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Passive Activity Loss ATG - Chapter 1, Overview

Publication Date - December, 2004

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.


Table of Contents/ Chapter 2
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Chapter 1: Overview

Introduction

Prior to 1986, a taxpayer could generally deduct losses in full from rental activities and trades or businesses regardless of his or her participation. This gave rise to significant numbers of tax shelters that allowed taxpayers to deduct non-economic losses against wages and investment income. The Tax Reform Act of 1986, added IRC § 469, which limits the taxpayer’s ability to deduct losses from businesses in which he or she does not materially participate and from rental activities.

The passive activity loss rules are applied at the individual level and extend beyond tax shelters to virtually every business or rental activity whether reported on Schedule C, Profit or Loss From Business (Sole Proprietorship); Schedule F, Profit Loss From Farming; or Schedule E, Supplemental Income and Loss, as well as to flow through income and losses from partnerships, S Corporations, and trusts.

The passive loss limitations also apply in full to personal service corporations. The IRC § 469 also applies to closely held C Corporations, but has a limited applications.

The following is a brief overview. If an issue arises in any specific area, see the referenced chapters for in-depth discussions.

Types of Passive Activities

In general, losses generated by passive activities can only be used to offset income generated by passive activities.

There are two kinds of passive activities (IRC § 469(c)):

  1. Rentals, including equipment leasing and rental real estate; and,
  2. Businesses in which the taxpayer does not material participate (includes activities on Schedules C or F and from partnerships, S Corporations and LLCs[1])

What is Passive?

Income and losses from the following activities are generally passive[2]:

  1. Rental real estate (except rentals in which a real estate professional materially participates – IRC § 469(c)(7))
  2. Equipment leasing
  3. Sole proprietorship or farm in which the taxpayer does not materially participate (i.e. does not regularly work)
  4. Limited partnership interest, with some exceptions[3]
  5. Partnership, S c, and limited liability company business in which the taxpayer does not materially participate

Income and losses from the following are generally non-passive:

  1. Salaries, wages, and Form 1099-Misc commissions
  2. Guaranteed payments
  3. Portfolio income (interest, dividends, royalties, gains on stocks and bonds)
  4. Sale of undeveloped land or other investment property
  5. Royalties
  6. Sole proprietorship or farm in which the taxpayer regularly works (i.e. materially participates)
  7. Partnership, S Corporation or LLC business in which the taxpayer materially participates.

Activity Rules

  • The term “activity” under IRC § 469 does not necessarily mean a single business or separate entity owned by the taxpayer. Depending on the grouping decision made at the time the activity was acquired or in 1994 when the regulations were finalized, a taxpayer can treat several businesses as one single activity if they form an appropriate economic unit. Or, there could be two or more distinct activities within a single entity. For example, there could be a rental activity and a business activity within the same partnership.
  • Because material participation[4] is determined for each activity, the way the taxpayer’s business and rental operations are combined or divided into “activities” is very important.
  • Businesses forming an appropriate economic unit may be grouped into one single activity based on the following criteria[5]:
    1. Similarities/differences in types of activities
    2. Extent of common control
    3. Extent of common ownership
    4. Geographic location of the activities
    5. Interdependence between activities

For more information on activities, refer to Chapter 8.

Exceptions:

The general rule in IRC § 469 provides that passive losses can offset only passive income. There are, however, exceptions:

  • On an entire disposition to an unrelated party in a fully taxable transaction, both current and suspended losses may be deducted against wages, portfolio income and other non-passive income[6]. See Chapter 5.
  • Rental real estate losses up to $25,000 may be deducted by an individual whose modified adjusted gross income (MAGI) is less than $100,000[7].  To qualify for this offset, the taxpayer must actively participate, own at least 10 percent and not be a limited partner.  The $25,000 exception is phased out at the rate of 50 cents for every dollar of MAGI over $100,000.  Therefore, when MAGI exceeds $150,000, the $25,000 offset is not allowed.  See Chapter 2.

Beginning in 1994, a real estate professional may be able to deduct all current rental real estate losses regardless of how high his MAGI might be[8].  To deduct losses without limit, the taxpayer must spend more than half of his time in real property businesses and work more than 750 hours a year and materially participate in each separate rental real estate activity.  Again, see Chapter 2.

Disallowed passive losses can be carried forward indefinitely[9] until there is passive income or an entire disposition in a fully taxable transaction.  Net gain on the sale of a passive activity is generally passive income, which can be offset by unrelated passive losses.  See Chapter 5.

Participation Rules

There are two distinct types of participation:

  • Material participation; and,
  • Active participation.

Material participation generally applies to business activities.  The IRC § 469(h)(1) provides that if the taxpayer works on a regular, continuous, and substantial basis in operations, his losses are non-passive, i.e. deductible in full.  There are seven tests[10] discussed in Chapter 5.

