What Is a Suspended Loss?
A suspended loss is a capital loss that cannot be realized in a given tax year due to passive activity limitations. These losses are, therefore, "suspended" until they can be netted against passive income in a future tax year. Suspended losses are incurred as a result of passive activities, and can only be carried forward, known as a capital loss carryover.
- A suspended loss is a capital loss incurred in the current or previous years, but which is not eligible to be realized until a future year.
- Normally, capital losses are deductible against capital gains, or in some cases against ordinary income.
- A capital loss carryover is the net amount of capital losses eligible to be carried forward into future tax years.
Understanding Suspended Losses
While many losses incurred in a given tax year can be deducted in the same year they occur, losses generated from passive activities can only be used to offset income or gains generated from other passive activities.
These rules, set forth by the Internal Revenue Service (IRS), are known as the Passive Activity Loss (PAL) rules. Investors are prevented from using losses incurred from income-producing activities in which they are not materially involved to offset ordinary income. Income from rental properties is generally considered passive, even if you materially participated in their management. However, if you qualify as a real estate professional, then your participation isn't classified as passive.
How Suspended Losses Work
Passive losses are only deductible up to the amount of passive income. When the passive loss incurred is greater than the passive income generated, the excess loss can be suspended and carried forward indefinitely until the entity has enough passive income to absorb the suspended loss or until the activity is disposed of.
In effect, any loss in excess of passive income is called a suspended loss. For example, if a taxpayer has a passive loss of $8,000 and a passive income of $3,500, his suspended loss is $4,500.
A taxpayer who disposes of his entire interest in a passive activity may deduct the full amount of the suspended loss remaining for that activity at that time. Following our example above, if the individual carries forward the suspended loss for five years at which point he disposes of his interest in this activity, he may deduct the full $4,500.
Suspended losses that are incurred as a result of the disposition of a passive interest are subject to an annual capital loss limit.
Suspended losses can also be used to offset income realized in a later year that is generated from material participation in the activity that initially produced the loss. In this case, losses from an activity in which a taxpayer materially participates are subject to the at-risk rules, not the PAL rules.
For example, if a taxpayer incurs a $6,000 suspended loss in one year from a passive activity and then materially participates in the activity the following year and earns $10,000, then the suspended loss may be applied against $6,000 of the earned income, leaving the taxpayer with $4,000 of declarable income for the year.
Example of Suspended Losses
A famous case of suspended losses leading to reductions in tax liability is President Donald J. Trump. According to the New York Times, President Donald Trump’s 1995 tax filings “declared losses of $915.7 million, giving him a tax deduction so substantial that it could have allowed him to legally avoid paying federal income taxes on hundreds of millions of dollars of income for almost two decades.”