We have suspended passive activity losses associated with our rental property. If we sell one of the rental properties, can we claim those losses?
The short answer is that it depends on a few factors. However, it’s likely that the suspended passive activity losses can be claimed as there will be a complete liquidation of the taxpayer’s entire interest in that single rental activity.
Are passive activity losses “freed” upon liquidation?
It’s technically possible for passive activity losses to be “freed” upon liquidation if each property is treated as a separate activity per IRC Section 469(c)(7)(A)(ii). However, the definition of entire interest depends on the specific facts and circumstances of the case. The phrase “entire interest” can mean a single rental activity or it can mean a group of rental activities as is indicated in IRC Section 469(c)(7)(A). The latter would apply if the taxpayer met the requirements to be considered a real estate professional and elected to group the properties together. Furthermore, they would need to have suspended passive activity losses prior to becoming a real estate professional and electing to group the properties together.
How does a taxpayer accumulate suspended losses?
In understanding the amount of losses that can be claimed it’s important to note that the at-risk rules deal specifically with the taxpayer’s investment in an activity while the passive activity rules deal with the client’s participation in an activity. More specifically, the at-risk is the amount of cash and adjusted basis contributed into the specific activity as well as borrowed funds in which the taxpayer is personally liable. This means that the at-risk rules limit the amount of a business loss a company may deduct in any given tax year. They may only deduct up to the amount of their investment in an activity that they stand to lose (have at risk). If a loss exceeds their at-risk investment, the excess is a suspended loss and may be carried to future years indefinitely and deducted when there is sufficient at-risk basis to absorb the loss.
Passive activity losses on the other hand may only be deducted from passive income. Any excess is carried forward to future years and may be claimed in certain instances such as a disposition of the entire interest. This means that the suspended loss would be released as an ordinary loss that is fully deductible upon disposition.
So, how do the at-risk and passive activity rules work?
You first review if the client has basis and if the investment is at-risk. Meaning that they have sufficient basis to cover the losses. Then, you would look to see if they have passive losses that exceed their passive income.
How does this work in an example?
If the client contributed $150,000 in capital, $50,000 in property and was personally liable (recourse) for debt of $50,000, their at-risk amount is $250,000. That is their outside basis and the amount they are personally “at-risk” to lose. This means that if their losses are $350,000 and thus exceeds the $250,000 at-risk amount, the excess would be carried forward as a suspended loss until there is sufficient basis to recognize the loss. If they had passive income of $150,000, there would be a suspended passive activity loss of $100,000 since they are limited by the passive income and at-risk amount.
If you have any questions, please contact us.