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Passive Activity Loss ATG - Chapter 5, Dispositions

Publication Date - December, 2004

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.


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Chapter 5, Dispositions

In A Nutshell

Passive losses are generally deductible only to the extent of passive income.  However, current and suspended losses are fully deductible if there is a “qualifying disposition.”  Under IRC § 469(g), a “qualifying disposition” requires three criteria: 

  1. Disposition of an entire interest (or substantially all[1])
  2. In a fully taxable event (where all gain/loss is realized and recognized).
  3. To an unrelated party.

If these three tests are met, losses are fully deductible against non-passive income (unless the taxpayer has basis limitations).  Thus, in the year of disposition, losses allocable to the passive activity may offset portfolio and other investment income or may become part of a net operating loss. 

We have no regulations governing dispositions.  Thus, we must look to IRC § 469(g) and legislative history[2] for guidance. 

Entire Interest

The taxpayer must dispose of his entire interest in the activity, or substantially all of it, in order to trigger the recognition of loss.  If less than an entire interest is disposed, then the issue of ultimate economic gain or loss is unresolved.

A mere change in the form of ownership is not a qualifying disposition.  An entity is not necessarily an activity.  The conversion by the taxpayer of a business or rental activity from a sole proprietorship to an LLC or S Corporation in which the taxpayer still owns an interest is not a qualifying disposition, which triggers current and suspended losses. 

If a partnership conducts two separate activities within the entity, a fully taxable disposition of all assets used or created in one activity constitutes a disposition of the partner’s or shareholder’s entire interest in the activity.  The taxpayer must have adequate records of suspended losses and credits that are allocable to that activity.

Partial Interest

Disposing of substantially all of an activity (rather than an entire interest) may be treated as an “entire” disposition.  Reg. § 1.469-4(g) provides that the taxpayer must be able to show with reasonable certainty income, deductions and credits allocable to that part of the activity.

Reminder:  The taxpayer must still meet the fully taxable requirement and the sale must be to an unrelated party before losses are allowed as non-passive.

Real Estate Professional:

If the taxpayer made an election to group his rentals as a single activity under Reg.  § 1.469-9(g), the sale of one property would not constitute an entire disposition.  See Chapter 2 regarding Real Estate Professionals.  However, losses will be triggered to the extent of net gain reported.

Fully Taxable Transaction

In a fully taxable disposition, all gain or loss is realized and recognized in the current year.

An exchange of the taxpayer’s interest where all gain or loss is not recognized does not trigger suspended losses, (such as transactions governed by IRC § 351, 721 or 1031). To the extent the taxpayer has recognized gain on the transaction, that income generally is passive and may be entered on Form 8582, triggering passive losses. 

Transactions that are not fully taxable events include:

  • Likekind exchanges – IRC §1031
  • Conversion to personal use
  • Gift (donor’s suspended losses added to basis, no loss deduction allowed to the donor in any year - IRC § 469(j)(6))
  • Transfer of the activity to a corporation, partnership or LLC
  • Bankruptcy that has not been finalized.  Simply filing for bankruptcy is not a qualifying disposition. 

Reminders:

  • When debts are discharged in bankruptcy, to the extent cancelled debt is not taxed under IRC § 61(a)(12), IRC § 108(c) holds that that the amount of the debt forgiven absorbs certain tax attributes including passive losses.  Passive losses which have been absorbed by cancelled debt are not deductible.
  • For individuals who file for bankruptcy under Chapter 7, the unused passive activity losses and credits are transferred to the bankruptcy estate.  See Reg. § 1.1398-1(c). 

Death

Current and suspended passive losses are permitted only to the extent they exceed any step-up in basis in the hands of the beneficiary.  Basis is stepped up to fair market value.[3]  If the increase in basis exceeds unused passive losses, no losses are deductible on the decedent’s return.

As a practical matter, the basis step-up to fair market value is generally significant and absorbs remaining losses.  Thus none may be deducted.  They are lost forever.

Installment Sale

If the taxpayer sells a passive activity on the installment basis, current and suspended losses may only be deducted in the same ratio as the gain reported. If there is excess gain, that gain is passive income under Reg. § 1.469-2T(c)(2) and will permit deductibility of additional losses to the extent of the gain.

