Passive Activity Loss ATG - Exhibit 5.2: Dispositions Triggering Losses
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.
Exhibit 5.2: Dispositions Triggering Losses
ISSUE: Are current and suspended passive losses fully deductible due to a disposition? In other words, is the transaction an entire disposition to an unrelated party in a fully taxable transaction? If not, losses remain on Form 8582 and are deductible only to the extent of passive income.
_____ Verify that all gains and losses have been realized and recognized. The following are not fully taxable:
- Like-kind exchanges.
- Conversion to personal use.
- Transfer to a corporation or partnership.
- Transfer due to divorce (treated as gift-IRC § 469(j)(6) & § 1041(b).
- Installment sale (PALs triggered in ratio to gain reported).
- Bankruptcy (see below).
NOTE: The absence of Form 4797 attached to the return may indicate that there is not a fully taxable disposition.
_____ Verify the loss has been deducted in the correct year. The Senate Report indicates that the taxpayer’s accumulated tax loses should be permitted to be deducted when, and only when the actual economic gain or loss on the activity can finally be determined.
_____ Does the taxpayer still own the activity, just in a different entity form? An entity is not an activity. An activity is a business or a rental activity. The entity form may change, i.e. from a partnership to an LLC, but the taxpayer has not disposed of his “activity”, i.e. rental or business activity.
_____ Did the taxpayer sell his partnership/S Corporation interest – and then repurchase it within a short time? Substance versus form governs in tax law. The Senate Finance Committee Report on P.O. 99-514 (1986) states, “For example, sham transactions, transfers not properly treated as sales due to the existence of a put, call or similar right relating to repurchase do not give rise to allowance of suspended losses.”
_____ If the taxpayer is in bankruptcy:
- A transfer of a passive activity to a bankruptcy estate does not constitute an entire disposition in a fully taxable transaction (in other words, gain or loss has not been recognized). See IRC § 469(g), IRC § 1398(f)(1), Reg. § 1.1398-1(d)(1).
- If bankruptcy is complete, verify that tax attributes have been reduced by cancelled debt, specifically that current and suspended losses have first been applied against any mortgage or other debt forgiven. In many instances, the debt cancelled under § 108 fully absorbs any current or suspended losses, and therefore nothing is deductible on the return.
- Inquire whether the bankruptcy estate may have already used suspended passive losses. Some taxpayers carry the losses into subsequent years, despite having been used by the bankruptcy estate.
- Before allowing losses, consider basis and at-risk limitations. Furthermore, if the property is transferred out of the bankruptcy estate back to the taxpayer, he still has an ownership interest and losses are not triggered by IRC § 469(g). Such a transfer is not a qualifying disposition.
_____ Verify that disposition is not to a related party. See IRC § 469(g)(1)(B), § 267, § 707(b). If passive activity was sold or otherwise transferred to a related party, losses stay with the taxpayer. There is not a triggering disposition. The following are related parties: Spouse, brothers, sisters, sons, daughters, grandchildren; an individual and a corporation owned more than 50 percent by the same person; a partnership and a partner who owns more than 50 percent. The IRC § 267(a) disallows losses for sales or exchanges to related parties under IRC 267(b).
Be sure to look at the ownership percent on the Schedule K-1. Under IRC § 707(b)(1)(A), if a person, directly or indirectly, owns more than 50 percent of the capital interest or the profits interest of a partnership, he is a related party.
_____ Verify that substantially all of the activity was sold or otherwise disposed of. See IRC § 469(g) & Reg. § 1.469-4(g).
_____ Verify that activity has been truly terminated (in other words, that it is not continuing on as an LLC or other entity or another Schedule C under a different name, but the taxpayer still retains an ownership interest). The Senate Report (S. Rep. 99-313, 99th Cong., 2d Sess.) states, "The taxpayer must dispose of his entire interest in an activity in order to trigger the recognition of loss. If he disposes of less than his entire interest, then the issue of ultimate economic gain or loss on his investment in the activity remains unresolved. A disposition of the taxpayer’s entire interest involves a disposition of the taxpayer's interest in all entities that are engaged in the activity, and ... all assets used or created in the activity." (Emphasis added.) Note that the Senate report indicates all entities and all assets (used in the activity and inventory created by the activity).
_____ Check Form 8582 to see if Form 4797 gain on disposition may have been improperly entered on line 1a or 3a. Gain on disposition belongs on Form 8582 only if there is an overall gain after considering current and suspended losses. If there is an overall gain, both the gain and the losses should be on Form 8582. Gain should never be reflected on Form 8582 without the associated losses. If there is an overall loss after current and suspended losses are subtracted from net gain, nothing (neither gain nor losses) should be on Form 8582.
_____ If owner died, verify that suspended losses are allowed only to the extent they exceed the amount by which the transferee's basis in the passive activity has been increased. Basis is generally stepped up to FMV. If the increase in basis exceeds unused passive losses, no PALs are deductible. Neither the deceased taxpayer nor the beneficiary will ever be able to deduct the losses.
_____ If disposition was by gift or charitable contribution, loss is not deductible. Instead, the basis of the asset for the donee is increased by unused losses. See IRC § 469(j)(6).
_____ If loss is from a "rental", verify that it was not a temporary rental of the taxpayer's residence. If the rental period was less than a year or two, IRS may view it as a temporary rental lacking in the necessary profit motive under IRC § 183, i.e. a nondeductible loss. Deductions for rental of a personal residence may also be limited under IRC § 280A.
_____ Verify via Form 4797 and the depreciation schedules that prior year depreciation has been properly recaptured and treated as ordinary income.
_____ Consider whether the taxpayer is subject to AMT. Depreciation and other AMT preference and adjustment items relating to a passive activity are suspended until the year of a qualifying disposition (or there is passive income to trigger losses). Consequently, in the year of sale or other disposition, AMT may result. All prior and current year suspended preference and adjustment items should be reflected on the line on Form 6251, Alternative Minimum Tax- Individuals for passive activities.
LAW: Under IRC § 469(g), current and carryforward passive activity losses are fully deductible in the year of an entire disposition in a fully taxable transaction to an unrelated party. A qualifying disposition may create an Net Operating Loss (NOL) which can be carried back. See IRC § 172. NOTE: Whether or not there is a qualifying disposition, passive losses will always be triggered up to passive income reflected on the return.
CONCLUSION: Passive losses in the amount of $ ______ have/have not been adjusted for the following reason: ___________.