Release of capital and passive losses in dispositions of passive activities.

Under Sec. 469(g), on the entire disposition of a passive activity in a fully taxable transaction, previously suspended passive losses from that activity are freed up. If the gain from the disposition of the activity exceeds its suspended losses, the gain may be used to offset losses from other passive activities. Since the passive loss rules do not truly disallow losses, but rather defer them, the issue is merely one of timing.

It should be noted that there may be a reduction of adjusted gross income (AGI) in those cases in which a taxpayer disposes of property at a gain. Example: Taxpayer T has AGI in a particular year of $200,000, before taking into account the disposition of a passive activity. T now decides to dispose of his interest in limited partnership A, a passive activity. T has suspended passive losses (ordinary) of $30,000 tied to this activity, as well as an additional $15,000 of suspended passive losses (ordinary) from other activities and a portfolio long-term capital loss carryforward of $40,000. On disposition of A, T must recognize a Sec. 1231 gain of $50,000.

Assuming that T has no other Sec. 1231 transactions, the $50,000 gain would be taxed as a long-term capital gain. The $30,000 of suspended passive losses would be released and reported as nonpassive. In addition, the remaining $20,000 of gain would release the $15,000 of suspended passive losses from other activities. At the same time, the $50,000 gain (longterm capital) allows T to take the $40,000 long-term capital loss carry-forward. As a result, the disposition of A results in a decrease of AGI of $35,000 ($50,000 - $30,000 - $15,000 - $40,000) to $165,000. (Note that the net long-term capital gain of $10,000 would be taxed at 28%, while the $45,000 of ordinary losses would be deductible at T's marginal tax rate.)

Although at first glance this result may seem odd, it makes perfect sense when one considers the deferral implications of both the passive and capital loss limitations. If the passive loss limitations did not exist, T would have reported the $45,000 of passive losses from all of the activities in each year as incurred. Similarly, the $40,000 of long-term capital losses would have been taken as incurred. Then, in the year that A was disposed of, the $50,000 gain alone would have been reported. The $35,000 reduction of AGI therefore results from the deferral aspects of the Internal Revenue Code.

In conclusion, taxpayers with capital loss carryforwards that may not be used in the near future may wish to consider some tax planning strategies that include disposing of some passive activities, where practical, that appear to be providing no current tax benefits.