520,000

520,000

920,000

920,000

c.
Slicenhook Balance sheet
At Formation (January 2, 2013)
Tax Basis
Cash
$ 2,300,000
Land
460,000
Total
$ 2,760,000
Liabilities
Tax Capital:
Carrie D'Lake
Reed A. Green
Doug A. Divot
Total

$ 1,560,000
400,000
400,000
400,000
$ 2,760,000

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

d.

Ordinary Income:
Sales
Cost of goods sold
Operating expenses
Depreciation
Interest expense
Total ordinary income
Separately Stated Items:
Qualified dividends
Tax-exempt interest
179 expense
Fines and penalties
Meals and entertainment
Deductible
Non-deductible

Slicenhook Total
2013
2014
1,126,000
1,200,00
0
(400,000) (420,000)
(126,000) (124,200)
(105,000) (177,000)
(120,000) (96,000)
375,000
382,800

1,500
900
(39,000)
-

1,500
900
(1,800)
(3,000)
(3,000)

Each Partner's share


2013
2014
375,333
400,000
(133,333)
(42,000)
(35,000)
(40,000)
125,000

(140,000)
(41,400)
(59,000)
(32,000)
127,600

500
300
(13,000)
-

500
300
(600)
(1,000)
(1,000)

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

e. Slicenhook Partnerships page 1 and Schedule K to be included with Form 1065 and
Carries Schedule K-1 are shown below:

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

f.
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Outside Basis
Initial tax basis (inc. debt)
Ordinary income
Dividends
Tax-exempt interest
179 expense
Debt changes
Cash distributions
Basis at 12/31/13
Ordinary income
Dividends
Tax-exempt interest
Fines and penalties
M&E
Basis at 12/31/14
g.

D'Lake
$ 920,000
125,000
500
300
(13,000)
(100,000)
(100,000)
$ 832,800
127,600
500
300
(600)
(2,000)
958,600

Amount realized:
Cash
$ 730,000
Debt relief ($520,000 - $100,000) 420,000
Less: basis in partnership interest
Reeds realized and recognized gain

Green
$ 920,000
125,000
500
300
(13,000)
(100,000)
(100,000)
$ 832,800
127,600
500
300
(600)
(2,000)
958,600

Divot
$ 920,000
125,000
500
300
(13,000)
(100,000)
(100,000)
$ 832,800
127,600
500
300
(600)
(2,000)
958,600

$ 1,150,000
(958,600)
$ 191,400

To the extent Reed realizes any amounts attributable to hot assets, his gain will be
classified as ordinary. If Slicenhook sold its assets for their fair market value at the
sale date, the ordinary gain from depreciation recapture would be as follows:
Equipment
Total gain
Less: ordinary gain
Capital gain

Tax basis
$ 333,000

FMV
$ 600,000

Gain/Loss
$ 267,000

Reeds share
$ 89,000

$ 191,400
(89,000)
$ 102,400

Reed recognizes $89,000 of ordinary income from depreciation recapture on the


equipment and $102,400 capital gain from the sale of his interest in Slicenhook.
Indie will take an outside basis in his Slicenhook interest equal to his cash payment
of $730,000 plus his 1/3 share of Slicenhooks liabilities of $420,000 for a total of
$1,150,000.
h.

Indies inside basis is equal to Reeds inside basis before the sale: $958,600 or one
third of the total tax basis in all the partnership assets. Indies special basis
adjustment would be the difference between his outside basis and inside basis (both
net of liabilities) in Slicenhook and is calculated as follows:

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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Initial basis in Slicenhook


Minus: Indies inside basis
Special basis adjustment

$ 1,150,000
958,600
$ 191,400

The special basis adjustment relates to the investment in tax exempt securities,
equipment, building and land. If Slicenhook were to make a 754 election, Indie
would be allocated additional depreciation because of the increased basis in the
equipment and building. In addition if Slicenhook were to sell the land, Indie would
report less gain if Slicenhook had a 754 election in effect when he purchased his
interest.
i.

