The rule: IRC 469(g)(2)
When an investor dies, their estate generally inherits rental property with a stepped-up basis equal to fair market value (IRC 1014). Separately, suspended passive losses that the decedent accumulated during their lifetime are theoretically freed at death — but under IRC 469(g)(2), they are only deductible to the extent they exceed the step-up in basis.
In most cases of appreciated property, the step-up equals or exceeds the accumulated passive losses, so the losses simply disappear. The heir gets a clean slate: a fresh basis equal to FMV, no pending recapture, and no inherited passive losses.
A worked example
An investor purchased a rental for $400,000, claimed $150,000 in depreciation over the years (adjusted basis = $250,000), and accumulated $80,000 in suspended passive losses. At death the property is worth $600,000.
Step-up in basis = $600,000 − $250,000 = $350,000. The deductible loss at death = $80,000 suspended losses − $350,000 step-up = $0. All $80,000 of suspended losses are wiped out. The heir's new basis is $600,000 — and no depreciation recapture applies because the basis reset eliminated the embedded gain.
Planning implications
For investors who have accumulated large suspended passive losses, dying with the property in their estate can be the most tax-efficient exit — the step-up eliminates recapture AND the heir can depreciate from the new stepped-up basis. But the suspended losses that might have been usable are permanently lost.
If you have both suspended passive losses AND low appreciation, it may be more tax-efficient to dispose of the property before death to use the losses. If you have high appreciation, the step-up strategy ("swap till you drop") likely wins. Run both scenarios with a tax advisor.
Frequently asked questions
Do heirs inherit my suspended passive losses?
No. Suspended passive losses are not transferred to heirs. Under IRC 469(g)(2), they are deductible only to the extent they exceed the step-up in basis — which usually means they are wiped out entirely on appreciated property.
Does depreciation recapture disappear at death too?
Yes. The step-up in basis to fair market value resets the adjusted basis, eliminating the embedded depreciation. Heirs owe no recapture on gains that accrued before the date of death.
What if the property is not appreciated?
If the property declined in value, the step-up is smaller (or there may be a step-down if FMV < adjusted basis). In that case, some portion of the suspended losses may survive and be deductible. A tax professional should calculate this at death.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.