Passive Activity Loss ATG - Chapter 9: Credits
March 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.
Chapter 9: Credits
In A Nutshell
Credits generated by a rental activity or by a business in which the taxpayer does not materially participate are generally subject to the passive loss limitations. Passive losses are first applied against passive income; passive activity credits are limited to the tax equivalency of remaining passive income (tax attributable to remaining passive income). As a practical matter, often there is no remaining passive income to offset passive activity credits. Credits generated by rental real estate activities, most notably the LIHC, are eligible for the $25,000 special allowance. See LIH checksheet at end of the chapter. The disposition rules under IRC § 469(g) do not apply to credits.
- Most credits generated by passive activities are classified as passive credits and thus deductibility of the credit is limited to passive income.
- Credits are applied against passive income on a tax equivalency basis.
- Credits in excess of passive income cannot be deducted upon disposition.
- Identify the origin of all credits taken on the back of the Form 1040, looking for passive activity credits which may have been deducted without considering the passive activity credit limitations in IRC § 469.
- Review Form 8582 and 8582CR for passive loss and credit calculations.
- Examine the taxpayer’s Schedule K-1s and information on the return for credit detail.
- Remember that the passive loss and credit rules apply to individuals, trusts, estates, and PSC; and to a lesser extent, to closely held C Corporations.
Types of Credits
Most credits that originate with a passive activity are subject to the passive loss limitations. Passive activities include:
- Rentals; and,
- Businesses where the taxpayer does not materially participate.
Credits from rental activities typically include the LIHC and the rehabilitation credit. Credits from business activities can include any of the following: investment credit, work opportunity credit, credit for alcohol used as a fuel, credit for increasing research activities, enhanced oil recovery credit, disabled access credit, renewable electricity production credit, empowerment zone employment credit, Indian employment credit, credit for employer social security and Medicare taxes paid on employee tips, orphan drug credit, credit for contributions to community development corporations, non-conventional source fuel credit, or qualified electric vehicle credit.
Exception: The foreign tax credit is not subject the limitations in IRC § 469.
Review and determine the origin of any credit taken. Determine whether any credit is a passive credit.
Check Form 8582CR to see if passive activity credits have been limited.
Application of Credit
Credits are subject to an ordering rule. First, passive losses are offset against passive income. Then, to the extent any passive income remains, passive credits are allowed against the tax equivalent of remaining passive income. For example, a taxpayer in the 28 percent tax bracket with $9,000 in passive credits also has $8,000 in passive income and $6,000 in passive losses. The allowable credit is computed as follows:
|Less: Passive Losses||(6,000) [applied first]|
|Remaining Passive Income||2,000|
|Passive Income Tax Equivalent||560 [2,000 x 28%]|
|Passive Credit Allowed||560|
|Disallowed credit||8,440 [9,000 less 560]|
If the credits are from rental real estate, credits will also be allowed up to any remaining $25,000 offset after passive losses. Above is a simplified example. The Form 8582CR provides detailed instructions and a worksheet for calculating the tax equivalency of passive income available for passive credits.
- If passive losses exceed passive income, passive credits are not allowable – except for the low income housing and rehabilitation credit, which are permitted to the extent of the remaining $25,000 offset.
- Make sure that Line 6 of Form 8582-CR includes only the tax equivalent of net passive income (after subtracting losses), not total passive income. Income on line 6 should be carefully scrutinized. Often little, if any passive income remains after passive losses.
- Verify that the same passive income was not used twice once on Form 8582 and again on Form 8582-CR. Income is entered on Form 8582 lines 1a, 2a and 3a. The tax attributable to passive income (i.e. tax equivalent of passive income) is entered on Form 8582-CR on line 6.
Special Rental Real Estate Allowance
The $25,000 special allowance for rental real estate activities applies when passive losses and credits exceed passive income (See Chapter 2). Thus, low income housing and rehabilitation losses or credits may use the special $25,000 offset if certain requirements are met. The $25,000 is available only to individuals and is subject to phase-out limitations based on modified adjusted gross income.
