Tax planning opportunities for tax attributes and the decedent's final tax return.

• Author: Kinkaid, Amy I.

Several tax attributes and related tax planning ideas are lost when a taxpayer dies. However, careful and thoughtful planning for clients who are elderly or nearing death can result in substantial tax savings. It is important to recognize and discuss planning ideas with clients in advance to provide adequate time to implement and take complete advantage of the tax savings strategies available for these tax attributes.

Passive Activity Losses

A decedents suspended passive activity losses are allowed on the final income tax return, subject to certain limitations. Sec. 469(g)(2)(A) limits the deductible loss. The amount of the suspended loss allowed as a deduction on the final income tax return is reduced by the step-up in basis for the related asset to fair market value (FMV) under Sec. 1014. Sec. 469(g)(2)(B) disallows the excess losses as a deduction for any future tax year.

Example: The taxpayer owns a rental property. The building has an adjusted basis of $500,000, an FMV of $550,000, and passive suspended losses of $75,000. The taxpayer does not have any other passive income. If the taxpayer dies during the tax year, the deductible suspended passive loss on the taxpayer's final income tax return will be limited to $25,000 ($75,000-$50,000 step-up in basis). The deductible loss can offset other income such as interest, dividends, and earned income. The remaining $50,000 of passive loss will be permanently lost as a tax deduction.

In the example, if the property has declined in value and the taxpayer is not required to file a federal estate tax return, a practitioner should consider advising the taxpayer to gift the building before the taxpayer's death. The suspended passive activity loss of $75,000 would be added to the donee's basis in the property under Sec. 469(j)(6). Although the donee will not be able to use the suspended passive loss currently, none of the passive loss will be permanently lost as a tax deduction, as is the case on the decedent's final tax return. If the decedent retained the depreciated property until death, the heirs would have a stepped-down basis in the property equal to the date-of-death FMV rather than the original cost basis. The lower basis in the hands of the heirs would create a larger tax liability when they later sell the property.

Capital Loss Carryovers

Rev. Rul. 74-175 provides that capital loss carryovers expire upon a taxpayer's death and cannot be used on the estate's income tax return. The decedent cannot transfer a capital loss carryover to the estate because the decedent and estate are separate tax entities. A...