With potential reductions in the gift, estate, and generation-skipping transfer tax exemptions looming, many practitioners are rightfully focused on planning with these exemptions. However, as part of this planning, it’s also important to not lose focus on income tax attributes.

Capital loss carryovers, charitable carryovers, and net operating losses—to name a few—are all valuable tax attributes negatively impacted by a taxpayer’s death. In most cases, these attributes are limited or simply lost altogether.

This article will focus on some of these attributes, their treatment at death, and some planning ideas to limit or prevent their loss. 

NOLs and Capital Losses

Perhaps the most important guidance relating to income tax attributes is Revenue Ruling 74-175. While specifically addressing net operating losses (NOL) and capital losses at death, the ruling does make the sweeping statement, “in the absence of any express statutory language, only the taxpayer who sustains a loss is entitled to take the deduction.”

Because an estate and the estate beneficiaries are different taxpayers than the decedent, this ruling stands for the proposition that any tax attribute is lost at the taxpayer’s death, unless a specific provision of the tax code says otherwise. 

As mentioned above, the treatment of NOLs and capital loss carryovers at death are directly addressed in Revenue Ruling 74-175. Simply stated, those attributes are lost at death, a theme that’s often repeated for tax attributes at death. If, however, the deceased taxpayer was married and filing a joint return, the surviving spouse may use those loses to offset any income, in the case of:

• NOL carryforwards, or capital gains
• capital loss carryovers, generated after the deceased spouse’s date of death but before year-end

Such treatment is allowed because, pursuant to Treasury Regulations section 1.2-1(c), for joint filers, if spouses have different tax years solely because of the death of either spouse, the tax year of that deceased spouse is deemed to have ended with the end of the surviving spouse’s tax year. Once that year has ended, the NOL or capital loss not attributable to the surviving spouse—a determination that can also be a challenging accounting exercise—is lost.

It should be noted that with respect to NOLs, any such loss incurred in the year of death can still be carried back to earlier years, as provided by IRC section 172. Irrespective of the somewhat limited planning opportunities after death, for individuals with large NOLs and capital loss carryovers, proactive planning should be considered.

With respect to NOLs, these losses can offset any income. So, generating any type of income can be an effective use of the loss. That said, the more ordinary income that can be generated, the more efficient the offset will be. If applicable, one area to look at may be an individual’s IRA (or other retirement plan).

If a taxpayer has a significant IRA and NOL, a Roth IRA conversion could be highly advantageous. The conversion of an IRA to a Roth IRA, to the extent the account doesn’t have basis, is an acceleration of ordinary income. This income acceleration can then be sheltered using the NOL. Once made, the Roth is tax-free with respect to both income generated in the account and distributions.

The Roth conversion here could be particularly attractive now that the SECURE Act has limited the period of income tax deferral for nonspousal inherited IRAs to 10 years. Although beyond the scope of this article, the various state tax implications of this and other potential planning discussed should also be taken into account.

Capital loss carryovers may be more difficult to plan with, because they can only offset capital gain. In addition, because of the basis step-up to fair market value at death allowable under IRC section 1014, using a capital loss as part of a plan to increase the basis of an asset that will be held at death may not be particularly helpful.

However, if a taxpayer who’s looking to gift an appreciated asset also has capital loss carryovers, the opportunity exists to essentially pass basis to the donee. In such circumstance, instead of gifting the asset, consider gifting cash equal to the asset’s value. Then, in a taxable sale, the donee purchases the asset from the donor. The capital loss carryover shelters the donor’s gain, and the donee now has a basis in the asset equal to cost, rather than the lower carryover basis from the donor that would typically be the case with a gift.

Charitable Contribution Carryovers

Another tax attribute that is lost at death is charitable contribution carryovers. These carryovers are generated when a taxpayer makes contributions that exceed their applicable adjusted gross income (AGI) limitation. Along with death, taxpayers must also be aware that charitable carryovers expire five years after being generating, so there may be a particular urgency in dealing with this attribute. Legislatively, the rules on charitable carryovers at death are not controlled by Revenue Ruling 74-175, but rather Treasury Regulations section 1.170A-10(d)(4). Similarly, for married filing jointly taxpayers, an allocation of the carryover to a surviving spouse is also allowable and calculated under this regulation.

Unlike planning with NOLs, simply accelerating income that would have otherwise been deferred is an inefficient way of using a charitable carryover because the AGI limitations that cause the carryover in the first place prevent a dollar-for-dollar offset. For example, if an individual has a carryover subject to a 50% AGI limitation and then generates $1 million of taxable income, that carryover can only shelter $500,000 of the income. However, if that individual doesn’t make any additional contributions in subsequent years, a corresponding portion of the income that would’ve been generated anyway can be offset.

The practical issue here is that many individuals with charitable carryovers want to continue to give, irrespective of tax consequences. In such case, it may be possible to use a trust to replicate the giving the individual would have done but in a more tax efficient manner.

