8019 / May disallowed passive losses and credits be carried over and taken in a later year? How are passive losses and credits treated on the disposition of an interest in a passive activity?

A passive loss or credit disallowed under the passive loss rules in one year may be carried over and taken in a later year in which the taxpayer has passive activity income or tax liability.¹ However, if passive losses (or credits) from a publicly traded partnership (see Q 7728) are carried forward, such losses (or credits) may be offset only by passive income (or tax attributable to passive income) from the same partnership.² Special rules apply in the case of a rental real estate activity. See Q 8021.

If a passive activity is disposed of in a fully taxable transaction, losses from the activity will receive ordinary loss treatment (i.e., they may generally be used to offset other income of the taxpayer) to the extent that they exceed net income or gain from all passive activities (determined without regard to the losses just discussed) for the year. This treatment applies both to current year losses as well as losses carried over from previous years, with respect to the activity disposed of. The IRS has been given the authority to issue regulations that will take income or gain from previous years into account to prevent the misuse of this rule.³ However, a taxpayer will not be treated as having disposed of the entire interest in an activity of a publicly-traded partnership (see Q 7728) until the taxpayer disposes of his or her entire interest in the partnership.⁴

For the purpose of determining gain or loss from a disposition of property, the taxpayer may elect to increase the basis of the property immediately before disposition by an amount equal to the part of any unused credit that reduced the basis of the property for the year the credit arose.⁵ If the passive interest disposed of is sold under the installment method (see Q 667), previously disallowed passive losses are allowed as a deduction in the same proportion as gain recognized for the year bears to gross profit from the sale.⁶