The passive activity loss (PAL) rules were originally enacted to address abusive tax shelters and restrict taxpayers’ ability to reduce their tax liability through the use of loss deductions or credits. In many cases, any amount of loss from passive activities exceeding income from passive activities in a given year is not deductible and must be carried forward to succeeding tax years or until the activity is disposed of in a taxable transaction.
Unused PALs are suspended and carried forward to future years until the taxpayer (1) disposes of the particular activity that generated the losses, (2) generates net passive activity income in the case of a personal service corporation (PSC), or (3) generates net passive activity income or net active income in the case of a closely held corporation (CHC). A disposition generally occurs if the taxpayer’s entire interest in the activity is disposed of in a fully taxable transaction to an unrelated party (Sec. 469(g)(1)).
Example 1: A, Inc., is a PSC that owns two passive activities, a leased office building and a book unit. The building lease activity has no suspended losses and a current-year income of $10,000. The book unit has $50,000 in suspended losses and a current-year loss of $10,000. A has always treated the activities as two separate activities. A has active income of $100,000 in the current year.
A has decided that the book unit will never be profitable. Therefore, it plans to sell most of the assets involved with the book unit activity on December 30 of the current year. The assets to be sold have a fair market value (FMV) of $20,000 and a basis of $5,000. A plans to retain the book unit’s office equipment in its active business operations rather than sell it. That office equipment has an FMV of $1,000 and a basis of $500. Can A use the $50,000 of suspended losses from the book unit in the current year?
It would appear from the facts that A will dispose of substantially all of the book unit activity in the current year. A must be able to correctly account for the gross income, deductions, and credits that are allocable to that activity for the current tax year. As a result, A should be able to offset the $10,000 income from the building rental, the $15,000 gain from the sale of the book unit, and $35,000 of its active income with the $50,000 suspended loss and the $10,000 current-year loss from the book unit activity.
Sale of Entire Interest to an Unrelated Party
When an entire interest in a passive activity is sold to an unrelated party, current and suspended losses related to the activity may be used according to the following rules (Sec. 469(g)(1)(A)):
1. If the entire gain or loss from the sale of the property is recognized, the current-year loss from the activity (including all suspended losses) can be offset in full against any gain from disposing of the property or combined with the loss from such disposition.
2. If gain remains after item 1, it can be offset against any losses (including suspended losses) from all other passive activities. Any remaining gain is reported in the normal manner. However, any loss remaining is carried forward as a suspended passive loss.
3. If the result of item 1 is a loss, this loss can be offset against any net income or gain from all other passive activities (net of suspended losses carried from earlier years). If any of the loss from the disposed activity remains, it can then be deducted as a nonpassive loss.
Example 2: D is a CHC with suspended losses carried over from 2007 to 2008 as follows:
Property A $10,000 Property B 5,000 $15,000
On October 30, 2007, D sold property A to an unrelated party, realizing a long-term capital gain of $15,000. Property A generated a current-year passive loss of $1,500 in 2007 before the date of sale. D incurred a PAL of $3,000 on property B in 2007. The corporation does not have any active income in 2007 against which its PAL can be offset.
D disposed of property A for passive activity purposes because it sold its entire interest in the property in a fully taxable transaction to an unrelated party. D has a net passive gain of $3,500 resulting from the disposition of property A, computed as shown in Exhibit 1. This can be used to offset $3,500 of the loss on property B, as shown in Exhibit 2.
If the sale generates a $15,000 capital loss rather than a $15,000 capital gain, the loss is still reported on Schedule D, Capital Gains and Losses. If the corporation does not have any capital gains against which the loss can be offset, the loss is not allowed (because of the capital loss limitation) but is carried forward. (Since the property was disposed of in the current year, the loss is not disallowed under the PAL rules.)
The suspended and current passive ordinary losses from property A would be deductible against nonpassive income in the year of disposition. However, none of property B’s current-year loss or PAL carryover is deductible because the corporation does not have any passive income or active income with which to offset these losses.
Using Capital Gain to Absorb Capital and Passive Loss Carryovers
A capital gain can absorb both capital and passive loss carryovers.
Example 3: T Corp. has $12,000 of suspended PALs from two limited partnerships and an additional $4,000 suspended loss from a rental property. In 2006, it disposed of several speculative stocks, resulting in a capital loss on that year’s return and a $17,000 capital loss carryforward to 2007. In 2007, the three passive activities produced a combined net loss of $2,000. Also in 2007, T sold the rental property, recognizing a long-term capital gain of $20,000.
