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Passive Activity Loss ATG - Chapter 7: Interaction With Other IRC Sections

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 / Exhibit 7.1
Tax Code, Regulations and Official Guidance Search

Chapter 7: Interaction With Other IRC Sections

INTRODUCTION

The IRC § 469 on PAL is only one IRC section among several others that limit losses and deductions. Basis and the at-risk rules in IRC § 465 should always be applied before the passive loss rules[1]. Interest expense generated as a result of an “investment” in a limited partnership or other passive activity is not investment interest.  It is passive activity interest expense[2] and must be limited using Form 8582.   Similarly, any deduction from a passive activity (IRC § 179 expense, for example) must be entered on Form 8582 along with the ordinary loss.  Even if the taxpayer has sufficient passive income to trigger losses under IRC § 469, other IRC section limitations must be considered.

Generally, an examiner should consider other obvious disallowance provisions, such as hobby losses under IRC § 183, before applying the passive loss rules.  However, capital losses limited under IRC § 1211 are applied after the passive activity loss limitation.

There are two major exceptions to the passive loss rules: 

  1. Working interests in oil and gas activities;[3] and,
  2. Traders in stocks and bonds[4]

This Chapter addresses several other IRC sections, that reference or rely upon IRC § 469.

Investment Interest In a Nutshell

Investment Interest Expense

Investment interest expense is deductible only to the extent of investment income[5].  If there is no investment income, no investment interest expense is deductible currently.  See checksheet at end of chapter.

Investment interest expense is interest paid on loans to buy portfolio assets such as CDs or stocks and bonds.   Interest expense on an “investment” in a partnership or S Corporation generally is not investment interest expense.  Interest traceable to an investment in a partnership or S Corporation is either:

  1. Interest attributable to a business in which the taxpayer materially participates and thus fully deductible; OR;
  2. Interest attributable to a passive activity, which goes on Form 8582 line 1b or 3b and is generally limited to passive income.

Investment Income

Property held for investment is defined in IRC § 163(d)(5) via reference to IRC § 469(e)(1).  Investment interest expense is deductible only to the extent of investment income.  Investment income is:

  • Interest income, but not self-charged interest used as passive income.
  • Dividends, royalties, annuities, but not pension income.
  • Rental income from leased land[6].
  • Net short-term capital gains or other ordinary income from disposition of investment property.
  • Net long-term gain on the stocks and bonds only if there is an election on line 4e of Form 4952 for that income to be taxed at ordinary rates.  The same amount must also be entered on Schedule D line 21 if the long-term gain is used as investment income on Form 4952.
  • Net income from a business, which is not a passive activity, and in which the taxpayer does not materially participate. This is a highly restrictive provision.  Only two activities fit this criteria:
    • Working interests in oil and gas; and
    • Traders in stocks and bonds.

If income on Form 4952 is in the non-passive column on the back of Schedule E, it is a strong indicator that the taxpayer may be incorrectly using ordinary business income as investment income.   Business income generally is not investment income.

Investment Interest Expense

Investment interest expense is:

  • Interest on loans to buy CDs, stocks, bonds or other assets producing portfolio income (interest, dividends, annuities, royalties).
  • Interest to buy C Corporation stock (produces dividends)[7], but not to buy S Corporation stock.
  • Interest on land held for investment[8] (no intent to develop).
  • Interest expense paid on an investment in an entity which is a trader in stocks and bonds, if the investor does not materially participate[9]

Note:  Interest attributable to an S Corporation or partnership businesses in which the taxpayer materially participates is generally deductible without limitation.  It is reflected on the back of Schedule E in the non-passive column.  See Notice 89-35.  If the taxpayer does not materially participate in a partnership or S- Corporation, interest expense is passive activity interest[10], goes on Form 8582 line 3b, and is not deductible without passive income.

Issue Identification:

  • Form 4952 line 4 income is generally composed of interest, dividends and short-term capital gains, which can be easily identified via Form 1040 lines 8 and 9 and Schedule D line 7.  Investment income on Form 4952 line 4 is not income from any business, nor ordinary income from partnerships or S Corporations nor any kind of rental income.  An adjustment to investment income generally produces a disallowance of investment interest expense, since investment interest expense is deductible only to the extent of investment income.
  • Investment interest expense on Form 4952 line 1 is not interest expense traceable to a business in which the taxpayer does not materially participate or any rental activity.  These are passive activities and passive activity interest goes on Form 8582.  It does not matter if the passive activity is conducted through a partnership or S Corporation.  Interest expense belongs on Form 8582 not Form 4952.