Dissimilar to individuals, trusts do not have AGI limitations. Instead, charitable deductions for trusts are limited by “gross income.” Here, an individual can contribute an asset or assets to a separate taxpaying (or nongrantor) trust that would produce approximately the amount of gross income that the individual wishes to give. If structured properly, this transfer to the trust can be done without gift tax consequences, if desired. The trust would then make the contribution with the gross income generated, now offsetting that income dollar for dollar. At the same time, the individual is not making the contribution personally and is therefore using their charitable carryover.

Investment Interest Expense Carryovers

Turning to investment interest expense, these carryovers are generated when interest paid on loans used to purchase investment assets that produce taxable income exceed a taxpayer’s ordinary investment income in a tax year. As one might expect, these carryovers are also lost at death.

For taxpayers with these attributes, consider the election under IRC section 163(d)(4)(B) that treats preferential rate income, such as long-term capital gains and qualified dividends, as ordinary income for purposes of the investment interest expense rules. While effective in using the carryover, assuming a taxpayer has this income, the election is not overly efficient because it in effect converts an ordinary income expense to a lower rate expense.

Instead of making the above election, in the right circumstances, using intra family loans can generate interest income.

Assume that a parent has significant investment interest expense carryovers and it’s unlikely that enough ordinary investment income will be generated in the future. The parent can loan money to heirs or a separate taxpaying trust for the benefit of heirs (borrower). The borrower can use those funds to purchase taxable income producing assets, thereby creating deductible investment interest expense for that borrower. The interest income paid to parent will be offset by the interest expense carryover, thus creating an effective income and estate tax plan.

The final income tax attribute examined are passive activity loss (PAL) carryovers. These losses are generated when a taxpayer incurs ordinary losses in a passive investment. Because the taxpayer does not “materially participate” (i.e., is only an investor), the government doesn’t allow these losses to offset other nonpassive income. Instead, these losses are suspended until such time as the taxpayer has other passive income or fully disposes of the investment from which they were generated (unless sold to a related party), at which point the losses may be used.

Unlike the use-it-or-lose-it rule of the other attributes addressed, the rule for PAL carryovers at death is different.

Under IRC section 469(g)(2), if a passive activity is transferred by reason of the death of the taxpayer, then the suspended passive activity losses can be deducted against income on the decedent’s final income tax return, to the extent they’re greater than the basis step-up, if any, on the asset that generated the loss. Any losses not in excess of this basis step-up are lost. 

To illustrate this rule, assume that at the time of the taxpayer’s death, a passive investment has a basis of $70,000, a fair market value of $80,000, and PAL of $30,000. By virtue of being included in the taxpayer’s estate, the investment’s basis is stepped up to $80,000. Because the $30,000 of PAL exceeds the $10,000 basis step-up by $20,000, that $20,000 can be taken as an ordinary loss on the taxpayer’s final income tax return. The remaining $10,000 of PAL is lost.

While this rule is straightforward in its application in this example, what may be less straightforward is its application when assets are held in a grantor trust but not included in the taxpayer’s gross estate at death.

Because assets held in a grantor trust are treated as still owned by the grantor for income tax purposes, it follows that the rules of IRC section 469(g)(2) should be applied the same way. Assuming the assets of the grantor trust are not included in the gross estate, it’s doubtful the IRS would allow a basis step-up. As a result, 100% of the PAL generated by assets held in a grantor trust and not included in the taxpayer’s gross estate at death should be triggered and allowed on the final tax return.

From a planning perspective, individuals with larger PALs could consider transferring those assets to a grantor trust. This planning could be done in conjunction with other estate planning using the taxpayer’s gift tax exemption. If the taxpayer doesn’t wish to use gift exemption or has none left and is married, the use of an inter vivos martial trust could accomplish the same result.

Takeaway

Given the potential changes in the tax law at the end of 2025, if not sooner, many practitioners are focused on using gift and generation-skipping transfer (GST) exemptions now. As seen above, this use-it-or-lose-it concern should also be applied to the various and often valuable income tax attributes an individual may have. With proper planning, not only can these attributes be realized, but they can also be incorporated into and enhance the overall wealth transfer plan.   

Carl Fiore, JD, LLM, is a managing director in the Andersen US National Tax office, where he focuses on gift, estate, individual, charitable and fiduciary tax consulting and compliance matters. Carl has significant experience with tax and financial matters affecting entrepreneurs, executives and other high-net-worth individuals. He has worked with numerous families and closely held businesses to develop and implement wealth maximization plans through the use of family entities, income tax planning, stock option planning, charitable giving strategies, and effective gift and estate tax planning. Carl has been published and interviewed in Trusts & Estates, The Metropolitan Corporate Counsel and The TaxStringer, and is a frequent speaker on tax planning matters. Carl is also a co-author of the Andersen treatise, Tax Economics of Charitable Giving. Before joining Andersen, Carl worked in the Private Client Services practice of Arthur Andersen, and as a trusts and estates associate at Capell and Vishnick. He can be reached at carl.c.fiore@Andersen.com or 646-213-5125.