Active participation[11] relates only to rental real estate activities and is a less stringent standard than material participation.  If the taxpayer makes management decisions, he generally can deduct up to $25,000 in losses against non-passive income, subject to the $150,000 MAGI limitation.  See exhibit at end of Chapter 2

 Neither the material participation standard nor the active participation standard generally applies to long-term equipment rentals.  Equipment leasing losses are generally passive regardless of the level of participation[12].  Thus, equipment leasing losses are generally not deductible unless the taxpayer has passive income from other sources.

FORM 8582

Passive losses and income are most commonly found on Schedule E.  The computational form used to limit these losses is Form 8582, Passive Activity Loss Limitations, with line 16 being the sum of passive losses allowed for the current year (line 11 for tax years before 2002).[13] See exhibit at the end of this chapter for more help.  The following breaks down Form 8582 for 2002 and later years:

Part I of Form 8582 simply breaks down all passive activities in which the taxpayer is involved into three categories:

  1. Rental real estate activities in which the taxpayer actively participates belong on line 1.  These rentals qualify for the special $25,000 allowance, subject to the MAGI limitations, which is computed on line 7.
  2. The commercial revitalization deduction from rental real estate activities belongs on line 2.  The taxpayer will get the revitalization deduction regardless of the level of his income and whether or not he actively participates - up to the $25,000 offset not up used by other rental losses.
  3. All other passive activities, including rental real estate without active participation and equipment rentals, go on line 3.  Losses entered on line 3 are not deductible unless the taxpayer has passive income.

Part II is the calculation for allowable losses from rental real estate with active participation on line 1.  See MAGI computation in Chapter 2.

Part III calculates the total allowable passive activity losses for the entire return.  Line 16 (bottom line) allows losses up to total passive income, plus any allowable rental real estate losses and the commercial revitalization deduction up to $25,000.

Beginning in tax year 2002, Form 8582 contains line changes due to the commercial revitalization deduction enacted in 2000.   If the taxpayer enters his passive business losses on Form 8582 line 2b as he did in past years, he will incorrectly be permitted the $25,000 offset.  In 2002, if he properly enters his losses on line 3b, no loss will be allowed in the absence of passive income.  

Some of the important line changes are as follows:

FORM 8582

  • Losses from a passive business
    2001 Line # 2b  in 2002  is Line # 3b
  • Portion of $25,000 offset used
    2001
    Line # 9  in 2002  is sum of  Line # 10 & Line # 14
  • Total passive losses allowed currently
    2001
    Line # 11  in 2002  is Line # 16
  • Worksheet - where losses are on return
    2001 Line # WS 5  in 2002  is Line # WS 6

Resources

  • Passive Activity Intranet Website: http://abusiveshelter.web.irs.gov/pal/ (not available to the public).  Website includes interviews, IDRs, questions and answers, and self-study Powerpoints for many issues.
  • IRS Publication 925, Passive Activity and At-Risk Rules
  • IRS Publication 527, Residential Rental Property (includes vacation homes)
  • Instructions for Form 8582
  • MSSP Partnership Guide
  • Trust Audit Technique Guide
  • PAL Technical Advisor

Summary

  1. There are only two types of passive activities:
    • Rentals, regardless of the level of participation, and
    • Businesses[14] in which the taxpayer does not materially participate.
  2. Passive activities are deductible only to the extent of passive income. The following are exceptions to this rule:
    • Up to $25,000 in rental real estate losses are permitted if MAGI is less than $100,000.
    • A real estate professional may deduct rental real estate losses, if he materially participates.
    • Current and suspended passive losses are allowed on a qualifying disposition.
  3. Material participation applies to businesses and to rentals of a real estate professional.  Active participation applies to taxpayers who are not real estate professionals.
  4. The Form 8582 computes allowable passive losses for the current year. The worksheets merely allocate the $25,000 offset and passive income amongst passive activities on a prorata basis.

[1] The LLC will file as either Partnerships, C Corporations, or are disregarded, in which case, the activity is reported on an individual’s Form 1040 Schedule C.  See IRC § 301.7701-3(a).   For the sake of simplicity in this text, where we use “partnership”, included are multi-member LLCs taxed as partnerships.  When we use “sole proprietorship”, we also mean single-owner LLCs.

[2] See IRC § 469(c)(2).  There are exceptions discussed later in the text in Reg. § 1.469-1T(e)(3).

[3] See Chapter 4 and Reg. >§ 1.469-5T(e).

[4] IRC § 469(h)(1)

[5] Reg. § 1.469-4(c)

[6] IRC § 469(g)

[7] If married filing separately and living apart from spouse at all times during the tax year, up to $12,500 in rental real estate losses may be deducted if MAGI is less than $50,000. See IRC § 469(i).

[8] IRC § 469(c)(7) and Reg. 1.469-9

[9]  IRC § 69(b)

[10] Reg. § 1.469-5T(a)

[11] IRC §469(i)(6)

[12] IRC § 469(c)(2)&(4)

[13] Generally, FORM 8582 should be attached to the return.  See the instructions for FORM 8582 for exceptions.  Publication 925, Passive Activity and At-Risk Rules also provides good information.

[14] “Business” means a non-rental business activity throughout the text.


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