Gift or Inheritance and Suspended Losses
Passive activities disposed of by gift or inheritance have special rules to deal with suspended losses. This tax topic is explained in further detail below.
Inheritance
When a passive interest is transferred due to death, the accumulated suspended losses from the activity are deductible on the decedent’s final return. The deduction amount is limited to the excess of the basis of the property in the hands of the transferee (heir) over the decedent’s adjusted basis in the property just before death. In other words, the amount of the passive activity loss that equals the step-up in basis due to the decedent's death is not allowed as a deduction to anyone in any tax year. (Code Sec. 469(g)(2))
Example: Robert was the sole owner of a residence used as a rental, a passive activity, when he died in 2022. In his will he left the property to his brother Tom. At Robert’s date of death, the value of the rental was $500,000, his adjusted basis was $494,000, and he had unused passive activity losses of $8,000. Since Tom’s basis of the rental is increased by $6,000, the deduction on Robert’s final return for the year of death would be limited to $2,000 ($8,000 - $6,000). If the stepped-up basis had been $502,000 or more, none of the suspended passive loss would have been deductible ($502,000 – 494,000 = $8,000; $8,000 - $8,000 = $0).
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Gift of Passives
Suspended losses are used to adjust basis of gifted property upward just before the transfer (IRC §469(j)(6)). Two bases are possible: When the losses are added to the donor’s basis, there may be a basis that exceeds FMV. In this case, there are two bases. The basis as calculated is used to measure a gain, but FMV at the date of the gift is always used as the basis for loss (Reg. 1.1015-1(a)(2)). See the following example:
Example - Gift/Inheritance of Passives – Taxpayer owns a rental property with a basis of $120,000 and FMV of $150,000. There is $40,000 of previously suspended losses in connection with the property.
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If taxpayer dies, the beneficiary receives the property with basis of $150,000 (FMV). This represents a step-up of $30,000. $30,000 of the suspended losses is deemed used to produce the step-up, and the remaining $10,000 suspended loss is deductible in full on decedent’s final return as a Tier 1 miscellaneous itemized deduction. If the losses had not raised the basis above FMV, there would be no deduction available to the decedent. (CAUTION: The example may not apply to inheritances from someone who died in 2010.)
If the taxpayer gifted the property while alive, the basis of the gift is normally $120,000. But here, the $40,000 of suspended losses is added to bring the basis to $160,000. No deductions are allowed to the donor.
NOTE: In this case, the new basis of $160,000 is greater than the FMV of the property, so this is a “dual basis” property. To realize a gain, the property must sell for more than $160,000. To realize a loss, the property must sell for less than $150,000. A sale for a price BETWEEN $150,000 and $160,000 results in neither gain nor loss.
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