Passive Activity Loss ATG - Exhibit 5.3: Income Issues On Disposition Of A Passive Activity
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.
Exhibit 5.3: Income Issues On Disposition Of A Passive Activity
ISSUE: On the sale (or other disposition) of a passive activity, is gain or other income on Form 8582 truly passive income? Should gain on sale be removed from Form 8582, thereby limiting deductibility of passive losses?
_____ Verify that income on Form 8582 line 1a, and 3a resulting from a disposition is also reflected on Form 4797 and Schedule D or elsewhere. Form 8582 is merely a computational form for allowable passive activity losses. Income on Form 8582 must also be reflected on the appropriate schedule. Generally, income on Form 8582 from the sale of a building used in a rental activity is carried from Form 4797 to Schedule D (capital gain portion) and Line 15 of the front Form 1040 (ordinary income).
NOTES: (1) If no Form 4797 is filed with the return, it is indicative that there was not a fully taxable disposition which would trigger suspended losses. (2) Gain on sale, however, generally is passive income. See Reg. § 1.469-2T(c)(2).
_____ Ensure that only net gain has been entered on Form 8582 line 1a or 3a, not the entire sales price.
_____ Verify that net gain from Form 4797 has been entered on Form 8582 line 1a or 3a and the current net loss on line 1b, 2b or 3b and carryover losses on line 1c or 2c. The result is that only excess gain after current and carryforward losses have been absorbed can be used of offset other passive losses. If there was a gain on disposition, but current and carryforward losses exceed the gain, nothing should be entered on Form 8582. In both instances, the full taxable gain should be on Schedule D and current and suspended losses on Schedule E. See Form 8582 Instructions, page 8.
NOTE: Some taxpayers enter only the Form 4797 gain on Form 8582 without considering the impact of current and suspended losses, thereby erroneously allowing other passive losses. If net gain is more than current and suspended losses, both the net gain and all losses must be reflected on Form 8582.
_____ Verify that activity was a passive activity (rental or business without material participation) in the year of disposition in which gain is recognized.
Reg. § 1.469-2T(c)(2)(i)(A)(3) If activity is not passive for taxable year of disposition, gain is non-passive. Example: building rented in prior years, but not rented in the year of sale. Check Schedule E (or Form 8825, Rental Real Estate Income and Expense of a Partnership or an S Corporation, if from a partnership or S Corporation) for rental income and advertising. If none, indicates not rented.
_____ Verify that income is not from the sale of land. Passive income is only generated by rentals or passive businesses. Whether held for investment or leased, gain on the sale of land is not passive and should not be on Form 8582. See IRC § 469(e)(1)(A)(ii)(II), Reg. § 1.469-2T(c), Reg. § 1.469-2T(f)(3).
_____ If there is a Form 6252 for an installment sale, verify that:
- Income entered on Form 6252 line 24 ties to Form 8582 line 1a, AND
- Current and carryforward losses are deducted in same ratio as gain.
NOTE: When gain recognized from an installment sale exceeds all the current and suspended losses, taxpayer need not compute any ratios. Losses are fully deductible.
_____ If the property is substantially appreciated, verify that the property was used in a passive activity for either 20 percent of taxpayer's holding period OR property used in a passive activity for the entire two-year period prior to disposition. Property is substantially appreciated if FMV exceeds 120 percent of adjusted basis. See Reg. § 1.469-2(c)(2)(iii). If 20 percent and 2-year rule requirements are not met, income is non-passive.
_____ If gain is from the sale of a building, verify that building was used in a passive activity in the year of sale. Passive activity is either a rental activity (check Schedule E for rental income and advertising) or a business in which the taxpayer does not materially participate. If there are no gross receipts/rents and no advertising, it is an indicator that there may be no rental or business activity in the year of disposition. Also verify that building was not simply held for investment, and thus income is non-passive. See IRC § 469(c), Reg. § 1.469-2T(c), Seits T.C. Memo 1994-52 If income is non-passive, it should be removed from Form 8582, thereby reducing allowable passive losses. Investment income is not passive income (IRC § 469(e)(1)(A)).
_____ If a business interest is sold, verify the taxpayer did not materially participate in any 5 of the prior 10 years. If losses/income are non-passive in any 5 of 10 years, current year gain will be non-passive even if the taxpayer did not work in the activity in the current year. See Reg. § 1.469-5T(a)(5).
_____ For 1994 and later years, consider whether the taxpayer might be a real estate professional. If he did most of the work or otherwise materially participated in the rental sold OR if he elected to group rental properties, gain on disposition is non-passive. A real estate professional is an individual who spent more than half his time on real property businesses and rentals AND more than 750 hours during the year. See IRC § 469(c)(7), Reg. § 1.469-9.
_____ Consider whether property was held for investment and thus falls outside the rental definition (i.e. that the rental activity is incidental to an investment motive). Did the taxpayer seriously intend to generate rental income or was his motive ultimate gain via capital appreciation? Reg. § 1.469-1T(e)(3)(vi) provides that property will not be treated as a rental if the principal purpose was gain from appreciation AND gross rental income is less than 2 percent of unadjusted basis or FMV OR property was leased to a business in which the taxpayer has an ownership interest AND gross rental income is less than 2 percent of unadjusted basis or FMV.
_____ Verify that income on FORM 8582 line 3a (2a for 2001 and prior years) is not from an activity in which the taxpayer materially participates. See Reg. § 1.469-5T(a). If the taxpayer and/or the spouse meets any of the following, he materially participates and income is non-passive and should not be on Form 8582, triggering passive losses:
- Did taxpayer work more than 500 hours a year in business?
- Did taxpayer do most of the work?
- Did taxpayer work 100 hours and no one worked more?
- Did taxpayer work 100-500 hours in several passive activities, the sum of which exceed 500 hours?
- Did taxpayer materially participate in the activity any 5 of the prior 10 years?
- If the business is a personal service activity, did he materially participate in any 3 prior years?
_____ If the taxpayer is involved in multiple related business entities, consider whether they form an "economic unit" (in other words, one single activity) under the activity rules in Reg. § 1.469-4(c). Consequently, the taxpayer materially participates, and income is non-passive. See anti-abuse provision in Reg. § 1.469-4(f).
_____ Consider whether taxpayer is subject to AMT. Depreciation and other AMT preference and adjustment items relating to a passive activity are suspended until the year of a qualifying disposition (or there is passive income to trigger losses). Consequently, in the year of sale, there may be AMT.
LAW: Gain from disposition (including recapture) of assets used in a rental activity or business in which taxpayer did not materially participate is generally passive income (Reg. § 1.469-2T(c)(2)(A)(2)). However, there are several exceptions, including gain on the sale of land. Gain on disposition may be used to trigger other PALs only if it exceeds current and suspended losses from the entity/property sold.
ADJUSTMENT: Income reclassified as non-passive should be removed from Form 8582. Of course, it should still be reported on Schedule D or another appropriate schedule. Form 8582 should then be recomputed without the income which was recharacterized. Passive losses generally will be disallowed up to the amount of passive income treated as non-passive.