Dispositions

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Dispositions

Any passive activity losses (but not credits) that have not been allowed (including current year losses) generally are allowed in full in the tax year you dispose of your entire interest in the passive (or former passive) activity. However, for the losses to be allowed, you must dispose of your entire interest in the activity in a transaction in which all realized gain or loss is recognized. Also, the person acquiring the interest from you must not be related to you.

Worksheet B. Significant Participation Activities With Net Income

Name of activity
with net income

(a) Net income
(b) Ratio
See instructions
(c) Nonpassive income
See instructions
(d) Passive income
Subtract col. (c) from col. (a)
Totals 1.000

If you have a capital loss on the disposition of an interest in a passive activity, the loss may be limited by the capital loss rules. The limit is generally $3,000 for individuals ($1,500 in the case of married individuals filing separate returns). See Publication 544, Sales and Other Dispositions of Assets, for more information.

Example.

Ray earned a $60,000 salary and owned one passive activity through a 5% interest in the B Limited Partnership. In 2011, he sold his entire partnership interest to an unrelated person for $30,000. His adjusted basis in the partnership interest was $42,000, and he had carried over $2,000 of passive activity losses from the activity.

Ray's deductible loss for 2011 is $5,000, figured as follows:

Sales price $30,000
Minus: adjusted basis 42,000
Capital loss $12,000
Minus: capital loss limit 3,000
Capital loss carryover $9,000
Allowable capital loss on sale $3,000
Carryover losses allowable 2,000
Total current deductible loss $5,000

Ray deducts the $5,000 total current deductible loss in 2011. He must carry over the remaining $9,000 capital loss, which is not subject to the passive activity loss limit. He will treat it like any other capital loss carryover.

Installment sale of an entire interest. If you sell your entire interest in a passive activity through an installment sale, to figure the loss for the current year that is not limited by the passive activity rules, multiply your overall loss (not including losses allowed in prior years) by a fraction. The numerator of the fraction is the gain recognized in the current year, and the denominator is the total gain from the sale minus all gains recognized in prior years.

Example.

John Ash has a total gain of $10,000 from the sale of an entire interest in a passive activity. Under the installment method he reports $2,000 of gain each year, including the year of sale. For the first year, 20% (2,000/10,000) of the losses are allowed. For the second year, 25% (2,000/8,000) of the remaining losses are allowed.

Partners and S corporation shareholders. Generally, any gain or loss on the disposition of a partnership interest must be allocated to each trade or business, rental, or investment activity in which the partnership owns an interest. If you dispose of your entire interest in a partnership, the passive activity losses from the partnership that have not been allowed generally are allowed in full. They also will be allowed if the partnership (other than a PTP) disposes of all the property used in that passive activity.

If you do not dispose of your entire interest, the gain or loss allocated to a passive activity is treated as passive activity income or deduction in the year of disposition. This includes any gain recognized on a distribution of money from the partnership that you receive in excess of the adjusted basis of your partnership interest.

These rules also apply to the disposition of stock in an S corporation.

Dispositions by gift. If you give away your interest in a passive activity, the unused passive activity losses allocable to the interest cannot be deducted in any tax year. Instead, the basis of the transferred interest must be increased by the amount of these losses.

Dispositions by death. If a passive activity interest is transferred because the owner dies, unused passive activity losses are allowed (to a certain extent) as a deduction against the decedent's income in the year of death. The decedent's losses are allowed only to the extent they exceed the amount by which the transferee's basis in the passive activity has been increased under the rules for determining the basis of property acquired from a decedent. For example, if the basis of an interest in a passive activity in the hands of a transferee is increased by $6,000 and unused passive activity losses of $8,000 were allocable to the interest at the date of death, then the decedent's deduction for the tax year would be limited to $2,000 ($8,000 − $6,000).

If you inherited property from a decedent who died in 2010, special rules may apply if the executor of the estate files Form 8939, Allocation of Increase in Basis for Property Acquired From a Decedent. For more information, see Publication 4895, Tax Treatment of Property Acquired from a Decedent Dying in 2010, and the Instructions for Form 8939.

Partial dispositions. If you dispose of substantially all of an activity during your tax year, you may be able to treat the part of the activity disposed of as a separate activity. See Partial dispositions under Grouping Your Activities, earlier.