James, Justin, and Joseph are equal partners in the JJJ Partnership. The partnership balance sheet reads as follows on December 31 of the current year: Partner Joseph has an adjusted basis of $45,000 for his partnership interest. If Joseph sells his entire partnership interest to new partner Kayla for $65,000 cash, how much capital gain and ordinary income must Joseph recognize from the sale?
A) $20,000 ordinary income.
B) $20,000 capital gain.
C) $15,000 ordinary income; $5,000 capital gain.
D) $45,000 ordinary income; $25,000 capital loss.
E) None of the above.

Question

James, Justin, and Joseph are equal partners in the JJJ Partnership. The partnership balance sheet reads as follows on December 31 of the current year:  Partner Joseph has an adjusted basis of $45,000 for his partnership interest. If Joseph sells his entire partnership interest to new partner Kayla for $65,000 cash, how much capital gain and ordinary income must Joseph recognize from the sale?
A) $20,000 ordinary income. 
B) $20,000 capital gain. 
C) $15,000 ordinary income; $5,000 capital gain. 
D) $45,000 ordinary income; $25,000 capital loss. 
E) None of the above.

Quizplus · Accepted Answer

To determine the amount of capital gain or loss on the sale of a partnership interest, the selling partner must compare the amount realized (sale price) to their adjusted basis in the partnership interest. In this case, Joseph's adjusted basis is $45,000, but he sells his interest for $65,000. This means he has a realized gain of $20,000 ($65,000 - $45,000).

However, not all of this gain will be capital gain. The partnership balance sheet shows that the partnership has unrealized receivables and inventory items with a total value of $20,000. This means that Joseph's share of this unrealized gain (since he is selling his entire interest) will be treated as ordinary income. His share of the unrealized gain is calculated as follows:

Unrealized gain / Partnership value = Joseph's share of unrealized gain
$20,000 / ($500,000 + $20,000) = 4%

Joseph's share of the unrealized gain is therefore $800 (4% of $20,000).

So, Joseph will recognize $15,000 of ordinary income (his share of the unrealized gain) and $5,000 of capital gain ($20,000 realized gain - $15,000 ordinary income). Therefore, the correct answer is C.

James, Justin, and Joseph Are Equal Partners in the JJJ