Passive Activity Rules
Tax shelters were popular investments for tax avoidance because they could generate deductions and other benefits that could be used to offset other income. Some tax shelters even advertised a 10-to-1 tax write-off, meaning that $10 of losses could be claimed for each $1 invested; so a taxpayer in the 35% bracket could save $3.50 for each $1 invested, netting $2.50 at the expense of the government. The primary purpose of tax shelters was simply to generate losses so that the "investors" could lower their taxable income. Indeed, they were not even an investment, since they had no economic value — they were simply a means of taking advantage of tax loopholes.
Most of these tax shelters or partnerships took advantage of nonrecourse financing. Nonrecourse debt is an obligation for which the borrower is not personally liable. For instance, a partnership to buy real estate often uses mortgages collateralized by the property. None of the partners have any personal liability for the mortgages — neither does the partnership. If there is a default, the lender's only option is to foreclose on the property. Many of these tax shelters generated losses in the early years through accelerated depreciation and interest expense deductions. Consequently, 2 major provisions were added to the tax law to limit the effectiveness of tax shelters: at-risk limitations and passive activity rules.
Although the at-risk limitation rules reduced the deductions, they still allowed taxpayers to defer income to a future year. So to prevent this, Congress passed passive activity rules that allowed passive losses to be deducted only from passive profits. Passive activity rules cover real estate investments, limited partnerships, closely held corporations, or any other type of investment in a business in which the investor is not active or for which losses of the business are passed through to the investor.
Passive loss rules segregate income into 3 categories: active, passive, and portfolio. Active income comes from activities in which the taxpayer was a material participant, and includes such sources of income as:
- wages, salaries, commissions, bonuses, and other types of employment compensation
- profit from a trade or business
- capital gains on the sale or disposition of assets that were used in an active trade or business
- gains from the disposition of intangible property where the taxpayer significantly contributed to the creation of the property.
Portfolio income is simply investment income, such as from interest, dividends, and from capital gains from the sale of investment property, such as stocks and bonds. Passive activity rules do not apply to investments of publicly traded financial securities, because they are unnecessary: business losses cannot be passed through to stockholders or bondholders. Instead, business losses will potentially decrease the value of the stock or the bond.
Passive income is defined by IRC §469 as any trade or business or other income-producing activity where the taxpayer does not materially participate, and with certain exceptions, this includes all rental activities even if the taxpayer does materially participate. Self-charged interest, which is interest earned by a taxpayer based on a loan to a business in which the taxpayer has an interest, is also considered passive income if the loan proceeds were used for a passive activity. Both portfolio and passive income may be subject to the 3.8% Medicare tax that is assessed on net investment income for high-income taxpayers.
Accumulated Losses from a Qualified Disposition of a Passive Activity are Deductible
Passive losses can only be deducted from passive income that is not limited by at-risk limitation rules. Passive activity losses can be deducted from active or portfolio income only when the taxpayer's interest in the activity is terminated in a qualified disposition. However, any passive gain in the final year is first offset against suspended passive losses from previous years for the activity.
Example: How to Deduct Passive Losses against Passive, Active, or Portfolio Income after Terminating a Passive Investment
- You bought an apartment building for $100,000.
- In the tax year in which you terminate the activity, you sell it for $140,000, net profit = $40,000.
- If you have suspended losses of $50,000, then this loss must first be subtracted from the $40,000 gain.
- Then the remaining $10,000 loss can be subtracted from other active or portfolio income.
There are 3 tests for a qualified disposition:
- the entire interest must be disposed of;
- the disposition must be a taxable transaction;
- the transferee must be an unrelated party — not family members, businesses controlled by the taxpayer, or other related entities.
Nontaxable dispositions, from which passive losses cannot be deducted, include gifts, conversion to personal use, transfers to a business entity controlled by the taxpayer, and an interest disposed of in a chapter 7 bankruptcy, since passive losses are treated as a tax attribute that is reduced by unrecognized canceled debt. A disposition affected by foreclosure will be treated as a final disposition if the foreclosure is final.
However, rental property that qualifies as a principal residence because the owner lived in it for at least 2 of the 5 years preceding the sale can deduct passive losses from the rental activity even if the entire gain from the sale was excludable under the home sale exclusion.
If a passive interest with suspended losses is sold as an installment sale, then the total profit from the sale must be divided by the number of years over which the payments are made. Each annual gain is then offset by a pro rata amount of the suspended losses. For instance, if you sell a passive interest for an $8,000 profit over a 4-year period and you had $1,000 of suspended losses, then $250 of the suspended losses can be deducted from the $2,000 (=$8,000 ÷ 4) profit apportioned to each year.
If an interest in a passive activity is sold at a loss, then it can be used to offset other capital gains. Losses can be applied to earned income, but only to the extent of $3,000. Any remaining amounts can be carried forward to offset gains in earnings in future years, but any offset to earned income is subject to the $3000 limit per year.
If the passive activity is given as a gift, then the suspended losses are not deductible, but they do increase the donee's basis if the donee sells the property at a profit. However, if the donee sold at a loss, then the donee's basis is the fair market value of the property when the gift was received. So, for instance, if you give your daughter an interest in a passive activity that has $10,000 of accumulated suspended losses, and if your daughter sells the passive interest for a $4,000 profit, then $4000 of the suspended losses can be used to increase the tax basis so that she owes no tax on it. The remaining $6,000 of suspended losses is lost.
If an investor with suspended losses in a passive interest dies, then any losses that exceed the fair market value (FMV) of the property minus the tax basis of the property is deductible on the decedent's final return.
