Passive activity loss rules to remember for decedents & estates.
What happens when a passive activity interest in a partnership or S corporation is owned by an individual who dies? How are the losses allocated to the decedent and the decedent's estate? What happens to the decedent's suspended losses? What is the tax treatment of the losses to the estate? To answer these questions we must examine the general PAL rules applicable to all noncorporate taxpayers and some special rules that apply to decedents and estates.
Allocation of PALS
First, let's examine the allocation of losses from a passive activity to a deceased taxpayer and his or her estate as the successor in interest. Assume that during life, the individual had passive activity losses that were not deductible in any prior year, giving rise to suspended losses that are carried forward to the year of death. In the year of death, additional passive losses are sustained. The allocation of the current year (year of death) losses to the decedent and estate are different for a partnership interest than an S corporation interest.
If the passive activity is a partnership interest, the losses of the partnership in the year of death attributable to the decedent's interest are fully allocated to the decedent's estate since the tax year of the partnership does not close due to the death of a partner [IRC Sec. 706(c)(1) and Reg. Sec. 1.706-1(c)(3)]. All of the current year losses (before and after death) are allocated to the estate as the owner at the close of the partnership year, unless the decedent's interest is considered sold to the partnership on the date of death pursuant to the partnership agreement. For example, if the decedent and partnership are calendar-year taxpayers, and the decedent died on May 15, 1995, all of the losses for the 1994 partnership year are allocated to the decedent. All of the losses for the 1995 partnership year, however, are allocated to the decedent's estate unless the partnership agreement stipulates that the decedent's interest is considered sold on the date of death. If considered sold, the losses through May 15, 1995, are allocated to the decedent, and the balance of the year to the estate.
If the passive activity is an S corporation interest, the losses of the S corp. in the year of death are allocated to the decedent and estate on a daily basis [IRC Sec. 1366(a)(1)]. In the above example, unlike a partnership, there would be a mandatory allocation of passive losses to the decedent for each day of the S corp. tax year the decedent held the interest (through May 15, 1995), and to the estate for each day thereafter.
Decedent's Final Return
Once we know the decedent's suspended passive activity losses from prior years, and the losses allocated to the decedent in the year of death, we can determine the tax treatment of the total losses for the decedent's final return.
To the extent the decedent has passive income in the year of death, the passive losses are deductible in full against the passive income. If the losses exceed the income, what happens to the excess passive losses? Are they deductible? Do they pass on to the estate? Are they lost?
The excess of passive losses over passive income is not deductible on the decedent's final return even though (pursuant to IRC Sec. 469) excess losses are deductible in full when there is a full disposition of the passive activity. Death does not constitute a full disposition of a passive activity for purposes of IRC Sec. 469. A carryover of the excess losses to the decedent's estate is also not allowed. In order to provide some relief, a deduction is allowed for the decedent's excess losses to the extent they exceed the excess of 1) the basis of the interest in the hands of the estate over 2) the decedent's adjusted basis [IRC Sec. 469(g)(2)]. In other words, a deduction for the excess losses is not allowed to the extent the estate receives a step-up in basis, as the step-up is granted instead of the loss deduction. If the excess losses exceed the basis step-up, the excess is deductible on the decedent's final return. If there is no step-up in basis for the passive activity at death, the losses are unsuspended and deductible in full on the decedent's final return.
PALS of the Estate
As indicated earlier, all noncorporate taxpayers, including estates and trusts, are subject to the passive loss rules.
Therefore, the decedent's estate as successor in interest will sustain its own passive losses, and be subject to the same deduction limitations as the decedent for as long as it owns the passive activity interest. There is a special rule that allows estates to deduct up to $25,000 each year of rental real estate losses for their first two taxable years [IRC Sec. 469(I)(4)]. If the decedent uses a revocable living trust as a will substitute and owns the passive interest in the trust, however, the trust as successor in interest is not permitted to deduct the rental real estate losses. The estate must carry forward all passive activity losses that are suspended until such time that the losses can be used against passive income.
Estate Sale of PAL Interest
During the administration of the estate, the passive activity interest will either be sold in an arms-length transaction or distributed to the estate beneficiaries succeeding to the property. If the entire interest is sold, the estate's suspended passive activity losses for that interest become active losses and are fully deductible. If the sale results in a gain, the gain is considered passive income and the losses are deducted against the gain, with any excess losses deductible against other income. If the gain exceeds the losses, the excess gain is passive income that can be further offset by losses from other passive activities.
Estate Distribution of PAL Interest
If the passive activity interest is distributed to the estate beneficiaries in a tax year other than the estate's final (termination) year, the losses for that year are apportioned to the estate and its beneficiaries in the same manner as they were apportioned to the decedent and the estate. In the case of a partnership, the losses are allocated to the owner of the interest as of the close of the partnership year, with no required allocation to the estate through the date of distribution (just as there was no required allocation to the decedent through date of death). In the case of an S corp. interest, the losses are allocated to estate and the beneficiaries of the estate on a daily basis (just as they were allocated to the decedent and estate on a daily basis).
The estate's suspended losses (prior years and current years) for the distributed interest are not activated because the distribution is not considered a disposition pursuant to IRC Sec. 469. The estate (similar to the decedent) cannot carry forward the suspended losses since it no longer owns the passive activity interest, nor can it pass the loss through to the beneficiaries. In order to provide a tax benefit for these losses that would otherwise be lost, a special provision allows for an adjustment to the tax basis of the property distributed. Pursuant to IRC Sec. 469(j)(12), if an interest in a passive activity is distributed by an estate, the basis of such interest immediately before such distribution shall be increased by any passive activity losses allocable to such interest that were not deductible by the estate. The beneficiaries would therefore receive a step-up in basis for the losses previously disallowed.
Estate's Final Year
In the final or terminating year of the estate, carryover losses are passed on to the estate beneficiaries who succeed to the estate's property [IRC Sec. 642(h)]. However, the provisions of IRC Sec. 642(h), which are applicable to net operating losses, capital losses, and excess deductions in the year of termination, were never expanded to include passive activity losses. Therefore, the tax treatment of the distribution of a passive activity interest in the final year of an estate will be the same as the tax treatment of a distribution in a year other than the final year (i.e. the interest receives a step-up in basis) since a pass through of the losses are not even allowed in the final year.
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|Publication:||The CPA Journal|
|Date:||Jul 1, 1996|
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