Investment Interest Examination Techniques

Examination Techniques:

Investment Income:  For investment income, request a schedule detailing:

  • The Form 1099-Misc, Schedule K-1s, or other supporting documents for interest, dividends, royalties and any other income claimed as investment income on Form 4952.
  • The source of investment income on Form 4952 line 4a. 

Reminder:   Income from a rental activity or business, whether a partnership, S Corporation or other entity, is not investment income.  Business income, whether passive or non-passive, is not investment income.

Exceptions:  (1) working interests in oil and gas and (2) traders in stocks and bonds.

  • Determine if investment income on line 4 of F4952 is reflected elsewhere on the return.  Investment income is generally on Schedule B as interest and dividends and on Schedule D line 7 as short-term capital gains. 

Reminder:   investment income must be reported on the return.  The Form 4952 does not report income.  Investment income is not income from a business nor is it income form the sale of a business asset.

  • If a capital gain election has been made on Form 4952 line 4e, verify the same amount is also on Schedule. D line 22.  In other words, verify that the income has been taxed at ordinary rates.  If there is no entry on Schedule D line 22, the taxpayer has erroneously used the lower capital gain rate.

Investment Interest Expense

  • Request Form 1099-Misc and Schedule K-1s supporting investment interest expense claimed on Schedule A line 13.
  • Inquire what the purpose of the loan was.  Ascertain that the interest expense was for loans used to buy CDs, stocks, bonds, annuities, or an investment in land.  An investment in a rental activity or passive business (including those conducted via a partnership or S Corporation) is passive activity interest and belongs on Form 8582 line 1b or 3b, not on Form 4952.
  • Frequently, Schedule K-1s from partnerships will reflect large amounts of interest expense designated as investment interest expense (Schedule K-1 line 14a for 2003 and prior years).  By designating the interests expense as investment interest expense, that means the partnership borrowed monies to buy CDs, stocks, bonds, etc.  If there is a large number on line 14a, the examiner may want to consider an examination of the partnership return in order to question what the loan proceeds were used for.   An investment in another partnership or S Corporation generally is not property held for investment under IRC § 163(d).

Investment Interest Supporting Law

  • IRC § 163(d)(1):  Interest on loans to buy CDs, stocks, bonds, land (i.e. investment interest expense) is deductible only to the extent of investment income.  Interest income is defined via reference to IRC § 469(e)(1).
  • IRC § 469(e)(1):  Portfolio income includes:  Interest, dividends, annuities or royalties not derived in the ordinary course of a business.  Gains on stocks, bonds, land, etc. not derived in the ordinary course of a business.
  • Reg. § 1.469-2(f)(10):   Permits income that is recharacterized as non-passive under Reg. § 1.469-2T(f)(3) [leased land], (4) [equity financed lending activities], and (7) [acquisition of entity engaged in licensing intangible property] to be treated as portfolio income, i.e. investment income.  The regulation does not include self-rented income.  Thus, income which is recharacterized under Reg. § 1.469-2(f)(6) is neither passive income nor investment income.
  • Reg. § 1.163-8T(a)(3):  Interest expense is allocated in the same manner as the debt to which the interest relates is allocated.  Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures.
  • IRC § 163(d)(3)(B):  Interest traceable to a rental or business, partnership, or S- Corporation  in which the taxpayer does not work on a regular basis (passive activity) is not investment interest (does not go on Form 4952 line 1; instead it is reflected on Form 8582 1b or 3b).
  • IRC § 163(d)(4)(iii):  Investment income is also net long-term capital gain if the taxpayer elects (F4952 line 4e) to be taxed at ordinary rates as opposed to the lower capital gains rate.  If no election, long-term capital gains are not investment income.
  • Reg. § 1.163(d)-1(b):  Election to treat long-term capital gains as investment income, and thus taxed at ordinary rates, must be made by due date of return (including extensions).
  • IRC 1§ 63(d)(4)(D) Income from a rental or business (including those conducted via a partnership or S Corporation) in which the taxpayer does not work on a regular basis is not investment income.
  • Notice 89-35 Allocation of interest in connection with partnerships and S Corporations.