Unrelated Party

If a passive activity is sold to a related party, losses are not triggered (except to the extent passive income is generated).  They remain with the taxpayer and are shown on Form 8582 until the activity is ultimately acquired by an unrelated third party.   See IRC § 469(g)(1)(B).  Aside from IRC § 469(g), IRC § 267 generally does not permit a loss on the sale of property to a related parties.  The following are related parties[4]:

  • Members of a family;
  • An individual and a corporation in which he owns directly or indirectly more than 50 percent in value of the outstanding stock;
  • Two corporations which are members of the same controlled group;
  • A grantor and trustee of any trust;
  • A trustee and a beneficiary of the trust;
  • A corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation and more than 50 percent of the capital interest or profits interest in the partnership;
  • An S Corporation and another S Corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or,
  • An S Corporation and C Corporation if the same person owns more than 50 percent in value of the outstanding stock in each corporation.

Issue Identification:

On disposition, losses are entered on the same schedules normally used: 

  • Schedule E for current and suspended losses.
  • The Form 4797 and Schedule D for disposition of assets and the sale of a partnership interest.  If there is no Form 4797 attached to the return, there may not be a fully taxable disposition, (i.e. the sale of assets may not yet have been completed).

The instructions to Form 8582 advise taxpayers to note “entire disposition of a passive activity” on any schedule reflecting gain or loss.  However, many taxpayers fail to make this note:

  • If there is a Form 6252, Installment Sale Income, for an installment sale, determine whether losses were deducted in excess of the prescribed ratio.
  • If the return indicates the taxpayer is deceased, look for large non-passive losses deducted.  Sometimes losses have not been reduced by the basis step-up.

Examination Techniques:

  • Ask who the activity was sold to and if the buyer is related to the taxpayer.
  • Determine if the taxpayer retained an interest in the activity.
  • Determine if the taxpayer is still responsible for any liabilities of the activity.
  • Determine if all gain (or loss) is reflected on the return.
  • Determine if a final return has been filed for the S Corporation or partnership.
  • If an installment sale of a passive activity is indicated on Form 6252, ensure that only the recognized gain is reflected on Form 8582 and that the entire current and suspended losses have not been deducted on the Schedule E.
  • Verify prior year losses via review of last year’s Form 8582 worksheet 5.  If suspicious, request prior years’ Schedule K-1s to verify total amount of carryforward losses.

FORM 8582:  Dispositions with Net Losses

If there is an overall net loss on disposition of a passive activity (after considering all current and suspended losses), none of the gains or losses should be entered on Form 8582.  Gains and losses from the sale should be reported on Schedule D and/or Form 4797.  Current and carryover losses should be reported on Schedule E in the non-passive column with a note to the left “Entire Disposition of Passive Activity”.

The purpose of Form 8582 is to compute the allowable passive losses.  If the disposition of the passive activity is a qualifying disposition as previously discussed, the losses attributable to that activity are allowed in full, and, as such, would not be required to be reflected on Form 8582.

Dispositions with Overall net Gain

Income from the sale or other disposition of passive activity is generally passive income if the activity was a passive activity in the year of sale (Reg. § 1.469-2T(c)(2)(i)).  Similarly, income from the sale or property used in a passive activity is passive income.  If there is overall net income on a disposition (gain on the sale exceeds the current and prior years losses), income and losses should both be reflected on the same line of Worksheet 1, 2 or 3 of Form 8582.  As discussed above, if there is an overall net loss on the disposition, nothing should be entered on Form 8582.  If there are two dispositions, one with an overall net loss and another with an overall net gain, they should be netted.

The following gains generally are not passive and should not be used to offset passive losses:

  • Sale of land (whether leased[5] or held for investment[6])
  • Sale of self-rented property[7]
  • Sale of a building not used in a passive activity in the year of sale[8]

Additionally, gain on the sale of a rental is non-passive if the taxpayer is a real estate professional[9] and performed most of the work.

The fact that an activity is passive does not determine the character of the gain (or loss) in terms of whether it is capital or ordinary in nature.  Gain on disposition, usually capital in nature, will be reflected on Form 4797 and Schedule D.  Current gains/losses as well as suspended losses represent ordinary income.  They are generally entered on Schedule E and do not reduce capital gains reflected on Schedule D. 

Issue Identification:  Watch for returns where the net gain on Form 4797 has been entered on Form 8582, but not the current and carryover losses.  If there is an overall net loss, nothing should be reflected on Form 8582.  By entering the income without the losses, the taxpayer has erroneously triggered deductibility of other passive losses.

Examination Techniques:

  • On dispositions generating large amounts of income offsetting other passive losses, verify the disposition is from a passive activity (from a rental activity or a business activity in which the taxpayer does not materially participate).
  • Verify the gain was not from the sale of land or a building used in an investment activity.  Investment income is no passive income.
  • Verify the net gain and not the sales price was entered on Form 8582.  If the sales price is used, passive income is inflated and unrelated passive losses are triggered in error.

