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Jan 1992

Suspended losses and dispositions. (Federal Taxation)

by Hyman, Martin

    Abstract- The Tax Reform Act of 1986 limits the ability of taxpayers to offset income from earnings and portfolio income with losses and credits from trade or business activities that did not personally involve them. Taxpayers can only obtain benefits from these losses if there is net passive income, in which case loss is only suspended and are carried forward, or if there is disposition of the passive activity, which requires that the entire interest in the said trade or business activity be disposed of.

Suspended Losses

If net passive losses arise, they are not lost but are suspended and carried forward. If the suspended losses are not deductible in any given year, the amount of the suspended losses from each passive activity is determined and carried forward on a pro rata basis. The portion of the loss that is suspended and carried forward is determined by the ratio of net losses from that activity to the total net losses from all passive activities for the year. This allocation is necessary to determine the suspended losses for any particular activity; these are allowed in full upon disposition.


Suspended passive losses are fully activated upon disposition of the activity. To qualify as a disposition, the entire interest in the activity must be disposed of. This requires a disposition of the taxpayer's interest in all entities engaged in the activity and all assets used or created in the activity. Even if the suspended losses allocable to the activity produce a net loss upon disposition the loss would be allowed in full. Taxpayers should be aware of their suspended passive losses. In the case of a disposition where no cash is received, such as a bankruptcy, the taxpayer would be able to offset the relief of debt and the restoration of the capital account against such suspended losses. When a passive activity is disposed of, and the suspended losses allocable to that activity are less than the gain recognized upon disposition, passive losses allocable to other activities may be utilized.

Example. If activity A is sold with a recolgnizzed gain of $50,000 and there is $20,000 in suspended passive losses pertaining to that activity, the net gain will be $30,000. If, however, there are current or suspended passive losses from other activities, they can be used to offset the remaining $30,000 gain.

An important tax planning point that should be noted is that when capital gain is recognized upon disposition, the gain is passive income. This passive income serves double duty to the taxpayer. He or she will not only be allowed to take current and suspended losses to offset the passive income but also will be able to offset capital losses against it as well. Therefore, if capital gain of $100,000 is recognized upon disposition of a passive activity, $100,000 in passive losses will be allowed to offset it. Also, because the character of the income is capital gain, up to $103,000 in capital losses can be taken currently.

Installment sales are considered dispositions if the entire interest in the activity is disposed of under Sec. 453. Suspended passive losses allocable to the activity are activated in the same ratio that gain recognized for the year bears to gross profit. For example, assume that gross profit from sale of an activity on the installment method is $1,000,000 and suspended passive losses at the time of disposition are $100,000. If, thereafter, gain recognized in a particular year is $200,000, suspended losses of $20,000 would be activated.

Dispositions by sale or bankruptcy are common forms of disposition. However, dispositions can be achieved by other methods, and each of these methods will have a different effect. For example, if an interest in a passive activity is disposed of by gift, the basis of the interest in the hands of the transferor, immediately before the transfer, is increased by the amount of the suspended losses allocable to such interest. If an activity is abandoned, it will trigger suspended losses if the abandonment would give rise to a deduction under Sec. 165(a). Transfers by reason of death will trigger suspended losses to the extent the losses exceed the stepped-up basis of the property at death. Usually this will allow suspended losses to the extent they exceed fair market value of the property.


Taxpayers can elect, in the initial year of operations, to treat activities separately. This allows the activities to be treated separately for disposition purposes. Thus, if an activity is disposed of, the suspended losses would be allowed in full. This allows the taxpayer to avoid the activity regulations that aggregate commonly controlled businesses and thus defer the deductibility of otherwise allowable suspended losses.

To make the election, the taxpayer must attach a written statement to his or her return. The statement sets forth:

* Name, address, and identifying number of the taxpayer;

* A declaration that an election is being made under Reg. Sec. 1.469- 4T(o) to identify the undertaking with respect to which the election is being made;

* Identification of the remainder of the activity.

When planning for AMT purposes, the amount of income or loss from a passive activity must be redetermined taking all adjustments and preference items into consideration. Thus, suspended passive losses for AMT purposes may be different than such losses for regular tax purposes.

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