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Passive Losses

Section 469 limits the deductions and credits taxpayers may claim in connection with activities in which they do not materially participate. Deductions attributable to passive activities, to the extent they exceed income from passive activities, generally may not be deducted against other income, such as wages, portfolio income, or business income, that isn’t derived from a passive activity. A similar rule applies to credits. deductions and credits that are disallowed under the passive activity rules are carried forward and treated as deductions and credits from passive activities in the next year. Suspended losses generally are allowed in full when a taxpayer disposes of his entire interest in the passive activity to an unrelated person.

Income and Loss. Gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of business (portfolio income), expenses directly allocable to portfolio income, and gain or loss attributable to the disposition of property producing portfolio income or property held for investment are not taken into account in determining income or loss from passive activities. A special rule permits closely held C corporations to apply passive activity losses (or credits) against active business income (or tax liability allocable to it), but not against portfolio income. (Section 469(e))

Personal Service Income. Income an individual receives from the performance of personal services related to a passive activity isn’t treated as income from a passive activity. So, for example, in the case of a limited partner who is paid for performing services for the partnership (as salary, guaranteed payments, or an allocation of partnership income), the payments cannot be sheltered by passive losses from the partnership or from any other passive activity. (Section 469(c)(3))

Interest Deduction Limitation. Interest expense allocable to passive activities is treated as a passive activity expense and not as investment interest. Deductions attributable to passive activities otherwise allowable for interest expense are subject to the passive loss limits and not the investment interest limitation. Similarly, income and loss from passive activities generally are not treated as investment income or loss in calculating the amount of the investment interest limitation.
Interest on debt secured by a person’s principal residence and one other residence is not subject to the passive loss limits as long as the interest meets the definition of qualified residence interest under section 163(h)(3). So, for example, a taxpayer who rents out her vacation home so that a portion of the mortgage interest is allocable to the rental use of the home is not subject to the disallowance of the interest deduction under section 469.

General Application. The passive activity rules apply to individuals, estates, trusts, closely held C corporations, and personal service corporations. (Section 469(a)(2)) Losses and credits attributable to limited partnership interests generally are treated as from passive activities. Special rules apply to rental activities. Working interests in oil and gas property are excluded from the definition of passive activity if the taxpayer’s liability is not limited with respect to the interests. (Section 469(c)(3))

An activity generally is a passive activity if it involves the conduct of any trade or business and the taxpayer does not materially participate in the activity. (Section 469(c)(1)) An individual materially participates in an activity only if he is involved in the activity’s operations on a regular, continuous, and substantial basis. Regardless of whether an individual owns an interest in an activity directly (for example, as a proprietor) or through a passthrough entity (such as a partnership or an S corporation), he must be involved in the activity’s operations on a regular, continuous, and substantial basis in order to be treated as materially participating. (Section 469(h))

Rental Activities. Except for those in the real estate business, passive activities include any rental activity, whether or not the taxpayer materially participates. (Section 469(c)(2)) An activity in which substantial services are provided, and payments are for those services rather than for the use of property, however, is not a rental activity. For example, operating a hotel or motel when substantial services are provided is not a rental activity. On the other hand, long-term rentals or leases or property (for example, office equipment or leased cars) generally are rental activities. Losses from rental activities are allowed against income from other passive activities, but not against other income.

Real Estate Rental Activities. An individual may deduct annually up to $25,000 of passive activity losses (to the extent the exceed passive activity income) that are attributable to rental real estate activities in which the taxpayer actively participates. (Section 469(i)) The $25,000 allowable deduction is not available to corporations or trusts, and only in limited circumstances to estates.

An individual is not actively participating in a rental real estate activity if she has an interest that is less than a 10 percent interest in the activity at any time during the year. An individual is not presumed to be actively participating, however, merely by having a 10-percent-or-greater interest. (The active participation requirement generally does not require as much personal involvement as the material participation standard that applies to most activities.)
The $25,000 allowance for losses from real estate rental activities is phased out ratably as a taxpayer’s adjusted gross income (determined without regard to passive activity losses) increases from $100,000 to $150,000.

The $25,000 allowance for rental real estate applies, in a deduction equivalent sense, to credits attributable to rental real estate activities as well. Under a special rule, the $25,000 allowance applies to low-income housing and rehabilitation credits regardless of whether the taxpayer claiming the credit actively participates in the activity. Further, the adjusted gross income phaseout for the allowance does not apply for low-income housing property placed in service after 1989, and the phaseout for rehabilitation credits does not begin until adjusted gross income exceeds $200,000.
Real Estate Professionals. A taxpayer’s losses are not subject to limitation under the passive loss rules if the taxpayer materially participates in rental real estate activities and meets eligibility requirements relating to real property trades or businesses in which the taxpayer performs services. Whether a taxpayer materially participates in rental real estate activities is determined as if each of the taxpayer’s interests in rental real estate is a separate activity, unless the taxpayer elects to treat all interests in rental real estate as one activity. (Section 469(c)(7))

A taxpayer meets the eligibility requirements if:

bulletmore than half of the personal services the taxpayer performs in a trade or business during the tax year are in real property trades or businesses in which the taxpayer materially participates; and
bulletthe taxpayer performs more than 750 hours of service during the tax year in those trades or businesses.
A closely held C corporation meets the eligibility requirements if more than 50 percent of its gross receipts for the tax year are from real property trades or businesses in which the corporation materially participates.
Dispositions. When a taxpayer disposes of an entire interest in a passive activity to an unrelated party in a fully taxable transaction, current and suspended passive losses are treated as nonpassive and are deductible against passive and nonpassive income. Any unused suspended credits are not allowed when a passive activity is sold, but they can be carried forward and used to offset tax on income from other passive activities. (Section 469(g))

An installment sale of an entire interest in an activity in a fully taxable transaction triggers the allowance of suspended losses. The losses are allowed in the ratio that the gain recognized each year bears to the total gain on the sale.
On a taxpayer’s death, suspended losses are allowed to the extent they exceed the step-up in basis of the property. Losses to the extent of the basis step-up are not deductible.