Dispositions of Passive Activities

The tax law generally limits a deduction for losses from passive activities to the extent of passive activity income. Unused losses are suspended and carried over, only to be used to offset passive activity income in future years. However, when there is a qualifying disposition of a passive activity, losses from that activity that have been carried over can be claimed in full (without regard to passive activity income). How do the disposition rules work?

What is a qualifying disposition?

There are 3 tests for a qualifying disposition:

• The disposition must be of your entire interest (or substantially all). A sale of your ownership interest in an activity is a good example of a disposition. A mere change in the form of the entity running the activity is not a disposition.
• The disposition must be a fully taxable event where gain or loss is realized and recognized (explained later).
• The disposition must be made to an unrelated party. This means dispositions to third parties and not to a family member, a business controlled by the taxpayer, or other related entity.

 Fully taxable event

To be a qualified disposition, there must be a taxable event in which gain or loss is recognized. A tax-free exchange is not a taxable event because gain is not recognized. Examples of other nontaxable events that would not unleash pent-up losses include gifts, conversion to personal use, transfers to a partnership or corporation, and filing for bankruptcy.

If there is an installment sale of the passive activity, losses can be taken in the same ratio in which gain is recognized. If there is excess gain, that gain is passive income that will enable you to deduct passive activity losses from other passive activities (the ones that have not been disposed of).

In the case of death, losses are allowed only to the extent they exceed any step-up in basis in the hands of the heir or beneficiary, which usually means that suspended losses are lost forever.

Impact of selling a home

Can gain on the sale of a principal residence be viewed as passive activity income that can be used to offset passive activity losses? The IRS has ruled that selling a home that’s been converted to rental property is a complete disposition even though gain is excluded under the home sale exclusion (up to $500,000 for joint filers and $250,000 for singles). The IRS gives this example:

A homeowner buys a residence for $700,000 that is used as a principal residence for more than 2 years. The home is then converted to rental property, and the owner has a $10,000 loss annually for 3 years. (Assume his income is too high to allow him to use the annual $25,000 rental loss allowance.) The home is sold for $800,000, and the $100,000 gain is not taxed because of the home sale exclusion (he met the 2-out-of-5-year requirement for this exclusion). The homeowner can deduct the suspended $30,000 loss because there has been a complete disposition of the property.

Foreclosure

When property subject to a mortgage is foreclosed upon, does this action constitute a taxable disposition? Normally, a foreclosure is a taxable event. However, the foreclosure must be final. If a taxpayer contests this action, there cannot be any disposition for tax purposes until the matter is settled.

Bankruptcy

Special rules apply in the case of bankruptcy. When an individual files for bankruptcy under Chapter 7 (the type of bankruptcy that results in a fresh start), the unused passive activity losses are transferred to the bankruptcy estate.

When debts are discharged in bankruptcy, the amount of canceled debt not taxed effectively absorbs passive losses (which are treated as a tax attribute that is reduced by unrecognized canceled debt). Thus, passive losses absorbed by canceled debt are not deductible.

NII tax

The determination of whether passive losses can be taken is important not only for regular income tax purposes, but also for the net investment income (NII) tax. This is an additional 3.8% Medicare tax on net investment income for high-income taxpayers. The same passive activity loss rules apply for the NII tax.

Conclusion

Many taxpayers have passive losses from rental activities and investments in businesses in which they are “silent partners.” Understanding when passive activity losses—current and suspended—can be taken is important in tax planning.

Source: ILM 201428008;Alexander Herwig, TC Memo 2014-95