By virtue of the netting process on Schedule D, the $20,000 capital gain allows full use of the $17,000 capital loss carryover. Through the netting process on Form 8810, Corporate Passive Activity Loss and Credit Limitations, the $20,000 capital gain allows full use of the $16,000 suspended PALs and the $2,000 current-year PALs. T is able to use both the $17,000 capital loss carryover and $18,000 of the current and suspended PALs.
In situations such as in the preceding three examples, taxpayers should maintain extensive records documenting:
1. The assets sold, their basis and accumulated depreciation at the date of sale, and their sale price;
2. For all other assets, the basis and accumulated depreciation, plus information on their FMV; and
3. Calculations showing what percentage of the total FMV of all assets (those sold and those not sold) is made up of the assets sold to a third party and what percentage of the total FMV of all assets is made up of the assets that are not sold.
Observation: A transaction must be a taxable event to qualify as a complete disposition. Therefore transactions such as like-kind exchanges, conversions to personal use, gifts, transfers to an ex-spouse on divorce, or transfers to corporations, partnerships, or LLCs do not qualify.
Disposing of Substantially All of an Activity
If a disposition of substantially all of an activity occurs, the taxpayer may treat the part disposed of as a separate activity, but only if the corporation can establish with reasonable certainty (Regs. Sec. 1.469-4(g)):
1. The deductions and credits allocable to that part of the activity for the tax year under Reg. 1.469-1(f)(4) (relating to carryover of disallowed deductions and credits); and
2. The gross income and any other deductions and credits allocable to that part of the activity for the tax year.
Thus, corporations may deduct suspended losses upon disposition of substantially all of an activity provided they can account for the losses from the part of the activity disposed of. However, the term “substantially all” is not defined in the regulation and, under a literal reading of Sec. 469(g), a disposition of an entire interest in an activity is required before suspended passive losses can be deducted. Chapter 5 of the IRS Passive Activity Loss Audit Technique Guide (December 2004) indicates that taxpayers may need to maintain separate books and records of their activities to be able to establish with reasonable certainty the suspended and current deductions and credits allocable on disposition.
It is also important to remember that if passive activities have previously been grouped together in determining overall gain or loss from the activity, the sale of one of the activities in the group would not be considered the disposition of an entire interest. Therefore, the losses related to the sold property would remain suspended until substantially all of the properties in the group are disposed of.
Example 4: Assume that M, Inc., is a medical practice operating as a PSC. M owns two rental properties. Property A is an unimproved parcel of real estate being held as a future office site and rented to an unrelated person as a parking lot. Property B is an office located next door that was once used by M as an x-ray lab.
At one time property A yielded a profit of about $10,000 each year. However, due to increased insurance and property tax costs, the profit has decreased to about $2,000 per year. Property B is rented at a low rate simply to defray the costs of holding the property. It normally yields a loss of about $5,000 per year.
Several years ago M was advised to group the two rental properties together as a single activity so that the losses from property B could be used to offset the profits from property A. Even though the rental activity has been producing a net loss of about $3,000 per year for the past several years, the current tax preparer has continued to treat the two properties as a single activity because that is how it was done by the former preparer. As a result, the activity has suspended losses of $15,000 at the beginning of the year according to the preparer’s tax preparation software.
During the current year, M sells property B and realizes a gain of $45,000 on the sale. In discussing the transaction with one of his CPA patients, the doctor who owns M is informed that he may be able to offset part of the gain with any suspended losses on the property. The doctor calls up his return preparer to see if there are any suspended losses on property B and, if so, whether they can be deducted.
The preparer knows that there has been a suspended loss on property B for the past several years but has never mentioned this to the doctor. He is relieved to hear that this problem will now go away because the property has been sold. He tells the doctor that he will be able to offset the $15,000 in suspended losses against the gain on the sale of property B.
Unfortunately, the preparer is wrong. Since the two rental properties have been treated as a single activity for purposes of the PAL rules, there has not been a disposition of substantially all of the activity. As a result, M will have to report the entire $45,000 gain on the sale of property B. The suspended loss of $15,000 will have to be used to offset future profits, if any, from property A.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 20th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, Kellie J. Bushwar, Mary C. Danylak, James A. Keller, Penny Kilpatrick, and Michael E. Mares, published by Thomson Tax & Accounting, Ft. Worth, TX, 2007 ((800) 323-8724; ppc.thomson.com ).