8018 / How is a passive loss treated if the taxpayer is subject to other limitations on loss deductions?

The determination of whether a loss is disallowed under the passive loss rules is made after the application of (1) the limitations on the deductibility of losses in excess of basis with respect to investment in a partnership (see Q 7750) or S corporation (see Q 805), and (2) the “at risk” rule (see Q 8003 to Q 8009). A passive loss that would not be allowed because of the basis limitations or the at risk rules is suspended and carried forward under the basis and/or at risk provisions, not the passive loss rules. The amount becomes subject to the passive loss rules in subsequent years when it would be otherwise allowable under both the basis and at risk limitations.¹

According to the Senate Finance Committee Report, TRA ’86, amounts at risk are reduced even if deductions that would be allowed under the at risk rules are suspended under the passive loss rules. Similarly, basis is reduced if the deduction would be allowed under the at risk rules but is suspended under the passive loss rules. When a taxpayer’s amount at risk or basis has been reduced by a deduction not allowed under the passive loss rules, the amount at risk or basis is not reduced again when the deduction becomes allowable under the passive loss rules.²

Under the regulations, passive activity deductions do not include: (1) a deduction for an item of expense (other than interest) that is clearly and directly allocable to portfolio income; (2) a deduction allowed under IRC Sections 243, 244, or 245 with respect to any dividend that is not included in passive activity gross income; (3) interest expense (other than expense allocated to a passive activity expenditure and which is neither qualified residence interest nor capitalized); (4) a deduction for a loss from the disposition of property of a type that produces portfolio income; (5) a deduction that is treated as a deduction that is not a passive activity deduction; (6) a deduction for any state, local, or foreign income, war profits, or excess profits tax; (7) a miscellaneous itemized deduction that is subject to partial or total disallowance; or (8) a deduction allowed for a charitable contribution.³