Definition: Hot assets are business assets that have the potential of built in ordinary income. In other words, these are assets that would generate ordinary income if sold. The main two examples are inventory and accounts receivable.
What Does Hot Assets Mean?
Hot assets is not a term that FASB or GAAP created. Instead, it was created by the IRS under IRC section 751 to classify certain types of current assets during a partnership liquidation. What the IRS was worried about was that a partner could leave the company by “liquidating” his interest and get special long-term gains tax treatment.
The preferable capital gains tax treatment could reduce the partner’s personal income taxes dramatically, so the IRS made a rule about it. They decided that if the partnership has any hot assets, the leaving partner must recognize ordinary income to the extent of his percentage ownership in the hot assets. The rest of the partnership interest can still be treated as capital gains.
This prevents the partner from receiving favorable tax treatment from liquidating his or her interest. The amount of the exiting partner’s ordinary gain or loss is the difference between the amount realized from his portion of hot assets and the partnership basis in these assets.
This subject can get pretty complicated depending on the situation, so I won’t get into all the details. The main thing to know is that hot assets are ordinary income producing assets like inventory. If the partnership sold the inventory, it would recognize ordinary income. Thus, the IRS says that an exiting partner must also recognize any gain or loss from the liquidation of his interest as ordinary to the extent of the hot assets attributed to him.
If there is any gain or loss left after that, it would be classified as a capital gain.