Deductible Loss on Decedent's Final Return = Suspended Loss – (FMV – Tax Basis)
- Suspended Loss = $10,000
- Property FMV = $7,000
- Tax Basis = $3,000
- Deductible Loss on Final Return = $10,000 – ($7,000 – $3,000) = $10,000 – $4,000 = $6,000.
Carryover of Suspended Losses
If the taxpayer has more than 1 passive activity, and losses exceed passive income, then before the losses can be carried forward, the losses must be allocated among the passive activities with losses, where each activity is allocated a loss according to the following formula:
Net Passive Loss = Sum of All Passive Income – Sum of All Passive Losses
Carryover Losses for Activity = Net Passive Loss × Loss from Activity ÷ Sum of All Losses from Activities That Had Losses for the Taxable Year
Net passive losses suffered during the tax year can be deducted from net passive income earned during that same year from all activities. However, if net passive losses exceed net passive income, then the excess loss can be carried forward, but the total excess loss must be allocated to all activities that suffered a loss. In future tax years, the allocated losses can only be deducted against income earned by that activity. Only when the activity is finally disposed of can any remaining losses be deducted: 1st from passive income from other activities, then from earned or portfolio income.
A more limiting rule applies to publicly traded partnerships. Any losses from a PTP can only be deducted against the income of that PTP, so losses must be carried forward until the PTP profits or until the taxpayer disposes of his entire interest in the PTP.
For instance, suppose you have the following losses and income:
- Activity A: a loss of $50,000;
- Activity B: a loss of $30,000;
- Activity C: a profit of $20,000.
This yields a net loss of $60,000 (= $20,000 – $80,000) and a total loss of $80,000 (= $50,000 + $30,000). Hence, the losses have to be allocated thus:
- Activity A: $60,000 × $50,000/$80,000 = $37,500
- Activity B: $60,000 × $30,000/$80,000 = $22,500
So $37,500 of losses from Activity A can be carried forward and subtracted from the income earned by Activity A in the future, and the $22,500 of losses allocated to Activity B can offset any future income from that activity. Only when the activity is disposed of can any losses allocated to that activity be deducted from other income.
Credits that arise from passive activities are also limited to the tax that is attributable to the passive income. To calculate the amount of taxes that can be offset by credits from passive activity, the total tax due must be calculated for all income including the passive income. Then, before applying any credits, the tax must be calculated without the net passive income and deducted from the total tax liability. This yields a tax that is attributable to the passive income. Only this amount of the tax can be reduced by credits from the passive activity. No passive credits can be used if there is no passive income.
Example of Applying Passive Credits
Suppose the following:
- Total Tax Liability before Applying Credits = $100,000
- – Total Tax Liability without Passive Income before Applying Credits = $70,000
- = Tax Attributed to Passive Income = $30,000
Here, passive credits can only be used to offset the $30,000 in taxes attributable to the passive income.
Passive credits can be carried forward just like passive losses, but with an important exception. Any unused tax credits are lost completely when the activity is disposed of. Passive credits can only offset regular tax liability attributed to the passive income — passive credits do not offset AMT liability. If the taxpayer's tax liability is great enough to use the suspended credits in the final year of activity, then the passive credits are treated as regular tax credits and subject to the same limits as business credits.
If the taxpayer qualified for an investment credit or rehabilitation credit, that reduced the basis of property in the activity, then the taxpayer can elect on Form 8582-CR to increase the basis of the property by the amount of the unused credit.
Passive activity rules can be mitigated or avoided by grouping related activities as a single activity. If the activities can be considered as an economic unit, then income earned from the activities can be classified as active income if the taxpayer satisfies the material participation tests for any 1 activity within the group. If the grouped activity is still deemed passive, then losses generated by the group can also be used to offset income earned from that group in future years. A disadvantage of grouping, however, is that the cumulative losses from any 1 activity within the group cannot be used offset other types of income if that activity is disposed of. Only when the entire group of activities is disposed of can any cumulative losses be used offset passive income from other activities or from active or portfolio income.
Whether the activities can reasonably be considered an economic unit is determined by the facts and circumstances of the activities, but the following factors can be used to determine the reasonableness of grouping the activities as an economic unit:
- greater similarities among the activities
- greater common control or ownership
- close geographic location of the activities
- greater interdependencies among the activities, evidenced by providing products or services of the different activities together, using the same employees and the same set of books to account for the activities, and serving the same customers.
Activities by a partnership or S corporation are considered 1 economic unit if the taxpayer actively participated in the management of the business and at least 65% of the losses for the tax year can be allocated to active participants in the management of the business. Active participation can be inferred if the taxpayer makes decisions regarding the operation or management of the business, performs services for the business, and hires or discharges employees. A lack of participation is indicated by having only the authority to discharge the manager of the activity or if the manager is an independent contractor rather than an employee.
If the IRS considers the grouping unreasonable, then it may regroup the activities, resulting in higher taxes.
If the Passive Activity Becomes Active
If a passive activity becomes an active activity in which the taxpayer materially participates, then suspended losses can be used offset income from the new active activity, but it must be the same activity as when it was a passive activity. In the year that the business becomes active, suspended losses still have their passive character, in that they can only be used offset passive income in that year. However, if any losses are carried forward to the next tax year, then they can be deducted against the income of the now active business.
The taxpayer uses Form 8582, Passive Activity Loss Limitations to list all income and expenses from passive activities so that the passive income rules can be applied to all passive income. The allocation of losses is also determined on Form 8582. Any net income is then transferred to the appropriate schedule. So for a self-employed individual taxpayer, passive profits are reported on Schedule C, Profit or Loss from Business, income from capital asset sales are reported on Schedule D, Capital Gains and Losses; and partnership and rental income and allowable deductions are reported on Schedule E, Supplemental Income and Loss.