Use Market Crash To Bail From Burned Out Shelters?

Originally Published on forbes.com on August 5th,2011

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William Baldwin has written a great piece on the tax complications of “harvesting losses”. You might want to read that first.  Then take a look at your most recent Form 1040.  You may find that on Schedule D there is a big negative number.  Some day your ship will come in and you will have some big gains, which will be tax free since the gain will be offset by that negative number.  Executing the excellent strategy that Mr. Baldwin has laid out will make that number even bigger.  It’s kind of the reverse of what Joseph told the Pharaoh.  You are storing up hunger for the years of plenty.

As long as you have your return out though, thumb through it a little more.  I’m sure many Forbes readers have big fat returns.  See if there is a Form 8582.  Some of you will have a negative number there on line 4.  That is your passive activity loss carryover.  The passive activity loss rules require us to put our activities into passive and non-passive buckets.  You can only bring losses out of the passive bucket to the extent that there are gains in there. Losses are carried forward indefinitely  There is an extremely important distinction here that is not always understood.  This is not an offset.  The passive income allows the use of the passive loss.  It does not change its nature.  So if there is a capital gain in the passive bucket, it releases passive ordinary losses.  Passive losses are also released when the activity they are associated with is fully disposed of.

Now it is is possible that some of your passive activity losses are associated with what are called “burned out tax shelters”.  Somewhere in your papers you may have K-1 from a partnership.  You might see that the ending capital account is a big negative number.  It might be much bigger than the passive loss carryover associated with that activity.  That number is sometimes referred to as your “negative basis”.  I cringe when I hear that.  It shows a fundamental misunderstanding of Subchapter K of the Internal Revenue Code.  On the other hand it can certainly feel like negative basis.  If the capital account has been maintained on the income tax basis that would likely be your gain if you disposed of the partnership interest for nominal consideration.  Right now we are doing big picture.  Don’t attempt to execute all this at home.  Let’s assume that the negative capital is about what the gain would be and it is $250,000 and that the passive activity loss carryover associated with the activity is $50,000.  If you disposed of that activity for nominal consideration you would likely have a capital gain of $250,000 and $50,000 of ordinary losses would be released.  If you had passive losses carryovers from other activities they would also be released up to the $250,000.

Here is the magic.  When that $250,000 goes to your Schedule D it will be offset by your other capital losses.  The passive losses that it released will be ordinary losses, that will finally shelter your other income.  I spoke with my friend Larry Einzig of The Community Builders.  They have done a fantastic amount of good work developing affordable housing over the years.  One of the arrows in their quiver has been the tax advantages that are accorded investors in affordable housing.  They have sometimes accommodated investors in their deals by accepting charitable contributions of interest in deals they have been involved in.  If you have affordable housing partnership units with a not-for profit sponsor that may be a strategy to consider.  The strategy could also work for someone who has a building with value in excess of its basis, but debt in excess of its value.

Now the harvesting of the losses that Mr. Baldwin explained requires relatively quick action.  Executing this follow on action to get a huge benefit from those harvested losses should be done slowly and deliberately.  There are many complications that I have glossed over, the “hot asset” rules, for example, that might make some of your gain ordinary.  You must talk to your advisors about this.  For some people it might work very well.