The Honorable Margaret Richardson
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Re: Passive Activity Losses and Divorce

March 21, 1995


Dear Commissioner Richardson:

Recently, as part of its staff training materials, the Internal Revenue Service issued its Reference Guide for Passive Activity Losses (Training 3149-115 (3/94) TPDS 83479V). The AICPA is writing to request your review and reconsideration with respect to the division of property subject to the passive loss rules, and transactions incident to a divorce.

We do not believe that suspended losses should be added to the basis of the property when the activity is transferred pursuant to I.R.C. §1041. We are of the opinion that in the case of such transfers, the undeducted losses and unused credits should merely carryover to the transferee spouse. To reach a conclusion other than this is both unsupportable and clearly contrary to the purpose and intent of §1041.


In part, the aforementioned reference guide provides as follows:

The transfer of passive activities incident to a divorce is not considered a fully taxable transaction and any suspended losses would not be freed-up under IRC Section 469(g). IRC Section 1041(b) states that any transfer of property incident to a divorce will be treated as a gift for purposes of Subtitle A (Income Taxes). Since IRC Section 469 is part Subtitle A, the transfer of passive activities incident to divorce would be treated as gifts and the losses of the "donor" spouse are added to basis. (Reference Guide for Passive Activity Losses, Training 3194-115 (3/94) at 4-8 and 4/9)

We believe that your conclusion, that losses in this situation should be added to the basis of the activity in the hands of the transferee spouse, should be reconsidered based upon the discussion set forth below.

First, §1041 was added to the Code in 1984. Thus, the language of §1041(b), treating a transfer of property between spouses, whether or not incident to a divorce, did not contemplate §469(j)(6), which was added in 1986. I.R.C. §469(j)(6) requires that in the case of a transfer of a passive activity by gift, the basis of the interest is to be increased by the amount of any undeducted passive activity losses attributable to the property.

Congressional history relating to §1041 notes that a husband and wife are a single economic unit. In implementing §1041, it was Congress' intent to accomplish a division of property between spouses without tax consequences or ramifications. At the time §1041 was drafted this could be accomplished by treating the transfer as a "gift" between the spouses. Section 469(j)(6) would not carry forth this intent with respect to passive activities being transferred between spouses. If the Congressional intent of §1041 were to be carried out, the transfer of a passive activity between spouses, with undeducted passive activity losses, would merely carryover the undeducted losses to the transferee spouse. How an asset is titled during marriage should not affect the basis or income taxation of that asset when transferred pursuant to the terms of §1041.

Transfers of passive activities, subject to §469(j)(6), derive their basis from I.R.C. §1015. This section determines the basis of property which is the subject of a gift to a third party. However, this section does not apply to transfers subject to §1041. See I.R.C. §1015(e). Rather, it is specifically provided the §1041(a)(2) will determine the basis of such transfers. That section does not adjust the basis of the property, but rather provides that the basis shall always be the same in the hands of the transferee as in the hands of the transferor. Unlike §1015, if the fair market value of property transferred subject to §1041 is less than the transferor's basis, no adjustment is made to lower the basis to its fair market value. See I.R.C. §1041(a)(2). When a passive activity is gifted to a third party such an adjustment may be required. Senate Report Accompanying H.R. 3838 (The Tax Reform Act of 1986), S. Rep. No. 313, 99th Cong. 2d Sess. 713-746 (1986) at 726 n. 12. This further emphasizes the fact that transfers between spouses, or incident to a divorce, are not to be treated in the same manner as gifts to third parties.

Temp. Treas. Reg. §1.469-1T(j) also recognizes the single economic unit of a husband and wife filing a joint tax return. This provision treats a husband and a wife as a single taxpayer for the computation of the passive activity credits among one's various activities. It also treats a husband and a wife as a single taxpayer for the identification of disallowed passive activity deductions and credits. See Temp. Treas. Reg. §§1.469-1T(j)(1)(i) and (ii). When taxpayers cease to file a joint return, they are required to have separately tracked their disallowed deductions and credits arising with respect to their separate interests in the passive activities. Treas. Reg. §§1.469-1T(j)(2) and (3). If, however, the ownership is determined in a transfer between spouses or incident to a divorce, the ownership of the activity, as determined by the spouses or by the court, should be respected. Thus, if the taxpayers are treated as a single taxpayer during their marriage, they should be treated as a single taxpayer for the purposes of the division of the activity between themselves. When the activity is divided, the ownership of the property should be controlled by I.R.C. §1041. Subsequently, the allocation of carryover losses and credits should be determined under Temp. Treas. Reg. §§1.469-1T(j)(2) and (3). Thus, once ownership is determined, the disallowed losses and credits are associated with the activity. Basis in such transactions is controlled by §1041(b)(2) and should not be affected by §469(j)(6) or §1015. At this time, regulations do not exist regarding the disposition of passive activities. Temp. Treas. Reg. §1.469-1T(c)(12)(iii).

The Reference Guide for Passive Activity Losses does not take into consideration the fact that §1041 applies to transfers from one spouse to the other spouse outside of the context of a divorce. The guide specifically directs its comments to transfers incident to a divorce. Transfers between spouses, not incident to a divorce, will also be affected by your position. Congressional intent clearly recognizes "the fact that the husband and wife are a single economic unit" and that the marital unit should be treated as a single taxpayer (General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (H.R. 4170), prepared by the staff of the Joint Committee on Taxation (December 31, 1984), pages 710-711). If transfers within the marital unit will cause the capitalization of suspended losses, this intent will be circumvented. Your position creates traps for the unwary when performing estate planning or transferring passive activities within the marital unit for other reasons. We believe this to be an unintended result which requires your reconsideration.

Finally, it should be noted that §469(j)(6) was intended to prevent trafficking in unused passive loss deductions. A transfer within, or the division of, a single economic unit differs from a transfer to a third party by gift. In the case of a divorce, the transfer takes place in an adversarial setting. This can not be construed as a transfer that "traffics" unused passive losses. It is respectfully requested that this difference also be recognized.

Furthermore, we suggest that a regulation addressing this matter be promulgated; we would be happy to offer assistance in drafting such a regulation.

The AICPA and its membership appreciates your consideration of this matter. We hope that you are able to appreciate the distinctions drawn in this request and that you will revise the position taken in your audit guide.

We hope you will give these proposals favorable consideration. We would be happy to meet with you or your staff to discuss these matters. If you have any questions, please call me at (202) 467-3004 or one of the following individuals: Ward M. Bukofsky, Chair, Individual Taxation Committee, at (310) 278-5850; Stephen M. Walker, Chair, Domestic Relations Task Force, at (505) 242-5271; or Eileen Sherr, Technical Manager, at (202) 434-9256.




Deborah Walker
Tax Executive Committee

cc: Leslie B. Samuels, Department of the Treasury, Assistant Secretary
William Jackson, IRS, Branch Chief (CC:IT&A:BR6)
Claire Toth, IRS, Chief Counsel (CC:DOM:P&SI:1)