MILAN, July 29 (Reuters) - UniCredit said on Thursday it would hold exclusive talks with Italy's government over Monte dei Paschi, a move that could see the Tuscan lender return to private ownership four years after it was rescued by the state.

Rome has long singled out UniCredit as the best buyer for Monte dei Paschi (MPS) which needs another 2.5 billion euros in capital after the 2017 bailout that cost Italian taxpayers 5.4 billion euros.

Legal risks following decades of mismanagement, poor loan quality and a weakened commercial franchise have made MPS a tough sell, forcing the Treasury to work hard to line up sufficient incentives for a buyer.

Banking stress test results on Friday are expected to highlight MPS' fragility.

UniCredit Chief Executive Andrea Orcel, who took over in April, said the bank had signed a termsheet with the Treasury detailing the conditions at which it could buy "selected parts" of MPS.

"This is just the start of a due diligence ... we have not negotiated the transaction ... all we have is some guidelines so that we have an alignment between the two parties on what we're trying to achieve," he told a conference call.

However, a person involved in the negotiations said the Treasury was confident it would reach an accord after the summer and had a draft deal already in place.

Orcel said talks would last a few weeks and a decision could emerge sometime in September.

UniCredit said the conditions set for a deal meant that there would be no impact on its core capital. Also, it would not take on any impaired loan of MPS and be allowed to offload also MPS' performing loans that appear risky.

The source close to the deal said state-owned bad loan manager AMCO would take on MPS' problem loans.

UniCredit would also be shielded from any actual and potential risks stemming from MPS' pending lawsuits. The source said such risks would be spun off from the bank and be kept in state hands.

The conditions for an accord mean the acquisition would bring a double-digit boost to UniCredit's earnings per share as well as improve its price to tangible book value ratio, Orcel said.

A potential deal would "strengthen our competitive position in Italy and allow us to generate material synergies," he said.

Orcel, a veteran dealmaker and former UBS chief of investment banking, had so far shown little appetite for a deal, saying he was focused on an internal overhaul at UniCredit and a business plan the bank is due to present in the autumn.

"I have been clear on the role that M&A can play, it is not a goal per se, it can be an accelerator," he said.

Reuters reported on July 21 that the government was working on making MPS attractive to UniCredit despite Orcel's public reticence.

UniCredit reports first-half results on Friday. (Reporting by Valentina Za and Giuseppe Fonte; Writing by Rachel Armstrong; Editing by Aurora Ellis and Alistair Bell)