RENTAL OF PERSONAL RESIDENCE IN A NUTSHELL

Interest expense on the rental of a personal residence or second home[11] is excepted from the passive loss rules under IRC §  469(j)(7).  Other expenses attributable to the rental activity are still subject to all the passive loss rules.  See checksheet on IRC § 469(j)(7) interest at end of chapter.

Furthermore, the personal use provisions of IRC § 280A override the passive loss limitations[12].  If the taxpayer or relatives[13] use the property at less than fair rental value for more than the greater of 14 days or 10 percent of the number of days rented at fair market value, then IRC § 280A applies and generally limits losses to net income.  To the extent that the property was used personally, a pro rata share of interest and the full amount of taxes are permitted on Schedule A as itemized deductions.

Issue Identification:

  • Watch for Schedule E rentals with the same or similar address as on the front of the return.
  • Unusually low gross receipts during peak rental periods may indicate rental at less than fair market value or possible personal use.
  • Property that has little or no advertising and was unrented for many weeks during the year may indicate high personal use.

Examination Techniques:

Inquire early in the examination as to whether the property was used personally by the taxpayers or relatives.  Ask if anyone used the property at less than the standard rental rate, i.e. at less than fair rental value.

Documents to Request:

  • Copies of any leases or rental agreements
  • Detail regarding personal use by taxpayers, relatives or any other person at less than fair market value[14] in order to calculate personal days versus days rented at fair market value.

Supporting Law:

  • IRC § 280A:  Disallows certain expenses in connection with business use of home, rental of vacation homes, etc.
  • IRC § 469(j)(10):  If a passive activity involves the use of a dwelling unit to which IRC § 280A(c)(5) applies for any taxable year, then any income, deduction, gain, or loss allocable to such use shall not be taken into account for purposes of this section for such taxable year.

Interest Issues

Under IRC § 469(j)(7), interest expense on the rental of a personal residence or second home is excepted from the passive loss rules.  However, as with any personal residence interest [15], it must be entered on Schedule A and is subject to the itemized deduction limitations[16].  This provision does not permit the entire loss to be deducted without limitation; it only provides that interest is excepted from the passive loss limitations.

Issue Identification:

  • Has qualified residence interest expense been placed on Schedule A where it is subject to various limitations?  It is simply not deductible in another column on Schedule E.
  • Is the rental truly the taxpayer’s personal residence?  A property in which the taxpayer has not lived in for years may no longer qualify as a residence.
  • Watch for taxpayers who currently live overseas and rent their personal residence.
  • Is the rental merely a temporary rental with no profit motive under IRC § 183?  Therefore, no loss of any kind may be deducted.

Examination Techniques:

  • Probe early in the examination as to whether the property is the taxpayer’s principal or secondary residence.
  • Verify via bank statements and/or cancelled checks that the interest was actually paid in the tax year deducted.
  • Verify that qualifying interest has been properly reflected on Schedule A as an itemized deduction.

Documents to Request:

  • Detailed explanations from the taxpayers regarding the use of their property as their principal residence.
  • How often did the taxpayers visit the property?
  • Did the taxpayers physically reside in the property during the year?  Provide exact dates.
  • Do the taxpayers file state tax returns where the property is located, have a car registered in that state, have a valid driver’s license from that state?
  • If the responses appear questionable or unreasonable, ask for documentation or third party statements to corroborate the taxpayer’s oral testimony.

Supporting Law:

  • IRC § 469(j)(7) and Reg. 1.163-8T(m)(3):  Provides that passive activity losses will be computed without regard to qualified residence interest.
  • IRC § 163(h)(4)(A)(i):  Defines qualified residence interest as either a principal residence or a second residence.
  • Stolk 40 T.C. 345, affirmed 326 F.2d 760 (2nd Circumstance 1964)  The taxpayer moved out of his principal residence two years prior to its sale, and the Court held that the property did not qualify as his principal residence.
  • Friedman TC Memo 1982-178  The Court held that a residence used by the taxpayer only during the summer months cannot qualify as a principal residence.

Net Operating Losses

Unlike passive losses, a NOL can be carried back 2 years and forward 20 years for 2003 [17] and can offset portfolio income as well as wages and other non-passive income.  An important audit step is to verify that a purported NOL is not, in fact, a passive loss.  The chart below addresses the carryback and carryforward rules for various years.

