Disallowed passive activity losses are generally suspended and may be carried forward indefinitely until they are able to be used to offset passive income in future years. The IRS has this suspension to basically prevent taxpayers from benefiting from a net loss that is derived from passive activities until the economic interest in the activity is completely relinquished.
Qualifying Disposition of Passive Activity
When a qualifying disposition of the passive activity that generated the losses occurs, the suspended losses become fully deductible. The IRS defines a qualifying disposition as a transfer that disposes of the taxpayer’s entire interest in the passive activity to an unrelated party in a fully taxable event.
If the activity is not a fully taxable event (such as a transfer of property to a partnership for a partnership interest or the contribution of property to a controlled corporation in exchange for stock) the disposition will not qualify as a disposition of the passive activity. This will disallow the taxpayer from realizing the suspended losses.
Gains & Losses from the Disposition
When a qualifying disposition does in fact take place, any loss from the activity for the year of the disposition that exceeds any new income or gain for that year from all other passive activities is considered a non passive loss.
In terms of any gain from the disposition of the passive activity, the gain is offset first by any loss from the activity for the tax year of the disposition and then by any suspended losses from the activity.
The remaining suspended losses, if any, are applied first against any net income or gain from other passive activities, and finally against non passive income.
Installment Sale Basis
In the event that the gain from the sale is recognized on the installment sale basis, only a proportionate share of the suspended loss (corresponding to the percentage of the gain recognized in any taxable year) is deductible.
Suspended Losses Exceed Gain
In the event that a taxpayer disposes of a passive activity that has suspended losses that exceed the gain on disposition, the net passive income and net passive losses from all of the taxpayer’s other activities must be netted before any excess passive income is applied against the suspended passive losses from the disposed of passive activities. Only the remaining excess losses from the disposed of activity are treated as losses not from a passive activity.