FORM 8582: Dispositions with Net Gain 

As indicated above, gain on the sale or other disposition generally is passive income.  Gain on Form 4797 and Schedule D should first offset losses from the same activity.  If any gain remains, it offsets losses from other unrelated passive activities.

On dispositions with an overall net gain, the net gain, current losses, and suspended losses are all reflected on Form 8582.  Entering the gain, but not the losses, on the Form 8582 results in unrelated passive losses being allowed in error.  Any gain must first offset losses from the same activity.

The purpose of Form 8582 is purely computational.  The examiner should verify that all income shown on Form 8582 line 1a or 3a is reflected elsewhere on the return, most commonly on Schedule  E or Schedule D.  The Form 8582 does not report income.  If income shown on Form 8582 is not reflected on the return, it is unreported income!  

Summary

  • For current and suspended losses to be deductible, the taxpayer must sell or otherwise dispose of his entire interest in a passive activity.
  • The disposition must be a fully taxable transaction.  Transfers to other entities and likekind exchanges are non-qualifying dispositions.  Losses remain on Form 8582.
  • When a taxpayer dies, only losses in excess of the step-up in basis are allowed.  Stated differently, the decedent’s losses are allowed only to the extent they exceed the amount by which the beneficiary’s basis in the passive activity has been increased.[10]
  • On an installment sale, losses are triggered in ratio to gain reported.
  • When gain and current and suspended losses are netted, if there is an overall loss, nothing should be entered on Form 8582.
  • If there is an overall gain on disposition, all gains and losses should be entered on Form 8582.  Any excess gain, generally is passive income which may trigger deductibility of unrelated passive losses.  

Supporting Law

  • IRC § 469(g):  Passive losses are allowed on an entire disposition to an unrelated party in a fully taxable transaction.
  • IRC § 469(g)(1)(B):  If an entire interest in a passive activity  is sold to a related party, passive loss remains with the taxpayer on FORM 8582 until the related party sells to an unrelated party.
  • IRC § 469(g)(2):  On death of a taxpayer, passive losses are deductible on to the extent they exceed the difference between adjusted basis and the stepped-up basis FMV in the hands of the beneficiary.  In other words, the step-up in basis usually absorbs the decedent’s passive losses, and therefore, no deduction is allowed to the taxpayer, estate, or beneficiary.
  • IRC § 469(g)(3):  On an installment sale, losses are recognized in the same ratio as gain reported.
  • IRC § 469(j)(6):  When a passive loss is gifted to a person or charity, losses are added to the donee’s basis.  They are not deductible by the taxpayer/donor.
  • IRC § 469(j)(12):  When an estate or trust distributes a passive activity, losses are not deductible by the estate or trust.  They are added to the beneficiary’s basis.
  • IRC § 1398(f)(1), Reg. § 1.1398-1(d)(1):  A transfer of an interest in a passive activity between an individual and a bankruptcy estate is not a qualifying disposition, which triggers deductibility of losses.
  • Reg. § 1.469-2T(c)(2)(i)(A)(2):  Gain on disposition generally is passive income if the activity was a passive activity in the year of disposition.
  • Reg. § 1.469-2T(c)(2)(i)(A)(3):  Gain on disposition is not passive income if the activity is not a passive activity in the taxable year of disposition.
  • Reg. § 1.469-2T(f)(3):  If less than 30 percent of the unadjusted basis of leased property is depreciable, gain is non-passive.
  • Reg. § 1.469-2(f)(6):  Gain on the sale (or rental income) of property leased to a business in which the taxpayer materially participates (i.e. where he regularly works) is non-passive.
  • Reg. § 1.469-4(g):  If substantially all of an activity is sold, that portion may be treated as a separate activity.
  • Reg. § 1.469-6 on dispositions has not yet been written.  Thus, we have no regulations on dispositions other than those mentioned above.

[1] Reg. § 1.469-4(g)  

[2] Committee Reports on P.L. 99-514 (Tax Reform Act of 1986) 

[3] IRC § 469(g)(2)

[4] IRC § 267(b) and § 707(b)

[5] Reg. § 1.469-2T(f)(3) 

[6] IRC  § 469(e)(1)(A)(ii)(II)

[7] Reg. § 1.469-2(f)(6) 

[8] Reg. § 1.469-2T(c)(2)(i)(A)(3)  

[9] IRC § 469(c)(7)

[10] IRC § 469(g)(2)

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Page Last Reviewed or Updated: 04-Mar-2014