Passive Dispositions

From TaxAlmanac

Disposition of an Entire Interest in a Passive Activity

Generally, all current and prior passive losses are allowed in full for a passive activity if a taxpayer disposed of the entire interest in the passive activity. However, for the losses to be allowed, a taxpayer must dispose of the entire interest in the activity in a transaction in which all the realized gain or loss is recognized.

The exchange of an entire interest in a passive activity in a nonrecognition transaction, such as a like-kind exchange governed by section 1031, does not free up prior unallowed losses. (Senate Committee report to PL 99-514, note 6). To the extent the taxpayer does recognize gain on the transaction, the gain is treated as passive activity income, against which passive losses may be deducted.

The gifting of a passive activity does not free up the prior unallowed passive losses. Any suspended losses increases donee's basis in the property. If a property changes hands because of a divorce decree, the transfer is considered a gift, and does not free up any suspended losses.

Also, for the losses to be allowed, the person acquiring the interest from the taxpayer must be an unrelated party. Unrelated parties are described in US Code Title 26 section 267(b)(1) or section 707(b)(1). Section 267(b)(1) provides that members of a family shall include only brothers, sisters (whether by the whole or half blood), spouse, ancestors and lineal descendants. Further, Private Letter Ruling Number 9017008 supports the definition of "lineal" descendents to exclude "in-law" relationships. The PLR goes on to cite case law to support this position (Topek v. Commissioner, 9 T.C. 763 (1947) and Stern v. Commissioner 265 F.2d 701, 3d Cir. (1954)).

Installment Sale of an Entire Interest

If a taxpayer sells an entire interest in a passive activity through an installment sale, to figure the loss for the current year that is not limited by the passive activity rules, multiply the taxpayer's overall loss (not including losses allowed in prior years) by a fraction. The numerator of the fraction is the gain recognized in the current year. The denominator of the fraction is the total gain from the sale minus all gains recognized in prior years.

Gain on Sale of Assets Used in Passive Activity

Gain on the disposition of property used in a passive activity is passive, if the activity was a passive activity at the time of disposition. If the taxpayer used the disposed property in more than one activity in the previous 12 months, the gain must be allocated between the activities on a basis that reflects the property’s usage during that time period. (See IRS Publication 925 for details). If the fair market value of the disposed of property is greater than 120% of its adjusted basis, the gain will be considered nonpassive unless one of the following applies:

1. The property was used in a passive activity for more than 20% of the time the property was owned.

2. The property was used in a passive activity the entire 24 month period before its disposition.