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TCP CPA Practice Questions Explained: Suspended Losses from Passive Activities

Suspended Losses from Passive Activities

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In this video, we walk through 5 TCP practice teaching all about suspended losses from passive activities. These questions are from TCP content area 1 on the AICPA CPA exam blueprints: Tax Compliance and Planning for Individuals and Personal Financial Planning.

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Suspended Losses from Passive Activities

Overview of Passive Activity Loss Rules

Passive activity losses (PALs) are financial losses within an investment in any business enterprise in which the investor is not materially involved. According to the IRS, passive activities generally include rental activities and businesses in which the taxpayer does not regularly, continuously, and substantially participate. The key rule for PALs is that they can only be used to offset passive income — they cannot be deducted from other forms of income such as wages, salaries, or investment income.

Calculating Suspended Losses

Suspended losses arise when passive activity losses exceed passive income in a tax year. These losses are not deductible in the year they occur but are instead “suspended” and carried forward indefinitely to future tax years. Suspended losses from a particular passive activity accumulate over the years until they can be used. To calculate suspended losses, you must track the losses and income of each passive activity annually. Any loss that cannot be offset by passive income in a given year is added to the suspended loss total for that activity.

Allocating Passive Income Among Passive Losses

When a taxpayer has income from passive activities and suspended losses from other passive activities, the income must be allocated to offset these losses. The allocation is generally done on a pro rata basis. This means that the passive income available in a year is distributed among the suspended losses based on the proportion of each loss to the total suspended losses.

For example, if there are three passive activities with suspended losses of $10,000, $15,000, and $5,000 respectively, and there is $6,000 of passive income, it would be allocated as follows:

  • Activity 1 ($10,000 loss): (10,000 / 30,000) x 6,000 = $2,000
  • Activity 2 ($15,000 loss): (15,000 / 30,000) x 6,000 = $3,000
  • Activity 3 ($5,000 loss): (5,000 / 30,000) x 6,000 = $1,000

Disposition of a Passive Activity

When a passive activity is fully disposed of in a fully taxable transaction, all accumulated suspended losses associated with that activity become fully deductible in the year of disposition. This means they can now be used to offset not only passive income but also nonpassive income. This provides a significant opportunity to reduce overall taxable income in the year of disposition.

Upon disposition, the suspended losses are first applied against any passive income generated from the same activity in the year of disposition. If any suspended losses remain, they are then used to offset any other passive income available in that year. Any still remaining can then be deducted from nonpassive income, such as wages or business income.

Example of Disposition Calculation

Let’s consider an investor with a suspended loss of $50,000 from a rental property (Passive Activity A) that is fully disposed of. In the same year, the property generates $10,000 in passive income, and the investor has another passive activity (B) generating $15,000 in passive income, along with a job yielding $100,000 in salary.

  1. The $50,000 suspended loss from Activity A first offsets the $10,000 passive income from the same activity.
  2. The remaining $40,000 suspended loss then offsets the $15,000 from Activity B.
  3. Finally, the remaining $25,000 of suspended loss can be applied against the $100,000 salary.

This sequence of deductions significantly reduces the taxable income, demonstrating the strategic tax planning importance of understanding and managing passive activity losses and dispositions.

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