Understanding Utilization of Suspended Passive Losses on Disposition
What are Suspended Passive Losses?
As AICPA candidates know, the passive activity loss (PAL) rules, as governed by Internal Revenue Code Section 469, limit the ability of taxpayers to offset income from non-passive activities with losses generated from passive activities. A passive activity generally includes any trade or business in which the taxpayer does not materially participate, as well as rental activities (with some exceptions for real estate professionals).
When total passive losses exceed total passive income for a tax year, the excess losses are not currently deductible. Instead, these suspended passive losses are carried forward indefinitely until the taxpayer has sufficient passive income to offset them or until a taxable disposition of the entire passive activity occurs.
Utilization of Suspended Losses Upon Disposition
The disposition of a passive activity presents a crucial opportunity to utilize any previously suspended losses related to that activity. When a taxpayer disposes of their entire interest in a passive activity in a fully taxable transaction to an unrelated party, the treatment of the suspended losses changes significantly.
In the year of disposition, the suspended passive losses associated with the disposed activity are no longer subject to the passive activity limitations. Instead, these losses are allowed in the following order:
- First, they can be offset against any gain recognized from the disposition of the passive activity.
- Second, if there are any remaining suspended losses, they can be offset against the taxpayer's net income or gain from other passive activities.
- Finally, if any suspended losses still remain after the above steps, they can be deducted against the taxpayer's non-passive income (e.g., wages, active business income). This is a significant benefit, as it allows the deduction of losses that were previously restricted.
Example
Let's consider an example to illustrate this concept:
Suppose Sarah has a rental property (a passive activity) that she sells in 2025 for a gain of $50,000. Over the years, she has accumulated $30,000 in suspended passive losses specifically related to this rental property.
In the year of sale, Sarah can utilize her suspended losses as follows:
- The $30,000 of suspended losses from the rental property can first offset the $50,000 gain from the sale. This reduces her taxable gain from the disposition to $20,000.
- If Sarah had any other passive income in 2025, any remaining suspended losses (in this case, none) could offset that income.
- If there were still suspended losses remaining (which there aren't in this example), they could then be used to offset Sarah's non-passive income.
This example highlights how the disposition of a passive activity can unlock the deductibility of previously suspended losses.
Important Considerations
- The disposition must be of the entire interest in the passive activity. A partial disposition does not trigger the full deductibility of suspended losses.
- The transaction must be a fully taxable transaction. Dispositions in non-taxable exchanges (e.g., like-kind exchanges under Section 1031) do not trigger the release of suspended losses.
- The suspended losses must be specifically attributable to the disposed activity.
Understanding these rules is crucial for AICPA exam candidates and future CPAs to effectively advise clients on the tax implications of passive activity dispositions.
