Can passive losses offset a Roth conversion?

Dear Tax Talk,
I want to convert a traditional IRA to a Roth IRA in 2013. I also have unused passive losses and passive credits from prior tax years (losses were carried forward). May those passive losses/credits be used in 2013 to offset some of the gain resulting from the Roth IRA conversion?
— Mark

Dear Mark,
Converting your traditional IRA to a Roth IRA is a big decision and there are a lot of issues to consider. You are on the right track in trying to determine the tax effect of the conversion for this tax year versus your income tax bracket in the future. You should be considering your age and life expectancy, the projected rates of return on your investment and whether you have the necessary funds to pay the taxes that may result. Unlike a traditional IRA, a Roth IRA allows you to make contributions from earnings after you reach age 70 ½, and you do not ever have to take mandatory distributions.

Unfortunately, you likely are not going to be able to use your disallowed passive losses and credits to offset the income that is a result of converting your traditional IRA to a Roth IRA. As a general rule, passive activity losses cannot be used to offset income from nonpassive activities. Generally, passive losses include trade or business activities in which you did not materially participate for the tax year and rental activities, regardless of your participation.

However, there is a way for passive losses to offset a Roth conversion. You should keep in mind that there is a special allowance for rental real estate activities that may allow some losses if the losses exceed passive income. You must have actively participated in the real estate, and the allowance is not available to married individuals who are filing separately and who lived with their spouse at any time during the year. The maximum special allowance is $25,000 for single individuals and married individuals filing a joint return for the tax year; $12,500 for married individuals who file separate returns for the tax year and lived apart from their spouses at all times during the tax year.

There are limitations based on your income. If your modified adjusted gross income is $100,000 or less ($50,000 or less if married filing separately), your loss is deductible up to the amount of the special allowance shown above. If your modified adjusted gross income is more than $100,000 ($50,000 if married filing separately), your special allowance is limited to 50 percent of the difference between $150,000 ($75,000 if married filing separately) and your modified adjusted gross income. Generally, if your modified adjusted gross income is $150,000 or more ($75,000 if married filing separately), there is not a special allowance.

IRS Publication 925 has the calculation for modified adjusted gross income on pages 4 and 5.

If you do not qualify for this special allowance, you will need to continue to keep track of your disallowed losses on Form 8582 and the disallowed passive credits on Form 8582-CR until such time as they become allowable to you in the future.

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