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Passive Activity Loss ATG - Chapter 3, Passive Income

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.


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Chapter 3: Passive Income

In a Nutshell

Because passive losses generally can offset only income from passive activities, some taxpayers have attempted to “create” passive income in order to trigger passive losses. In other words, non-passive income may have been improperly classified as passive and entered on Form 8582 in order to trigger deductibility of otherwise nondeductible passive losses. Therefore, a common issue is whether income on Form 8582 lines 1a or 3a is truly passive. For every dollar of passive income removed from Form 8582, there is frequently an adjustment to allowable passive losses of a dollar. Passive losses are generally deductible only to the extent of passive income.

Regardless of whether income is deemed to be passive or non-passive, it must always be reported somewhere on the return, most typically on Schedule E.  The Form 8582 is computational only, figuring the amount of passive loss deductible for the current year.  It not the form used to report income.

See passive income checksheet at end of chapter.

Passive Income

Passive income can only be generated by a passive activity.  Just because the taxpayer did not work for the income does not mean it is passive.  There are only two sources for passive income:

  1. A rental activity; or,
  2. A business in which the taxpayer does not materially participate.

Gain on a partial or entire disposition of a passive activity generally is passive income.  See Chapter 5 for a detailed discussion of passive income issues on  disposition.

While the following may seem passive, generally none are passive income:

  • Portfolio income, including interest, dividends, royalties, annuities and gains on stocks and bonds; [1]
  • Lottery winnings;[2]
  • Salaries, wages, Form 1099-Misc. commissions and retirement income;[3]
  • Guaranteed payments for services; and,[4]
  • Income from any activity in which the taxpayer materially participates.[5]

Even if generated by a passive activity, portfolio income is non-passive. 

Issue Identification:

  • Passive income is most commonly reflected on Schedule E as a net rental income or as income from a partnership or S Corporation in which the taxpayer does not materially participate.
  • Passive income may also be reflected on Form 4797, Sale of Business Property or Schedule D, Capital Gain and Losses due to the disposition of a passive activity or asset used in a passive activity.
  • Passive income may also be found on Schedule C and F if these are activities in which the taxpayer does not materially participate.

Examination Techniques:

  • Review Form 8582 lines 1a and 3a.  Verify income is reported somewhere on the return (Schedule E, D, C, F, etc.).  The Form 8582 is computational only, figuring the allowable passive loss.  It does not report income.  If there is income on Form 8582, which is not reflected elsewhere on the return, you have unreported income!
  • Scan Schedules B, Fiscal Year Supplemental Schedule of Income and Retirement Income Credit, Schedule D, and Schedule K-1 to verify that passive income does not include interest, dividends, royalties or stock and bond sales.
  • Verify the income is not from a partnership that is a trader in stocks, bonds and other securities.  Traders fall completely outside the passive activity rules (Reg. § 1.469-1T(e)(6)).  Schedule K-1 line 1 income from a trader in stocks and bonds is non-passive, even if the taxpayer is a limited partner!
  • For activities claimed as passive on Form 8582, verify that income is not from a business in which the taxpayer materially participates.  You may want to use one of the search engines on the internet to see what is said about the level of activity of the taxpayer.
  • Verify that income is not from a business which is related to another activity in which the taxpayer materially participates.  If so, possibly, the two businesses should be grouped as a single activity under Reg. § 1.469-4(f).  See Chapter 9.
  • Verify that passive income is not from the rental of a building or equipment to a business where the taxpayer works.  Reg. § 1.469-2(f)(6) recharacterizes so-called “self-rental” income as non-passive.
  • Verify that passive income is not from the rental or sale of land or other nondepreciable property.  See Reg. § 1.469-2T(f)(3).
  • Verify that compensation for the performance of personal services is not classified as passive income.  This includes W-2 wages, Form 1099-Misc commissions, retirement income and guaranteed payments.

Documents to Request:

  • The Form 8582 worksheets break down the income items on Form 8582.  Worksheet 1, 2 and 3 reveal which entities are generating income.  Worksheet 5 (6 beginning in 2002) indicates which schedule an allowed passive loss is reflected on.
  • Schedule K-1s and other documents supporting amounts reflected on Form 8582.

Supporting Law:

  • IRC § 469(c)  Passive income can only be generated by a rental activity or a business in which the taxpayer does not materially participate.
  • Reg. § 1.469-2T(c)  Income is passive if and only if the income is from a passive activity.
  • Reg. § 1.469-2T(c)(2)  Gain on the sale of a passive activity is passive income, if it was a passive activity in the year of disposition.
  • IRC § 469(e)(1)A)  and Reg. 1.469-2T(c)(3)  Portfolio income is non-passive.
  • IRC § 469(e)(1)(A)(ii) and Reg. 1.469-2T(c)(3)(C)&(D)  Gain on the sale of stocks and bonds is non-passive.
  • Reg. § 1.469-2T(f)(3)  Net income from lease or sale of land is  non-passive.
  • Reg. § 1.469-2(f)(6)  Income from rental real estate, equipment or other property leased to a business where the taxpayer works is non-passive.
  • Carlstedt TC Memo 1997-331  The taxpayers failed to sustain their burden of proving they did not materially participate in an S Corporation.
  • Seits TC Memo 1994-522  Gain from the sale of an apartment was investment income, not passive income.
  • Refer to Chapter 1 Case Summaries for more cases related to income.

