Can Passive Losses Offset Capital Gains? Fund K-1 Carryovers

What can suspended passive losses offset?

Suspended passive losses can offset a capital gain only when the gain comes from a passive activity, such as another syndication selling a building or your sale of a passive fund interest. Gains on stocks, bonds and fund shares in a brokerage account, interest, dividends and most hedge fund K-1 income are not passive, so they cannot absorb the losses. Whatever stays unused carries to the next year with no time limit (26 USC 469(b)).

These rules come from the Form 8582 instructions and Publication 925; Publication 544 explains section 1231 gain.

A case needs professional judgment when carryovers are missing or do not match the funds, when a fund groups several properties, when a state's numbers differ, or when an error began in a year that is now closed. What to gather: every K-1 since you entered each fund, every prior federal Form 8582 with its worksheets, and each state's passive loss form, such as California Form FTB 3801. To have them rebuilt fund by fund and matched to your K-1s, see fund investor tax help.

Why are my fund K-1 losses suspended?

A K-1 loss passes four limits in a fixed order: basis, at-risk, passive activity, then the excess business loss limit (Partner's Instructions for Schedule K-1). A loss held back by an earlier limit never reaches the later ones that year. Each limit keeps its own carryover, so one fund can have losses suspended under more than one limit.

• Basis. A partner deducts a loss only up to the adjusted basis in the interest. The capital account in item L of the K-1 cannot be used to figure basis: it leaves out your share of partnership debt, among other things. Tracking basis is the partner's job, not the fund's (K-1 instructions).
• At-risk. For real estate, qualified nonrecourse financing generally counts as at risk: a commercial or government loan secured by the property that no one is personally liable to repay (Form 6198 instructions).
• Passive. A limited partner generally does not materially participate and cannot use the $25,000 rental allowance for active participation (Publication 925). For most fund investors this is the limit that holds losses back.
• Excess business loss. Net business losses that pass the first three limits are capped each year: only the part above a threshold is blocked. The threshold is $512,000 on a joint return and $256,000 on other returns. Public Law 119-21 made this limit permanent, and the blocked part becomes a net operating loss carryover (Form 461 instructions).

Federal bonus depreciation of 100% and cost segregation studies can make early K-1 losses large; see Real estate syndication tax returns.

My carryovers vanished after I changed preparers. Where were they?

Prior-year unallowed passive losses live on your own prior Form 8582, activity by activity, not on the K-1. The fund has no record of them (Form 8582 instructions). When a return moves to new software or a new preparer, they must be entered again by hand, or they stop appearing.

Where to look on the last correct return:

How a missing carryover is rebuilt:

1. List every fund and syndication you have held and gather every K-1 since you entered.
2. Apply the four limits in order for each year, starting with the first K-1. Do not use the capital account as basis.
3. Compare each year's result with the Form 8582 actually filed. The first year the two differ is where the error began.
4. Carry the corrected amounts forward to the current year, activity by activity.
5. Repeat the work with state amounts for each state that has its own passive loss form.

If records are missing, ask the former preparer for complete prior returns with all forms and worksheets, and each sponsor for past K-1s. The IRS can send a copy of a filed return with its attachments on Form 4506; copies of Form 1040 are generally kept for 7 years from filing.

Claiming a carryover you cannot support is risky. If an overclaimed loss causes an underpayment from negligence or a substantial understatement, the accuracy-related penalty of 20% of the underpayment can apply on top of the tax (26 USC 6662). For what to collect before a switch, see Choosing a CPA for many fund investments.

Can suspended passive losses offset stock gains or a hedge fund K-1's gains?

No. Portfolio income is not passive income. That includes interest, dividends and gain on property held for investment, such as stocks, bonds and fund shares (Form 8582 instructions).

A hedge fund K-1 is usually not passive either, for one of two reasons:

• Investment gains. Gains, interest and dividends on securities the fund holds are portfolio income.
• Trading activity. An activity of trading stocks, bonds and other actively traded property for the account of its owners is not a passive activity (Form 8582 instructions). If the fund's activity is trading, its income is nonpassive even if you do nothing.

Some funds also hold rental or business activities, so check each K-1's statements for which items belong to which activity. Capital losses that pass the passive rules are still subject to the annual $3,000 net capital loss limit.

Can they offset gain when another syndication sells a property?

Usually yes. Gain from selling property used in a passive activity is passive activity income, and on Form 8582 passive income from all your passive activities absorbs passive losses from all of them (Publication 925). So a section 1231 gain when syndication C sells a building can free losses suspended from syndications A and B before A or B ever sell.

Check the recharacterization rules first. Net income from some rentals is treated as nonpassive and cannot absorb passive losses (Publication 925):

Some other gains are also excluded under Temporary Regulations section 1.469-2T(c)(2) and Regulations section 1.469-2(c)(2) (Form 8582 instructions). A limited partner in a typical syndication rarely meets the participation tests in the development and nonpassive-activity rules. The nondepreciable property rule needs no participation, so a land lease can be recharacterized for any investor.

My software won't net the loss against my fund's sale gain. Is it right?

It may be right in part. The usual causes:

• The fund sold one property, not the whole activity. Selling less than substantially all of an activity does not release that activity's prior-year losses. The gain is part of the activity's income for the year (Form 8582 instructions). You may treat the sale of substantially all of an activity as a separate disposition only if you can prove the losses and income that belong to the part sold.
• The gain was entered as portfolio income. A section 1231 gain from a rental fund belongs in the fund's passive activity, not with brokerage gains.
• The prior-year losses were never entered for that activity after a software or preparer change, so there is nothing to net.
• A recharacterization rule applies, as described above.

