Excess capital losses.

• Author: Sair, Edward A.
• Position: Exempt organizations

According to Sec. 4940(a), a tax-exempt private foundation must pay a 2% excise tax on its net investment income, for the tax year. Its net investment income, under Sec. 4940(c)(1) and (3), is gross investment income and capital-gain net income (if any) less deductions for ordinary and necessary expenses it paid or incurred in connection with producing the gross investment income.

Under Sec. 4940(c) (4) (A), capital-gain net income takes into account property used for the production of income and only gains and losses from the sale or other disposition of property used to produce interest, dividends, rents or royalties. If disposing of such property results in a capital loss, the foundation can subtract the loss only from capital gains, under Kegs. Sec. 53.4940-1(f)(3). It cannot deduct any excess capital loss from gross investment income in any tax year, nor can it use such loss to reduce gains in either prior or future tax years. Thus, Sec. 4940(c)(4)(C) provides that capital losses from sales or other dispositions of property are allowed, but only to the extent of capital gains, without carryovers.

As an alternative, the foundation can sell an unrealized capital-gain asset and immediately repurchase it. Of course, in so doing, it should not incur a transaction cost in excess of its excise tax rate (e.g., 1% or 2%). In using this advantageous strategy, the private foundation (1) does not needlessly forgo the capital loss, because the loss offset the capital gain; (2) does not pay the 2% excise tax on the recognized capital gain (which it might have to...