For many tax losses, deductions and credits, there are limits on how much you can claim in a given year. Often, unused tax attributes — including passive activity losses, capital losses, charitable deductions and net operating losses — can be carried forward to future tax years. But what happens to these carryovers when someone dies? In some cases, they can be used on the deceased’s final income tax return. Otherwise, they’re lost forever.
Here’s a look at the tax treatment of certain carryovers and some of the planning opportunities available.
Passive activity losses
Generally, losses from passive activities — such as rental real estate activities or businesses in which you don’t materially participate — can be deducted only from income from other passive activities. They can’t be used to reduce nonpassive income, such as wages, portfolio income and income from businesses in which you materially participate. Unused losses may be carried forward to future years until they’re used or the activity is sold or otherwise disposed of in a taxable transaction.
When a person with suspended passive losses dies, the losses may be claimed on the deceased’s final income tax return. But the deduction is limited to the amount by which a loss exceeds the step-up in basis of the related asset. Generally, for income tax purposes, the basis of an appreciated asset is stepped up to its fair market value as of the date of death.
For example, let’s say Brian owns a rental property with a fair market value of $1.5 million, an adjusted basis of $1.25 million and suspended passive losses totaling $300,000. When Brian dies, the deduction for those losses on his final income tax return is limited to $50,000 — $300,000 minus the $250,000 step-up in basis.
To avoid losing these deductions, one option is to sell the passive activity during your lifetime — a taxable disposition — and use all of the suspended losses. Another option is to gift the activity to your children or other loved ones. The suspended losses can’t be used, but they’re added to the recipient’s basis in the property, reducing his or her gain when the property is sold. However, if the property’s value declines, the suspended losses can’t be used to increase the recipient’s loss.
In any given year, you may use capital losses to offset capital gains. And if capital losses exceed capital gains, you can use the net loss to offset up to $3,000 of ordinary income. Unused losses may be carried forward indefinitely to offset capital gains, plus $3,000 of ordinary income, in future years. When you die, any unused capital loss carryovers expire — they can’t be used by your estate or transferred to your surviving spouse.
To avoid losing valuable tax deductions, it’s a good idea to track capital loss carryovers as you get older. There may be opportunities to sell appreciated assets, generating capital gains that can be used to absorb accumulated capital losses. In addition, between the date of death and the end of the calendar year, a surviving spouse can generate capital gain income to offset the deceased spouse’s capital loss carryovers on the couple’s final joint tax return.
The deduction for charitable donations is limited to a certain percentage of adjusted gross income (ranging from 20% to 50%, depending on the type of charity and property). Excess donations may be carried forward for up to five years. Charitable carryovers expire at death, but tax planning may allow a surviving spouse to boost the couple’s income and increase the amount of the carryovers that can be deducted on their final tax return. Any remaining carryovers are allocated between the spouses using a formula prescribed in IRS regulations.
Net operating losses
Sole proprietors and owners of pass-through entities can use net operating losses (NOLs) to offset other income. Excess NOLs may generally be carried back up to two years and carried forward up to 20 years to offset income in those years. When the business owner dies, unused NOLs expire and can’t be used by a surviving spouse or the estate. There may, however, be an opportunity for a surviving spouse to generate additional income in the year of death to absorb these losses.
Use them or lose them
Older taxpayers with significant carryovers should discuss potential tax-saving strategies with their tax advisor. With a little planning, you can ensure that these valuable tax benefits don’t die with you.
Sidebar: Whose carryover is it anyway?
For married couples, it’s important to determine the spouse to which carryovers are attributable. Typically, carryovers are deductible only by the spouse who incurred the loss and expire when that spouse dies. But in some cases, carryovers are attributable to both spouses. For example, if spouses own capital assets jointly and sell them at a loss, then when one spouse dies half of any carryovers attributable to those assets should be allocated to the surviving spouse, who can continue carrying them forward.
Similarly, if a couple jointly owns a passive activity or operates a business together, then arguably half of any passive activity loss or net operating loss carryovers should be allocated to the surviving spouse. IRS regulations provide a formula for allocating unused charitable carryovers between the spouses.