NOL Year Ending
Carryback Years
Carryforward Years
2003 2 20
2001 – 2002 5 20
8/6/97-2000 2 20
Prior 8/6/1997 3 15

A loss from a passive activity which cannot be used due to the passive loss limitations must be carried forward indefinitely[18] until there is passive income or an entire disposition of the activity in a fully taxable transaction[19].  In other words, if a taxpayer has a loss from a passive activity and no other passive income to offset it against, the loss cannot be carried back, but instead is suspended until a future year when the taxpayer has passive income or disposes of the activity.

On a qualifying disposition of a passive activity under IRC § 469(g), triggered prior year losses can create an NOL.  If, however, the sale is to a related party[20] or there is not a fully taxable transaction, losses remain passive and cannot create an NOL.

A regular NOL carryforward can offset any income.  However, a PAL carryforward can offset only passive income.  In the event that both a regular NOL and a suspended loss from a passive activity are carried forward into the same year, the PAL carryforward is applied first against passive income before the regular NOL is applied.

Passive losses allowed in excess of passive income due to the special $25,000 rental real estate allowance can become part of the taxpayer's NOL, which is carried back 3 years or forward 15 years.

Working Interests in Oil And Gas Property

OIL AND GAS

The passive loss limitations do not apply to an oil and gas activity in which the taxpayer has a working interest[21] if the entity does not limit his liability[22].  As a practical matter, this means if the taxpayer is a general partner or owns his interest in an oil and gas activity via a joint venture[23], his liability will not be limited.  The passive loss limitations do not be apply.  Losses or income will be non-passive.

On the other hand, if the taxpayer is a limited partner, LLC member, or S Corporation shareholder, his liability is limited, and he is fully subject to the passive loss rules.  He must prove that he materially participates, i.e. works on a regular, continuous and substantial basis in oil and gas operations before losses will be deductible.  See Chapter 4 on material participation, IRC § 469(h), and Reg.  § 1.469-5T(a).

Trading Personal Property for an Owner’s Account

TRADERS IN STOCKS AND BONDS

If a partnership or S Corporation is actively trading[24] property such as stocks or bonds for the account of the taxpayer/owner, the losses (or income) are non-passive under Reg. § 1.469-1T(e)(6).  Neither income nor losses belong on Form 8582.  Even if the taxpayer is a limited partner, he may deduct losses from a partnership which trades in stocks and bonds on his account.  Losses from an entity which trades in stocks and bonds belong in the non-passive column of Schedule E. 

Income from a trading partnership should not be on Form 8582 line 3a.  Trading activities are not passive activities.  Thus the income, even if the taxpayer performs no work, cannot be passive income. Clues the entity may be a trading activity:  name containing "investment", “equity”, "securities", "financial", "hedging", "XXX  fund",etc.   Furthermore, most trading partnerships us 523900 as the business code in block C on Form 1065.

CASULATY LOSSES

Casualties Losses

Even though an activity is passive, casualty losses are permitted if the casualty requirements in IRC § 165 are met.  Reg. § 1.469-2(d)(2)(xi) states that a casualty as defined in IRC §165(c)(3) will not be treated as a passive deduction[25].

Losses not compensated by insurance[26] can be deducted only up to the amount allowable under IRC 165.  While tax law permits a loss to the extent of FMV before and after the casualty, losses are limited to the taxpayer’s adjusted basis.    In some cases, there may actually be a taxable gain:  insurance proceeds less adjusted basis = gain. 

A casualty loss (business or nonbusiness) is limited to the lesser of:

  • Difference between FMV before and after casualty; OR,
  • Adjusted basis  (cost less depreciation)[27] 

A personal casualty is also subject to a $100 floor AND 10 percent AGI limitation[28].

Low Income Housing Losses

LOW INCOME HOUSING

For current years, low income housing losses are subject to the passive loss limitations just like any other rental real estate activity.  The exceptions for credits provided for in IRC § 469(i)(3)(C) and § 469(i)(6)(B) do not apply to LIH losses.  For information on the LIH credit, see chapter 10.

The taxpayer must actively participate to qualify for the $25,000 offset.  Furthermore, the $25,000 special allowance is phased out at the rate of 50 cents for every dollar over MAGI of $100,000.  If AGI exceeds $150,000, no LIH losses may be deducted (unless he has passive income). As many investors are limited partners, and limited partners do not qualify for the active participation standard[29], losses for limited partners should be entered on FORM 8582 line 3b (not line 1b).  Thus, no $25,000 offset is available, and losses are deductible only up to passive income reported on the return.

