Disposing of passive activities.

• Author: Ellentuck, Albert B.

Disposing of property related to a passive activity does not resolve all matters related to the property. Many issues remain as to basis, suspended losses, or loss carryovers, to name a few.

This case study has been adapted from PPC's Tax Planning Guide: S Corporations, 30th edition (March 2016), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters/ Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).

Gain or loss from the disposition of property retains the nonpassive or passive character of the activity in which the asset was used (Temp. Regs. Sec. 1.469-2T(c)(2) (i) (A)). For example, gain or loss from the sale of assets used in a trade or business is nonpassive if the taxpayer materially participates in the business. It is passive if the taxpayer does not materially participate. Gain or loss from the sale of assets (such as marketable securities or land held for investment) that generate portfolio income is portfolio (nonpassive) income or loss. Gain or loss on the disposition of rental property is passive income or loss.

Note: Dispositions of S corporation property used in a passive activity can be subject to the net investment income tax under Sec. 1411.

Carrying over unused passive losses

Losses (and credits) that a taxpayer cannot use because of the passive loss limitation rules are suspended and carry over indefinitely to be offset against future passive activity income (Sec. 469(b)). A taxpayer can apply suspended losses against passive activity income from any source, not just from the activity that created the loss.

Disposing of a passive activity allows suspended passive losses to be deducted

When a taxpayer disposes of the entire interest in a passive activity, that activity is no longer subject to the passive activity rules. If the activity is disposed of in a fully taxable (as opposed to tax-deferred) transaction to an unrelated party, both current and suspended passive activity losses generated by that activity (as well as any loss on the disposition) can be deducted (Sec. 469(g)(1)).

Note: Suspended passive losses allowed under Sec. 469(g)(1) are taken into account for net investment income tax purposes in the same manner in which they are taken into account for regular income tax purposes. Therefore, losses allowed under Sec. 469(g)(1) may constitute properly allocable deductions or may be included in the calculation of net gain in the year they are allowed, depending on the underlying character and origin of the losses (Regs. Sec. 1.1411-4(g)(9)).

Disposition of an activity by an S corporation

When the S corporation disposes of an activity in a fully taxable transaction to an unrelated party, shareholders can deduct suspended losses from that activity.

Disposition of S corporation shares

Disposition of all of the stockholder's shares in an S corporation is treated as though the shareholder disposed of each of the corporation's activities.

Capital loss limitation

If the disposition of a passive activity results in a capital loss, the $3,000 capital loss limitation applies. Resulting capital loss carryovers are not subject to the...