Interest Expense on a former passive activity

TP lost a rental to foreclosure in a fully taxable event (it was a 500k loss) as a result of the town asking for only the amount of taxes owed on the property. The mortgage to obtain that property is on another rental and the tracing rules were used to allocate the expense between the two properties since inception. What happens to the ongoing allocation of interest to that fully disposed activity?

§469(f)1 talks about a former passive activity's expenses as retaining the passive classification and
§469(f)(3) says:
The term “former passive activity” means any ACTIVITY (my bold) which, with respect to the taxpayer—
(A)is not a passive activity for the taxable year, but
(B)was a passive activity for any prior taxable year.

A respected teacher of real estate taxation said to continue to deduct the interest on Schedule E but since the activity ceased with the foreclosure then it is no longer an "activity", so how do you continue to deduct the interest on Schedule E (pg 2 - I would presume)? I think if there is no more "activity" and the interest becomes either personal or at best investment interest.

Thoughts?

Try example 2 of 1.163-8T(c)(2)(iii). Maybe. (Maybe gives me an out when I'm wrong).

There is a similar discussion here: viewtopic.php?f=8&t=3061
However, this one ends differently. We need to follow the proceeds.

For yours, there are no proceeds to follow.

What I do is continue to deduct on Sch E and mark the Sch E as non-passive due to the fully taxable sale that occurred.

I'm thinking slightly more clearly after a meal and a nap. OP is right - there is no longer an activity - it's been disposed of. 1.163-8T(j)(1) tells us to reallocate debt at the earlier of the date when the proceeds from disposition are used for another expenditure (which Wiles wisely notes is irrelevant because there are no proceeds) or

the date on which the character of the first expenditure changes (e.g., from a passive activity expenditure to an expenditure that is not a passive activity expenditure) by reason of a change in the use of the asset with respect to which the first expenditure was capitalized.

.

I would argue the character of the first expenditure has changed from passive activity to a disposed of passive activity, so it's time to reallocate the debt. The reg goes on to limit the amount reallocated to the vakue of the asset on the date it changed from a passive activity to a disposed of passive activity. We aren't told that value.

Again, Wiles comes through, just in way fewer words. What I do is continue to deduct on Sch E and mark the Sch E as non-passive due to the fully taxable sale that occurred.

There is a similar discussion here: viewtopic.php?f=8&t=3061
However, this one ends differently. We need to follow the proceeds.

For yours, there are no proceeds to follow.

What I do is continue to deduct on Sch E and mark the Sch E as non-passive due to the fully taxable sale that occurred.

Thanks for responding. You would show on Sched E pg 1 with just the expense?

"The amount of debt reallocated under paragraph (j)(1)(i)(B) of this section may not exceed the fair market value of the asset on the date of the change in use." - The fmv is not the problem - I'm having trouble with this: There was a change but there is no more 'use'. The activity ceased upon sale so how can we say there's a new use? I know common sense doesn't come into play with the tax code but if it did I think it would revert to personal in nature. The interest expense is over 30k per year going forward....

I'm thinking slightly more clearly after a meal and a nap. OP is right - there is no longer an activity - it's been disposed of. 1.163-8T(j)(1) tells us to reallocate debt at the earlier of the date when the proceeds from disposition are used for another expenditure (which Wiles wisely notes is irrelevant because there are no proceeds) or

the date on which the character of the first expenditure changes (e.g., from a passive activity expenditure to an expenditure that is not a passive activity expenditure) by reason of a change in the use of the asset with respect to which the first expenditure was capitalized.

.

I would argue the character of the first expenditure has changed from passive activity to a disposed of passive activity, so it's time to reallocate the debt. The reg goes on to limit the amount reallocated to the vakue of the asset on the date it changed from a passive activity to a disposed of passive activity. We aren't told that value.

Again, Wiles comes through, just in way fewer words. What I do is continue to deduct on Sch E and mark the Sch E as non-passive due to the fully taxable sale that occurred.

Nilodop, see my response to Wiles. I think there is no more activity and hence nothing to allocate.

The regs. are unclear and your analysis may be right. Bot Wiles' and mine also may be right. Our logic is as supportableas yours. I'd go for it. Note the language

the date on which the character of the first expenditure changes (e.g., from a passive activity expenditure to an expenditure that is not a passive activity expenditure) by reason of a change in the use of the asset with respect to which the first expenditure was capitalized.

. So that's when to reallocate, and it does not say that there still has to be an activity.

Thanks again. It's funny how you can interpret the tax law, think you're right and then read it again and take the opposite position.