Passive Loss Rules
A "passive loss" exists when the deductions of a trade or business activity exceed its income (annual loss) and the particular taxpayer who is reporting all or part of that loss does not materially participate, i.e. the activity is a "passive activity" with respect to that taxpayer.
A passive loss can ONLY be offset against (deducted from) income from a passive activity of the taxpayer.
A passive loss from one activity can be offset against income from a different passive activity of the same taxpayer.
Any passive loss that cannot be offset in one year is "suspended" and carried forward to the next year, where it is treated as a loss of the same activity during that year.
If there is more than one passive activity with a loss in any one year, the net passive loss for the year is allocated to, and carried forward by, each loss-generating activity proportionately.
Example:
Activity A
($5,000)
Activity B
5,000
Activity C
(10,000)
Net Loss
($10,000)
Allocated to
Activity A = $3,333
Activity C = $6,667
If the taxpayer disposes of the activity, or dies, before all suspended losses are offset against income, the suspended losses do not just disappear (at least not all of them).
If the taxpayer sells the activity, accumulated suspended losses are offset against any gain realized on the sale. If the suspended losses exceed the gain on sale, the excess can be deducted against other income. If the sale is a capital transaction (which it usually is), the net loss is treated as a short-term capital loss in the taxpayer's capital gain/loss calculation for that year.
If the taxpayer makes a gift of the activity, the suspended losses are added to the basis in the property. Therefore the losses are effectively suspended until the donee disposes of the activity, or is gradually reduced as a result of the activity's net income. (See rules concerning a donee's basis in gift property.)
If the taxpayer dies, the activity is part of the deceased taxpayer's estate with a basis equal to the activity's fair market value. (See the rules concerning "stepped-up" basis for decedent's estates.) Suspended losses are allowed (in the deceased taxpayer's final return) to the extent they exceed the step-up in basis allowed. Suspended losses equal to, or less than, the positive difference between the decedent's adjusted basis in the activity and its fair market value (the amount of step-up allowed) are lost. In effect, the suspended losses increase the estate's basis in the activity up to the activity's fair market value, then (if any losses are left) the balance is treated as a loss in the deceased taxpayer's final return.