For low income housing credits or rehabilitation credits, the active participation requirement does not apply. Result: these credits automatically qualify for the $25,000 allowance.
The $25,000 allowance is subject to phase-out provisions based on MAGI. For LIH rental activity losses, the phase-out range is the regular $100,000-150,000. For rehabilitation credits, however, the phase-out range is $200,000-250,000. For LIH credits, the phase-out range does not apply. For the phase-out, the $25,000 allowance is reduced $1 for every $2 that the MAGI exceeds the $100,000 (or $200,000 for the rehabilitation credit). See Chapter 2 for more detail. The chart below summarizes these rules:
|Issues||LIH Credits||LIH Rental RE Losses||Rehab Credits||Other Credits|
|$25,000 offset available?||Yes||Yes||Yes||Yes|
|Active participation required||No||
Limited Partner cannot be active
|No||Does not apply|
|Phaseout range||Does not apply||$100,000 - $150,000||$200,000 - $250,000||Does not apply|
The $25,000 special allowance is absorbed in the following order:
- Losses from rental activities with active participation;
- Rehabilitation credit (tax equivalent); and,
- Low income housing credit (tax equivalent)
Rental losses of real estate professionals are excepted from the passive loss limitations if the taxpayer materially participates in the rental. Since many investors in LIH are limited partners, it is important to recognize that it unlikely that the taxpayer who is a limited partner will rise to material participation.
- Review LIH losses closely since the taxpayer may erroneously believe that losses are treated the same as credits. A limited partner or the taxpayer with less than a 10 percent interest cannot be active. Thus, losses go on Form 8582 line 3b and receive no $25,000 offset. Check Schedule K-1s.
- The aggregate amount of total losses and credits (tax equivalent) are limited to $25,000. The taxpayer is entitled to only one $25,000 offset for all rental losses and credits in each tax year.
- Check the non-passive column on the back of Schedule E to verify that LIH losses have not been entered there erroneously, thereby avoiding the passive loss rules.
While IRC § 469(g) permits losses to be deducted upon disposition, passive credits may not be deducted under this provision even if the disposition is fully taxable and was made to an unrelated party! Instead, the taxpayer may elect to increase the basis of the disposed property by any unused credits (IRC § 469(j)(9)). The election is made by completing Form 8582-CR, Part VI. Absent the election, unused credits must be carried forward to future years in which passive income is available.
- For any disposition activity, make sure the credits were not deducted. IRC § 469(g) triggers losses, but not credits.
- Look at Form 8582-CR, Part VI, to see whether an election has been made to use credits to increase basis.
- Remember that passive activity income must exist in order for the taxpayer to deduct the tax equivalent of passive credits, even in the year of disposition.
- IRC § 469(a)(1)(B): Passive activity limitations apply to credits generated by rentals and businesses in which the investor does not materially participate.
- IRC § 469(d): Passive activity credits are deductible only to the extent of the tax allocable to (tax equivalency) passive income.
- IRC § 469(i)(6)(B): Low income housing credits and rehabilitation credits do not require active participation to qualify for the $25,000 special allowance. Even a limited partner can use the tax equivalent of $25,000.
- IRC § 469(j)(9): Passive credits are not deductible on disposition. An election may be made to increase the basis of the disposed property.
- Most credits generated by passive activities are subject to the passive loss limitations with the exception of the foreign tax credit.
- A passive activity credit is generally deductible only to the extent of the tax equivalent of passive income which remains after all passive losses are absorbed. Excess unused passive income after passive losses are absorbed is converted to the amount of tax that the passive income would generate. The tax equivalent of remaining passive income permits deductibility of passive activity credits.
- The tax equivalent of any $25,000 offset which remains after being absorbed by rental real estate losses permits deductibility of the LIH and rehabilitation credits.
- A passive activity credit is not deductible on disposition of a passive activity. The taxpayer may make an election to add the unused credit to basis.
 IRC §469(i)(3)
 IRC § 469(d)(2)(A)(ii) excludes IRC § 27(a) from the passive loss limitations.
 IRC § 469(i)(6)(B)
 IRC § 469(i)(6)(A)&(C)