Passive losses and sec. 731 gain.

• Author: Packard, Pamela
• Position: Limited partnerships

Use of suspended passive losses is a common challenge for taxpayers engaged in activities through limited partnership interests. Under Sec. 469, if losses from passive activities exceed income from passive activities, the excess losses cannot be deducted from income during that year. The excess loss is suspended and carried forward as a deduction from passive income realized in succeeding years. Unused passive losses are fully allowed on the taxable disposition of the entire interest in the passive activity (Sec. 469(g)).

A passive activity is one that involves the conduct of any trade or business in which a taxpayer does not materially participate (Sec. 469(c)). Generally, losses allocated to limited partners of limited partnerships are treated as losses from passive activities.

The key to using suspended passive losses is to generate income from passive activities. Passive activity income includes ordinary income and gain on the disposition of property used in the activity.

The issue is how to generate passive income. One solution is to trigger gain from a distribution in excess of a partner's partnership basis. For purposes of the passive loss rules, Sec. 731(a) gain from a distribution in excess of a partner's basis is treated the same as gain from a disposition of the partner's partnership interest (Rev. Rul. 95-5).

Gain can be triggered without an actual distribution of cash. Sec. 731 gain can be triggered by a Sec. 752(b) constructive cash distribution based on a reduction of a partner's share of a partnership's liabilities. Under this provision, any decrease in a partner's share of partnership liabilities is considered a distribution of money to the partner by the partnership. The gain recognized under Sec. 731(a) is generally considered gain from a sale or exchange of a partnership interest, which is a capital gain. (There can be exceptions to this result because of depreciation recapture, etc.)

Example...