Let us imagine that you are planning to expatriate in 2018, and that you will be a covered expatriate. You have a number of rental properties in the United States. Those rental properties have accumulated a substantial amount of passive activity losses (PALs) during the time that you have owned them. Because you are a covered expatriate, you will need to pretend you sold all those properties at fair market value on the day before your expatriation and report the gains or losses on your tax return as if you really sold the properties.
Today’s topic covers what happens to the suspended PALs you have accumulated in the rental properties: Do they get released when you pretend you sold the properties (and thereby reduce your exit tax), or do they remain suspended because you did not really sell the properties?
The short answer: You will be allowed to utilize those losses in the year of the deemed sale to help offset your taxable income. If you want to know why, keep reading.
According to Internal Revenue Code section 877A, “All property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value”.1
In our fact pattern, we assume you are a covered expatriate, so you will have to treat all your property “as sold” at fair market value on the day before your expatriation date. Notice 2009-85 refers to the requirement to treat all property as sold as a “deemed sale”.2
There is nothing in the Code or Notice 2009-85 that defines deemed sale. A deemed “sale” under section 877A should therefore be considered the same as a “sale or exchange” under section 1001.
Gains and losses from a deemed sale are recognized as follows:3
(A) notwithstanding any other provision of this title, any gain arising from such sale shall be taken into account for the taxable year of the sale, and
(B) any loss arising from such sale shall be taken into account for the taxable year of the sale to the extent otherwise provided by this title, except that section 1091 shall not apply to any such loss.
Proper adjustment shall be made in the amount of any gain or loss subsequently realized for gain or loss taken into account under the preceding sentence, determined without regard to paragraph (3).
The rules assume a “sale” occurs, and overrides other provisions of the Code. The rules say when to recognize the gains or losses from that “sale” – the taxable year of the sale.
Section 877A(a)(2)(A) prevents nonrecognition rules from applying and overrides any rules causing gain recognition to occur at a time other than the day before expatriation date.
Section 877A(a)(2)(B) permits the operation of all loss allowance rules, with the exception that it allows you to recognize losses that arise from the deemed sale that would otherwise be disallowed because of the wash sale rules.
Under the normal passive activity rules, if a passive asset is disposed of entirely (by sale or other disposition) during a taxable year, then any loss left over (after some calculations) “shall be treated as a loss which is not from a passive activity”.4
In other words, suspended losses that remain after an asset is sold are treated as ordinary losses that are deducted from ordinary income in the same year as the asset sale.
The deemed sale of your passive assets will be, for purposes here, a disposition of your “entire interest” in the passive activities.5 Recall that section 877A states that “all property of a covered expatriate shall be treated as sold” (emphasis added).6 This should be equivalent to a “sale or exchange” for purposes of the code generally.
Unless there are explicit exceptions under the passive activity loss rules or under section 877A that apply to you, your suspended passive activity losses should be deductible on the tax return that reports the deemed sale of your passive assets.
We have found no such exceptions. To the contrary: Section 877A(a)(2)(B) explicitly allows all losses that arise from the deemed sale, including wash sale losses that would otherwise be disallowed under section 1091. Since section 877A allows the loss and because the deemed sale is a loss-releasing complete disposition for section 469 purposes, the passive activity losses will be allowed.
The Code for covered expatriates (and expatriates in general) is silent when it comes to suspended passive activity losses. Likewise, there is no mention of suspended passive activity losses in Notice 2009-85. Those resources make up the entirety of the guidance we have from the IRS for covered expatriates.
If any exceptions apply to you, then, they would be found under the normal passive activity rules. The only possible exception there relates to dispositions involving related parties.7
Under the deemed sale rules, you are effectively selling the passive assets to yourself at fair market value. When the deemed sale takes place, you still own the assets but your new basis in the assets becomes the fair market value as of the day of the deemed sale.8 For tax purposes, a sale from you to yourself has taken place.
You are not considered to be a related party to yourself, however, because you are not defined as a member of your own family under section 267(c)(4): You are not your own brother, sister, spouse, ancestor, or decedent. None of the other definitions of a related party apply either. You should be able to deduct your suspended passive activity losses.
Those losses will be deducted from ordinary income on your expatriation year income tax returns.
The usual disclaimer applies: This is not legal advice, so don’t use it to make big decisions. Hire someone and get good, focused advice.