Reed does not recognize any gain or loss on the distribution. Rather he adjusts the
basis in the distributed assets.
Reeds outside basis in Slicenhook at the distribution is $958,600, including his
$420,000 share of partnership liabilities. Reed will need to allocate this basis to the
distributed assets. Reed first reduces his basis for the deemed cash distribution
relating to his reduction in Slicenhook debt ($420,000) leaving an outside basis of
$538,600 ($958,600 - $420,000) to allocate to the distributed assets. He determines
his basis in the distributed assets as follows:
1. First, he assigns a carryover basis to the distributed assets.
Cash
Potential Recapture
Investment
Equipment

$ 485,000
0
45,000
111,000

Since the sum of the adjusted bases of the distributed assets ($641,000) is greater
than his allocable basis in Slicenhook ($538,600), Reed has a required decrease
of $102,400.1
2.

The recapture potential inherent in the equipment should be assigned a basis of zero
and treated as a hot asset. Reed reduces the basis in the cold assets (investment
and equipment) distributed. The required decrease is allocated between the
investment and equipment according to their relative tax basis amounts.
Accordingly, the basis of investment should be reduced by $29,538 ($102,400 X
$45,000/$156,000), and the basis of equipment should be reduced by $72,862
($102,400 X $111,000/$156,000).
After completing the allocation Reeds bases in the distributed assets are:
Cash

$485,000

1 Since the basis reduction is not at least $250,000, the distribution does not meet the definition
of a substantial basis reduction, which would require a mandatory special basis adjustment.
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

Potential Recapture
0
Investment in stock ($45,000 - $29,538)15,462
Equipment ($111,000 - $72,862)
38,138
j.

If Reed sells his interest to Indie, Reed must immediately recognize a gain of
$191,400: $89,000 is ordinary income and $102,400 is capital gain. He has no future
tax liability related to the transaction. The capital gain will be taxed at a maximum
of 15%. Given Reeds assumed ordinary marginal tax rate of 35%, he would have
cash after tax of $683,490 [$730,000 (15% $102,400) (35% $89,000)] to
invest in other projects as he wishes.
Under his other alternative in which Slicenhook distributes cash, stock, and
equipment, Reed is able to defer any gain on the liquidation until the distributed
assets are sold. However as he sells the assets, he will recognize gain or loss. If Reed
were to immediately sell the distributed assets, he would recognize a $29,538 capital
gain on the investments ($45,000 FMV $15,462 basis); and on the sale of the
equipment he would recognize a gain of $161,862 ($200,000 FMV $38,138 basis) of
which $89,000 will be ordinary income due to depreciation recapture and $72,862
would be 1231 gain. This option would leave Reed with $674,276 after tax cash as
follows:
Cash
Investment in stock
Equipment

Tax basis
FMV
$485,000 $485,000
15,462
45,000
38,138
200,000

Gain/Loss After-tax Cash


-0$485,000
29,538
40,570
161,862
$157,920 *
$ 191,400 $ 683,490

*After-tax cash from the sale of investments is $40,570 [$45,000 (15%


$29,538)]. After-tax cash from the sale of the equipment is $157,920
[$200,000 (15% $72,862) (35% $89,000)], assuming the 1231
gain is taxed at capital gains rates.

Note that under the second alternative, Reeds after tax cash is the same
as under the sale option. However, Reed may incur additional costs to
sell these assets, which would reduce his after-tax cash.
In addition, under the sale option, Carrie and Doug would have a new partner in
their business. This might work out well if Indie agrees with the existing partners
about how the business should run. Otherwise, this might generate some conflict
between the partners. The partnership would retain all of its assets under this
option so it would not incur any additional cost to replace the equipment that would
be distributed to Reed under the distribution option. Under the distribution option,
not only might Slicenhook need to replace the distributed equipment but it would be
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Chapter 21 - Dispositions of Partnership Interests and Partnership Distributions

left with only $391,800 of cash ($876,800 pre-distribution [given in problem] $485,000 distribution).

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