Question: Walter and Steffie were married and in 1998 they purchased a primary residence together in Maine. In late 2020, the two divorced, but still owned the residence together. That year, they also converted the property to a Schedule E rental activity. The activity accrued suspended passive losses (PALs) through 2021.
When Walter remarried in June 2021, he decided to quitclaim deed the property to Steffie, who plans to sell the house eventually.
Does the transfer of the property release the suspended PALS?
Answer: No. Neither Walter nor Steffie will be allowed to immediately deduct the suspended passive activity losses associated with the house upon either transfer or sale although Steffie will be able to use her PAL in a different way.
When Walter transferred his ownership of the property to Steffie within one year of their divorce, under §1041(b), Steffie received a tax-free gift, with the carryover basis of the spouse who made the transfer. Therefore, Walter will not be able to deduct his portion of the suspended losses. Also, in this circumstance, when the transferred property involves passive activity income, for Steffie, the suspended losses are added to the tax basis of the asset being transferred. [§469(j)(6)]. Therefore, she will also not be able to deduct the suspended losses but may only use them to reduce her gain.
In official guidance from the IRS Market Segment Specialization Program (MSSP) Audit Technique Guide on Passive Activity Losses, the IRS states that transfers incident to divorce should be treated as gifts and the suspended losses of the donor spouse added to the basis passing to the receiving spouse. Thus, the recipient’s deduction of the suspended passive loss generally is deferred until the property is sold.
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