As you now know, if the passive activity rules apply to your business or real estate then you may not be able to deduct all your losses. Passive activity losses can only be used to offset passive activity income (they cannot be used as a deduction against your ordinary income). If you do not have any passive activity income, the loss is suspended and carries forward to the next year until you eventually have passive activity income. But what happens if you dispose of the passive activity business or real estate before you are entitled to use all of the passive activity losses?
If that is the case, and it is the entire activity that is being disposed of, then special rules apply. If the disposition is part of a fully taxable transaction (such as a sale), then the losses are recognized in the following order:
1) The current year passive activity losses are first used to offset all passive activity income from other activities for the year;
2) Then, the passive activity losses are deducted against ordinary income.
Lets look at an example to get a better understanding of what this means.
Joe is a limited partner in a small business, and owns one rental property. Joe is not a real estate professional and does not actively participate in the management of his rental properties. In 2015, the small business will have income of $5,000. The rental property has a loss of $3,000 prior to its sale during the year. The property had a tax loss for a number of years prior, and had unused passive activities losses of $30,000.
Because the sale of the property is a taxable event and represents the complete disposition of his ownership interest in that property, Joe is allowed to recognize his prior unused passive activity losses. First, though, he must offset the current year passive losses of $3,000 against the $5,000 of passive activity income from the small business. After that, he is entitled to deduct the previously unused passive activity losses of $30,000.
However, the rules are different if the disposition of the business or real estate is instead the result of the owner's death. In that case, the current year passive losses are still used to offset the current year passive activity income, but only to a certain extent. They will only be allowed to be used to the extent that the losses exceed the "step-up" in basis that occurs when property is transferred through inheritance. In other words, the losses are reduced by the amount of basis step-up. Any unused passive activity losses then disappear- they cannot be used as a deduction against ordinary income.
If you have any questions, please send me an e-mail.
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