Self-Rental Income

Certain types of income are treated (“recharacterized”) as non-passive.  If a taxpayer rents a property to a business in which he materially participates, net rental income is non-passive and should not be on Form 8582 line 1a as passive income.  See Reg. § 1.469-2(f)(6) and self-rented property checksheet at the end of the chapter.  Net rental losses, however, generally remain passive.

Even though income is treated as non-passive, it may offset suspended prior year passive losses from the same activity.[6]

  • Peruse Schedule E for any property with net income and few expenses, indicating that the property might be under a net lease.  Income from property leased to an entity where the taxpayer works is often structured as a net lease.
  • Check Form 8582 line 1a to see if what appears to be self-rental income from Schedule E is improperly reflected there.

Self-rented property is a frequent adjustment, as it is common practice for many professionals to own the property personally and lease it to a corporation or partnership where they conduct business.  

Exception:  Pre-88 Lease

Self-rental income is passive if there is a written currently binding lease signed before 2/19/88.[7]  However, as a practical matter, pre-1988 leases that bind years under examination are rarely seen, as the lease period would have to be 15 years or more.   Renewable options generally do not constitute a written binding lease, as the option is not legally binding until exercised.[8]

Examination Techniques:

Ask to see the lease for the year under examination.  If the lease was signed after 1988, income is non-passive

Leased Land

Income from leased land (ground rents) is non-passive and should not be on Form 8582 line 1a.  Reg. § 1.469-2T(f)(3) recharacterizes income from leased property where less than 30 percent of the unadjusted basis is depreciable as non-passive.

Examples:  fields leased to a farmer, mobile home parks, land leased for billboards, lots leased to sell Christmas tree, land leased for cell towers and campgrounds.

The character of an activity is not changed.  Even though income is recharacterized as non-passive, the activity remains a passive activity and, in fact, if it produced losses, they would generally be passive.  See Reg. § 1.469-2T(f)(1). 

Land held for Investment

Property (land, for example) held for investment is non-passive under IRC § 469(e)(1)(A)(ii)(II).

Issue identification:

  • If the land is entered on Schedule D and gains are limited to 20 percent versus being taxed at ordinary rates potentially as high as 39.6 percent, it is an indicator that the land was held for investment.  See IRC § 1(h).

Examination Techniques:

  • Peruse Schedule E.  If there is little or no depreciation, it is an indicator that the activity may be leased land.
  • If the taxpayer claims to be in the business of land sales, i.e. the activity is on Schedule C or in partnership, sporadic sales is an indicator that land is being held for investment versus being treated as a business.  Reminder:  if the taxpayer performs most of the work in a business, income is non-passive.   See Reg. § 1.469-5T(a)(2).

Supporting Law

  • IRC § 469(c):  Passive income can only be generated by a rental activity or a business in which the taxpayer does not materially participate.
  • Reg. § 1.469-2T(c):  Income is passive if and only if the income is from a passive activity.
  • Reg. § 1.469-2T(c)(2):  Gain on the sale of a passive asset or activity is passive income if it was a passive activity in the year of disposition.
  • IRC § 469(e)(1) and Reg. § 1.469-2T(c)(3):  Portfolio income is non-passive.
  • IRC § 469(e)(1)(A)(ii) and Reg. § 1.469-2T(c)(3)(C)&(D):  Gain on the sale of stocks and bonds is non-passive.
  • Reg. § 1.469-1T(e)(6): Traders in stocks, bonds and other securities are not passive activities.
  • Reg. § 1.469-2T(f)(3):  Net income from lease or sale of land is  non-passive.
  • Reg. § 1.469-2(f)(6):  Income from  property leased to a business where the taxpayer works is non-passive.
  • Carlstedt T.C. Memo 1997-331:  The taxpayers failed to sustain their burden of proving they did not materially participate in an S- Corporation.
  • Seits T.C. Memo 1994-522:  Gain from the sale of an apartment was investment income, not passive income.

Summary

  • Passive income has only two sources:  net rental income and income from a business in which the taxpayer does not materially participate.
  • Interest, dividends, royalties, annuities and gains on stocks and bonds are not passive income.
  • Net rental income from property leased to a business where the taxpayer materially participates is non-passive and should not be reflect on Form 8582.
  • Income from land, whether leased land or property held for investment, is non-passive.  Stated differently, net income (but not net loss) from the leasing of nondepreciable property (such as land) is treated as non-passive.

[1] IRC § 469(e)(1)

[2] PLR 8943055

[3] IRC § 469(e)(3)

[4] Reg. § 1.469-2(e)(2)(ii)

[5] IRC § 469(c)(1)

[6] IRC § 469(f)(1)

[7] Reg. § 1.469-11(c)(2)

[8] Thomas P. Krukowski, 114 T.C. No. 25 US Tax Court


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