You Can’t Take it With You: Passive Activity Loss Carryovers at Death

By:
Carl Fiore, JD, LLM
Published Date:
Mar 1, 2016

“You can’t take it with you.” Although more commonly associated with gift and estate tax planning among tax practitioners, this statement also applies to income tax as well. Capital loss carryovers, charitable carryovers, and net operating losses - to name a few - are all tax attributes that are impacted by a taxpayer’s death. In many cases, these attributes are limited or simply lost. The focus of this article will be the impact of death on passive activity loss carryovers.

Passive activity losses (PALs) are generated when a taxpayer incurs ordinary losses in a passive investment - typically a hedge or private equity fund, or real estate. Because the taxpayer does not “materially participate” (i.e., is only an investor), the government does not allow these losses to offset other non-passive income. Instead, these losses are suspended until the taxpayer has other passive income or fully disposes of the investment from which they were generated (unless sold to a related party), at which point the losses may be used. If neither occurs, PALs accumulate and carryover year-to-year. 

Along with these rules, PALs also are impacted under the tax code when a taxpayer transfers the investment. For example, if a taxpayer gifts a passive investment, PALs are added to the investment’s basis. Similarly, if those investments are held in a non-grantor trust or estate and are then distributed to a beneficiary, PALs are also added to basis. In the case of the taxpayer’s death, however, the rule is different. 

IRC section 469(g)(2) addresses disposition of a passive activity by death. If a passive activity is transferred by reason of the taxpayer’s death, then the suspended PALs can be deducted on the decedent’s final Form 1040 “to the extent such losses are greater than the excess (if any) of (i) the basis of such property in the hands of the transferee, over (ii) the adjusted basis of such property immediately before the death of the taxpayer.” As such, these “freed-up” PALs can offset other income (e.g., interest, dividends, earned income) on the decedent’s final Form 1040. Any losses not in excess of this step-up in basis “shall not be allowed as a deduction for any taxable year.” 

To illustrate this rule, assume at the time of the taxpayer’s death, a passive investment has a basis of $50,000, a fair market value of $75,000, and PALs of $30,000. Under IRC section 1014, by virtue of being included in the taxpayer’s estate, the investment’s basis is stepped-up to $75,000. Because the $30,000 of PALs exceeds the $25,000 basis step-up by $5,000, that $5,000 can be taken as an ordinary loss on the taxpayer’s final Form 1040. The remaining $25,000 of PALs is lost. While this rule is straightforward in its application to this example, what may be less straightforward is its application when assets are held in a grantor trust, but not included in the taxpayer’s gross estate at death.

As is generally true for all income tax purposes, for purposes of IRC section 469, a grantor trust and an individual are the same taxpayer. It therefore follows that the rules of IRC section 469(g)(2) should be applied the same way.  Assuming the assets of the grantor trust are not included in the gross estate, it is doubtful that the IRS will allow a basis step-up. As a result, 100% of the PALs generated by assets held in a grantor trust and not included in the taxpayer’s gross estate at death should be triggered and allowed on the final Form 1040. This position seems to be consistent with IRS conclusions on the matter. 

In Field Service Advice 200106018, the IRS concluded that IRC section 469(g)(2) applied when the sole beneficiary of a trust - who was treated as the owner of the trust for income tax purposes - died with PALs generated by the trust’s assets. The facts involved a qualified Subchapter S trust created by the decedent’s parents. The ruling concluded that the suspended losses were allowed on the taxpayer’s final income tax return to the extent they exceed the basis step-up on those assets.  Although not explicit as to how much of the PALs would be allowed in the FSA, the IRS did note that the trust assets were not included in the taxpayer’s gross estate, meaning there was no step-up in basis at death. 

While you cannot take passive activity loss carryovers with you, it does not necessarily follow that you have to lose them either. For individuals with large PALs, it is important that practitioners be aware of the rules relating to the disposition and transfer of passive assets, and be proactive in planning with these valuable tax attributes. 


fioreCarl C. Fiore, JD, LLM, has significant experience with tax and financial matters affecting entrepreneurs, executives and other high net worth individuals.  He has worked with numerous families and closely held businesses to develop and implement wealth maximization plans through the use of family entities, income tax planning, stock option planning, charitable giving strategies, and effective gift and estate tax planning. Carl’s primary practice areas are gift and estate planning, planning for same-sex couples and fiduciary income tax.  He also has experience in federal and state income tax consulting and compliance for individuals, partnerships, fiduciaries, estates, corporations and private foundations. He can be reached at carl.c.fiore@andersentax.com or 646-213-5125.

 
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