By: Martin M. Shenkman, CPA, MBA, JD
The passive loss rules limit the tax losses you can deduct from an activity in which you do not materially participate. IRC Sec. 469. Losses you cannot deduct are held in abeyance (suspended) until they can be deducted in the future. What happens if you die before that future date comes to deduct those suspended losses? The answer is some good news, some bad news, and, of course, more tax complexity. Good News: Death is treated as a complete disposition of the passive activity, freeing all the losses for deduction on your final personal tax return Form 1040. IRC Sec. 469(g) (2). Bad News: These formerly suspended passive losses have to be reduced by the step-up in income tax basis of the passive activity asset. IRC Sec. 1014. So if you hold a partnership interest that is worth $250,000, but your basis is only $100,000, you’d get a step up of $150,000 (to the fair value at death). Your suspended losses from that partnership interest would be deductible on your final return after reducing them by $150,000. Complexity: The basis rules are complicated. Your executor will have to contend with alternate valuation date values, and after 2009 the $1.3 and $3 million step ups when basis increases are otherwise eliminated. Whew.
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