Generally, a partner who sells an interest in a partnership will recognize capital gain or capital loss on the disposition. However, Internal Revenue Code Section 751 may cause an unanticipated tax consequence — the need for the partner to recognize ordinary income on the sale of the partnership. Investors in Master Limited Partnerships (MLPs) may have an increased level of sensitivity to this recognition due to the nature of MLP activities. Specifically, as MLPs tend to have a very capital-intensive balance sheet with large amounts of fixed assets, the depreciation recapture associated with a sale of the partnership interest may cause significant negative tax consequences if not appropriately considered.
Section 751 is a recharacterization of gain or loss on the sale of a partnership interest from capital to ordinary on Section 751 property owned by the partnership. Section 751 also may apply in the case of certain distributions of property to partners, such as unrealized receivables or substantially appreciated inventory, in exchange for some or all of the partners’ interest in other partnership property.
Section 751(a) property includes unrealized receivables and inventory items. The definition of unrealized receivables under Section 751 includes Section 1245 and 1250 property to the extent of depreciation recapture, and certain oil and gas property as described under Section 1254 to the extent it would be treated as ordinary if sold by the partnership. Accordingly, the sale of MLP units often can generate a substantial amount of ordinary income recognition under Section 751. This amount can reduce the capital gain on sale of the partnership interest or actually create a capital loss.
Below is a basic example illustrating the impact of Section 751:
Tax Basis in MLP 100,000
Sale Proceeds 150,000
Overall Gain 50,000
Section 751 Recapture 60,000
Capital Loss (10,000)
The amount of ordinary income is reflected in attachments to a Form K-1 received by the partnership. In the above example, a taxpayer could expect an overall $50,000 gain on the sale of the partnership interest. However, $60,000 of the amount is recharacterized as ordinary income, resulting in a $10,000 capital loss. Depending on the taxpayer’s situation, this capital loss may be subject to certain limitations based upon the taxpayer’s overall capital gain situation.
Given the nature of the activities of MLPs, Section 751 recapture amounts may be significant. When projecting the tax consequences of the sale of a partnership interest, it is imperative to consider the impact of these provisions. To the extent you are considering investing in MLPs or contemplating the sale of MLPs, consult your tax advisor as to an appropriate plan for the tax impact of a sale.
For more information contact Rob Velotta at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.