In order for a passive activity loss to qualify as a deduction it must meet one of two conditions. Either, it must arise in connection with the conduct of a passive activity in the tax year, or represent a carryover of a disallowed passive activity deduction for a preceding tax year. Disallowed passive activity loss for a year is allocated among all of the taxpayer’s activities that produced the loss. The allocation determines the treatment of disallowed losses when an activity ceases to be a passive activity to the taxpayers and the proper application of loss limitations that apply.
The passive loss limitation is lifted when a taxpayer disposes of his entire interest in a passive activity in a fully taxable transaction. Disallowed passive activity loss attributable to the activity and losses recognized on the disposition may be deducted from active and portfolio income. Alternatively, a taxpayer that disposes of a substantial part of an activity may treat that part as a separate activity for purposes of freeing passive losses if he or she can establish with reasonable certainty the share of losses and credits that are allocable to the disposed portion. This does not pertain to nontaxable dispositions i.e. gifts or disposition to related persons.