A passive gain still absorbs passive losses on Form 8582, from the selling fund's own carryover and from your other passive activities. What a partial sale does not do is free the rest of the fund's carryover beyond the passive income.

Are losses tracked per fund, per property or per grouped activity?

Losses are tracked per activity. Each fund is usually its own activity. A fund groups its own properties into one or more activities first, and you cannot split what the fund grouped. You may then group activities only if together they form an appropriate economic unit (26 CFR 1.469-4). Grouping matters because it decides which sale frees which losses: in one big group, a single property sale is a partial disposition and does not release the group's carryover, though its gain still counts as the group's income; as separate activities, the sale of one whole activity frees that activity's losses.

• Disclosure. A new grouping needs a written statement with the original return. Without the required disclosure, each trade or business or rental activity is treated as a separate activity (Rev. Proc. 2010-13, section 4.07). If every affected return was filed consistent with the grouping, a statement on the return for the year you discover the gap still counts as timely (Form 8582 instructions).
• Regrouping. Once chosen, a grouping stays, unless the original grouping was clearly inappropriate or a material change in facts made it clearly inappropriate. Then you must regroup and attach a statement explaining the change to the original return for that year (26 CFR 1.469-4(e); Form 8582 instructions). A one-time regrouping is also allowed on the return for the first year you are subject to the net investment income tax.
• Limits. A rental activity generally cannot be grouped with a business activity, and a trading activity in which you do not materially participate cannot be grouped with anything.

Why is my California, New York or New Jersey carryforward different?

States start from different numbers, so a state carryover rarely equals the federal one.

Nonresidents and part-year residents use only that state's share, and California asks part-year residents to figure suspended losses both ways and prorate. Keep a separate carryover schedule for each state. Which states you file in is covered in State returns for fund investors.

Do I fix it on this year's return or amend, and which years are still open?

It depends on whether the error changed tax in a year you can still amend. A refund needs Form 1040-X filed within 3 years after filing the original return or 2 years after paying the tax, whichever is later (Form 1040-X instructions).

• Carryover dropped, but no passive income in the meantime. The losses were never used, so they still carry forward (26 USC 469(b)). The corrected amount is generally entered on the current return's Form 8582, with the K-1s, old forms and rebuilt schedule kept to support it.
• Carryover dropped in a year that had passive income. That year's tax was likely too high. If the year is open, an amended return may give a refund.
• Error began in a closed year. The closed year's tax cannot be refunded or changed, but its figures still feed the carryover into open years. In a Tax Court case about an open year, the court may consider earlier years' facts but cannot decide whether a closed year's tax was overpaid (26 USC 6214(b)). How to carry the corrected amount forward depends on the facts and needs professional judgment.

States have their own amendment periods. A K-1 that is corrected after you file is covered in Late fund tax forms.

My fund paid cash or refinanced while my K-1 shows a loss. Does that change my suspended losses?

A distribution lowers your basis, and cash above your basis is taxable gain. It does not release suspended passive losses by itself. Gain from cash above basis is passive activity income when you have not disposed of your entire interest, so it can absorb passive losses (Publication 925). A refinance can also change your share of fund debt, which changes basis. See How partnerships are taxed.

How do suspended losses meet depreciation recapture when the fund sells?

When you dispose of your entire interest in a fully taxable sale to an unrelated person, that activity's suspended passive losses are generally allowed in full (Publication 925). Giving the interest away does not release them: they are added to its basis. At death, they are allowed only to the extent they exceed the step-up in basis (Publication 925). The released losses are ordinary deductions, while part of the gain on a building can be unrecaptured section 1250 gain, taxed at up to 25%. So a dollar of released loss reduces income taxed at your ordinary rates, while a dollar of that gain may be taxed at a different, capped rate. Details: Final fund tax form.

Example

Illustrative only, in US dollars. Each fund and syndication is a separate activity, and no basis or at-risk limit applies.

A rebuilt carryover

An investor's current software shows $180,000 of suspended passive losses from syndications A and B. Two years ago she changed preparers, and $60,000 of syndication A's carryover was never entered. Neither year since had passive income, so rebuilding from her K-1s and old Forms 8582 shows a true carryover of $240,000. Had either year had passive income, part of the $60,000 would have been used then, leaving a smaller carryover and a possible overpayment to amend if that year is still open.

A hedge fund gain does not help

This year her hedge fund K-1 shows $150,000 of capital gains. That gain is portfolio income, so none of the $240,000 is freed.

Another syndication's sale does help

In the same year, syndication C sells one of its buildings and her K-1 shows a $120,000 section 1231 gain. C rented the building for years and it is not land, so no recharacterization rule applies, and C has no suspended losses of its own. On Form 8582, the gain absorbs $120,000 of the $240,000 from A and B, shared between them in proportion to their losses.

Her California carryover is figured separately on Form FTB 3801 and is likely to differ.

Different for you?

• Your fund sold its last property, or you sold your whole interest: see Final fund tax form.
• You or your spouse may be a real estate professional: see Real estate professional status for fund investors.
• You want the general passive and material participation rules: see Business losses.
• You are the sponsor producing the K-1s: see Real estate syndication tax returns.
• You have K-1s from several states: see State returns for fund investors.
• You live in Canada and hold US real estate through a fund or syndication: see Canadians with US rental property.
• You need your basis or distributions explained: see How partnerships are taxed.
• You are switching preparers: see Choosing a CPA for many fund investments.
• A late or corrected K-1 arrived after you filed: see Late fund tax forms.
• Your carryovers are lost, an error began in a closed year, or your state numbers do not match: get fund investor tax help to rebuild them and match them to every fund.