Passive Losses and Sec. 731 Gain

Use of suspended passive losses is a common challenge for taxpayers engaged in activities through limited partnership interests. Under Sec. 469, if losses from passive activities exceed income from passive activities, the excess losses cannot be deducted from income during that year. The excess loss is suspended and carried forward as a deduction from passive income realized in succeeding years. Unused passive losses are fully allowed on the taxable disposition of the entire interest in the passive activity (Sec. 469(g)).

A passive activity is one that involves the conduct of any trade or business in which a taxpayer does not materially participate (Sec. 469(c)). Generally, losses allocated to limited partners of limited partnerships are treated as losses from passive activities.

The key to using suspended passive losses is to generate income from passive activities. Passive activity income includes ordinary income and gain on the disposition of property used in the activity.

The issue is how to generate passive income. One solution is to trigger gain from a distribution in excess of a partner's partnership basis. For purposes of the passive loss rules, Sec. 731(a) gain from a distribution in excess of a partner's basis is treated the same as gain from a disposition of the partner's partnership interest (Rev. Rul. 95-5).

Gain can be triggered without an actual distribution of cash. Sec. 731 gain can be triggered by a Sec. 752(b) constructive cash distribution based on a reduction of a partner's share of a partnership's liabilities. Under this provision, any decrease in a partner's share of partnership liabilities is considered a distribution of money to the partner by the partnership. The gain recognized under Sec. 731(a) is generally considered gain from a sale or exchange of a partnership interest, which is a capital gain. (There can be exceptions to this result because of depreciation recapture, etc.)

Example: Partner A has $100,000 of suspended passive losses from activity ABC, a real estate partnership. A's adjusted basis in his partnership interest is zero, including an allocation of guaranteed debt of $100,000. Other limited partners that can use their losses do not have basis in their partnership interests, and accordingly are willing to assume A's guarantee. The relief of A's liabilities is treated as a distribution of cash to him, bringing the adjusted basis of his interest to ($100,000) and triggering Sec. 731 gain of $100,000. This gain is included in A's calculation of income from passive activities, thereby freeing up the $100,000 of suspended passive losses to be used against other income items. Ideally, if A had current or suspended capital loss carryforwards, he could use them to offset the capital gain.

For taxpayers with suspended passive losses, Sec. 731 provides a means of using the losses to reduce ordinary income. Recognition of Sec. 731 gain can be used to trigger passive losses as well as offset capital losses. The ideal situation would be a taxpayer who had both suspended passive losses and capital loss carryforwards or current-year capital losses. The suspended passive losses could be used to offset the ordinary income, while the capital gain could be offset by the capital losses.

The issues related to passive activities, Sec. 731 gain and use of capital losses are complex. Practitioners should carefully review the applicable statutory and regulatory provisions pertaining to passive income, basis and at-risk rules before advising clients.

From Dean Halfacre, CPA, Atlanta, GA