Audit Tip:  Some taxpayers automatically place any rental activity on Form 8582 line 1.  For LIH losses to be entered on line 1, a taxpayer must actively participate.  The IRC § 469(i) provides that limited partners do not actively participate.   Examiners should carefully scrutinize Form 8582 line 1b (or worksheet 1) to verify that LIH losses have not been improperly entered there.  Entering LIH losses from limited partners on line 1b (instead of 3b where they belong) erroneously permits deductibility of up to $25,000 in losses against wages and portfolio income.   Examiners should also verify that an LIH loss has not been deducted in the non-passive column of Schedule E. 

Summary

  • An investment in a partnership or S Corporation generally does not generate investment interest.  If the activity is a rental or is a business in which the taxpayer does not materially participate, interest belongs on Form 8582.  It is passive activity interest.
  • Interest expense attributable to a rental of the taxpayer’s residence is not subject to the passive loss limitations.  It belongs on Schedule A and is subject to the itemized deduction limitations.
  • On disposition, prior year passive losses can create an NOL.
  • Losses attributable to working interests in oil and gas activities generally are fully deductible.  They are excepted from the passive loss rules.
  • Income or losses from a trading partnership that trades on the partner’s account are not passive activities and should not be on Form 8582.
  • Casualty losses are not subject to the passive loss limitations.
  • Low income housing losses are fully subject to the passive loss limitations (unless the taxpayer is a real estate professional who materially participated in the LIH activity).  However, even a limited partner may take the LIH credit to the extent of the tax equivalent of $25,000.

[1] Reg. § 1.469-2(a)(2)(ii) and Reg. § 1.469-2(d)(2)(x)

[2] Reg. § 1.469-2T(d)(3), 1.163-8T(a)(4)(B) and Notice 89-35

[3] IRC § 469(c)(3), Reg. § 1.469-1T(e)(4)(v)

[4] Reg. § 1.469-1T(e)(6) 

[5] IRC § 163(d)

[6] Reg. § 1.469-2(f)(10) and Reg. § 1.469-2T(f)(3)

[7] IRC § 469(e)(1) 

[8] IRC  § 469(e)(1)(A)(ii)(II)

[9] IRC § 163(d)(5)(A)(ii)

[10] Reg. § 1.469-2T(d)(3), § 1.163-8T(a)(4)(B) and Notice 89-35

[11] Qualified residence interest under IRC § 163(h)(3) 

[12] IRC § 469(j)(10) and § 280A(c)(5)

[13] IRC § 280A(d)(2)(A) and § 267(c)(4)

[14] IRC § 280A(d)(2)(C)

[15] Reg. § 1.163-8T(m)(3), IRC § 163(h)(4)(A), IRC § 280(d)(1)

[16] Total home acquisition debt cannot exceed $1,000,000 (500,000 if MFS) - IRC § 163(h)(3)(B)(ii).  Total home equity debt cannot exceed $100,000 ($50,000 if MFS).Interest which goes over these limits is nondeductible personal interest.  Home equity debt is limited to the smaller of (1) the $100,000 threshold or (2) the amount that the residence’s FMV exceeds the home acquisition debt.  The $1,000,000 and $100,000 dollar thresholds apply to the combined mortgages on the primary and second residence. There is a 3 percent phaseout for most itemized deductions. Home mortgage interest expense is limited if AGI is more than $126,600 (for 1999), 132,950 (2001), 137,3000 (2002), 139,500 (2003).

[17] IRC § 172 ; also see IRS Pub. 536

[18] IRC § 469(b)

[19] IRC § 469(g)

[20] IRC § 469(g)(1)(B)

[21] Reg. § 1.469-1(e)(4)(iv) defines “working interest” as a working or operating mineral int in any tract or parcel of land with the meaning of § 1.612-4(a). 

[22] IRC § 469(c)(3) and Reg. § 1.469-1T(e)(4)(v) (v)

[23] Oil and gas joint ventures are generally reflected on Schedule C

[24] Reg. § 1.469-1T(e)(6)(ii) and § 1092(d) 

[25] Same information in Notice 90-21, 1990-1 C.B. 332.

[26] IRC § 165(a)

[27] Reg. § 1.165-7

[28] IRC § 165(h)

[29] IRC § 469(i)(6)(C)


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