Non-Recognition Transfers
The term "non-recognition transfer" refers to a transaction in which there has been no recognition of gain or loss. IRS tax rules for such transactions are outlined below.
An exchange of the taxpayer's interest in an activity in a non-recognition transaction does not trigger suspended passive losses. Such transfers include:
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Transfer of property to a controlled corporation (Code Sec. 351)
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Contributions to partnerships (Code Sec. 721), or
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Like-kind exchanges (Code Sec. 1031) in which no gain or loss is recognized.
Following these types of exchanges, the taxpayer retains an interest in the activity and hence has not realized the ultimate economic gain or loss on his investment in the activity. In order for the excess suspended passive losses to be triggered, all gain or loss realized on a disposition must be recognized. (IRS Letter Ruling 9739004)
IRS gives as additional examples of transactions that are not fully taxable:
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A transfer to an ex-spouse on divorce, and
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A bankruptcy which has not been finalized (IRS MSSP Reference Guide, Passive Activity Losses, (2/05), p. 5-2).
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Suspended passive losses allocable to rental real estate that was sold by taxpayers to their son could not be deducted in the year the son sold the property (after using it as his residence) in a transaction that qualified for gain deferral under the pre-May 7, '97 home sale rollover rule. Instead, the losses remain suspended until the son disposes of the replacement property (his new principal residence) to an unrelated party in a fully taxable transaction (IRS Letter Ruling 9739004).
Partially Taxable Event
To the extent the taxpayer does recognize gain on the transaction (e.g., boot in an otherwise tax-free exchange), the gain is treated as passive activity income, against which the taxpayer may deduct passive losses (S Rept No. 99-313 (PL 99-514) p. 727).
Related Parties
A taxpayer is not treated as having disposed of an interest if the disposition is to a related party within the meaning of Sec 267(b) or Sec 707(b)(1), including the applicable attribution rules. In the event of such a related-party transaction, suspended losses remain with the taxpayer and may be offset by income from the taxpayer’s passive activities.
When a taxpayer’s entire interest is transferred to a related transferee followed by a transfer to an unrelated party in a fully taxable disposition, the taxpayer may deduct the suspended losses attributable to his or her interest in the passive activity to the extent the transfer would otherwise qualify as a disposition triggering the suspended losses.
Divorce
Under Sec 1041(b) and Sec 469(j)(6), if a taxpayer transfers property to a spouse incident to a divorce, the exchange is treated as though it were a gift. Therefore, any suspended losses attributable to the spouse giving up the interest in the passive activity are added to the basis of the property transferred to the other spouse. For the receiving spouse, the basis will be increased by the ex-spouse’s suspended losses, but the receiving spouse’s suspended losses on the same property will still be considered suspended losses, which are available currently to offset passive income.
Publicly Traded Partnerships
Publicly traded partnerships (PTP) are not passive! If a PTP shows net income for the year, it’s portfolio. If a PTP shows a net loss, the loss is suspended, and can only be offset in future years by income from that same PTP.
What is a PTP?
It is a partnership which is traded on an established securities market, or readily tradable in a secondary market (or its substantial equivalent). FORM 8582 IS NOT USED for reporting PTP income/loss. However, the suspended loss from each PTP must be tracked – which most tax software used by tax professionals will do – so that the loss can be properly used when there is income from the PTP in the future or when the taxpayer’s entire interest in the PTP is sold.