The non-recognition treatment under §1041 applicable to gains is equally applies to losses where a transfer is subject to §1041. IRC § 1041(a) dictates that the transferring spouse recognizes no loss on the transfer of depreciated property (i.e. property with FMV less than book value) and the recipient spouse receives the transferring spouse’s adjusted basis in the asset, even where its basis exceeds its fair market value at transfer. Please note that this treatment is in direct opposition to the treatment accorded by 1015(e) to asset transfers via gift that limits the grantee’s basis in depreciated property to its FMV at date of transfer rather than its higher basis.
For example, consider a scenario where W owns stock that she paid $100,000 for that has a current fair market value of $90,000. W sells the stock to H for $90,000. W is prohibited under §1041 from deducting the loss, and H’s basis in the stock is $100,000 under §1041. When H later sells the stock to a disinterested third party for $85,000, he may recognize a $15,000 loss, subject to any then relevant loss limitation rules elsewhere in the IRC at that time.
However, assume the same facts as in the above except, instead, W makes a gift of the depreciated stock to H. The tax results are identical as the gift is governed by IRC 1041; not under 1015(e).
Now, assume the same facts as in the original scenario but instead this time W gifts the stock to H and W’s daughter and the daughter sells the stock to a third party for $85,000. The daughter’s deductible loss on the subsequent sale would be limited to $5,000. IRC § 1015(a) would limit the daughter’s loss basis to $90,000 which is the FMV at the date of the gift resulting in recognizable loss of $5,000 on a sale for $85,000 and an economic loss to the family of $15,000 ($100,000 less $85,000).
IRC § 469, which dictates the tax treatment of passive activity losses, requires an exception to the above discussion regarding the general “transferred loss” provisions contained in § 1041.
IRC § 469(j)(6) requires that where an interest in a passive activity is gifted, any suspended passive losses related to the activity are non-allowable as future carryforward suspended passive losses but instead are added to the basis of the gifted property. This treatment trumps the loss treatment required under 1041 such that a recipient spouse of a passive activity property (e.g., rental property) may not claim as deductions the suspended losses accumulated by the transferor spouse and moreover of the couple, if joint returns were filed, with respect to the property.
To illustrate consider the following example where a couple divorces and H transfers a rental property pursuant to a settlement agreement to W. For several previous tax years, they incurred and accumulated passive losses in the rental activity on joint returns. Because the transaction is subject to 1041, W will be required to add 100% of the suspended passive losses to the basis of the property (H and W’s share) and will not be entitled to deduct the accumulated suspended losses on the transferred property even if she actively participates in the management of the property.