PASSIVE ACTIVITY INCOME AND LOSSES
GENERAL RULE: A taxpayer can deduct passive activity losses only from passive activity income. Passive activity losses that exceed passive activity income, generally can be carried forward. In the alternative, the excess can be deducted in the year the taxpayer fully disposes of the entire interest in the activity in a fully taxable transaction (with some exceptions).
SCOPE OF APPLICATION: The passive income and loss rules apply to: individuals, estates, trusts, personal service corporations, closely held corporations, and to the individual owners of S corporations, partnerships, limited liability companies, and grantor trusts. Publicly traded partnerships (“PTP’s”) do not enjoy all the benefits in the inherent in these rules: passive activity losses from a PTP can only offset income or gain from passive activities of the same PTP.
PASSIVE ACTIVITY INCOME
1. What is a passive activity? Simply put, a passive activity either of the following: (a) a trade or business activity in which the taxpayer does not materially participate; or (b) rental activities, even if there is material participation by the taxpayer, unless the taxpayer is a real estate professional. These are discussed separately below:
A. Trade or business activities in which the taxpayer does not materially participate. A trade or business activity is an activity that: involves the conduct which gives rise to deductions under § 162 of the Internal Revenue Code (“IRC”); is conducted in anticipation of a starting a trade or business; or involves research or experimental expenditures that are deductible under IRC § 174 (or that would be deductible if taxpayer chose not to capitalize them). There is an important limitation here: rental activities incidental to the holding of property for investment are not trade or business activity.
Material Participation. Any of the following for a given tax year constitutes material participation:
1. The taxpayer participates more than 500 hours in the activity.
2. The taxpayer’s participation was substantially all the participation in the activity.
3. The taxpayer participates in the activity for more than 100 hours during the tax year and at least as much as any other individual.
4. The activity is a “significant participation activity,” and the taxpayer participates in all significant participation activities for than 500 hours. “Significant participation activity” means any trade or business activity in which the taxpayer participates for more than 100 hours during the year and in which the taxpayer did not materially participate under any of the material participation tests, other than this test.
5. The taxpayer materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6. The activity is a personal service activity in which the taxpayer materially participated for any 3 (whether or not consecutive) preceding tax years. “Personal service activity” is an activity that involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
7. Based on all the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during the year. However, , if the participation is 100 hours or less, then it is not material participation. Management does not count as participation if either: (a) any person other than the taxpayer received compensation for managing the activity, or (b) any individual spent more hours during the tax year managing the activity than the taxpayer (regardless of whether such individual was compensated).
B. Rental activities, even if there is material participation by the taxpayer, unless the taxpayer is a real estate professional.
“Rental activity” means: refers to an activity: (1) in which tangible property (real estate or personal property) is used by customers or held for use by customers and (2) from which the gross income (or expected gross income) represent remuneration paid (or to be paid) mainly for the use of the property. However, if any of the following exceptions applies, the activity is not a “rental activity” that will constitute a passive activity:
1. The average period of customer use is 7 days or less.
2. The average period of customer use is 30 days or less and the taxpayer provides significant personal services with the rentals.
3. The taxpayer provides “extraordinary personal services” in making the rental property available for customer use. “Extraordinary personal services” means that services are performed by an individual and the customer’s use of the rental property is incidental to their receipt of the services.
4. The rental is incidental to a non-rental activity.
(A) Rental of property is incidental to an activity of holding property for investment if the main purpose of holding the property is to realize a gain from its appreciation and the gross rental income from the property is less than a ceiling amount. The ceiling is 2% of the smaller of: the property’s unadjusted basis, and its fair market value. The unadjusted basis” of property is its cost, not reduced by depreciation or any other basis adjustment.
(B) Rental of property is incidental to a trade or business activity if all of the following apply:
i. The taxpayer owns an interest in the trade or business activity during the year;
ii. The rental property was used mainly in that trade or business activity during the current year, or during at least 2 of the 5 preceding tax years; and
iii. The taxpayer’s gross rental income from the property is less than a ceiling amount. The ceiling is 2% of the smaller of: the property’s unadjusted basis, and its fair market value.
5. The taxpayer customarily makes the rental property available during defined business hours for nonexclusive use by various customers.
6. The taxpayer provides the property for use in a nonrental activity in its capacity as an owner of an interest in the partnership, S corporation, or joint venture conducting that activity.
Real Estate Professionals. For real estate professionals, rental real estate activities in which the taxpayer materially participates are not passive activities. For this purpose, each rental real estate activity is a separate one unless the taxpayer chooses to treat all interests in rental real estate as one activity
For real estate professionals, such income or losses are “nonpassive” income or losses. A “real estate professional” is taxpayer:
a. For whom more than half of the personal services performed in all trades or businesses during the tax year were in real property trades or businesses in which the taxpayer materially participated; and
b. The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participated.
NOTES: Personal services performed as an employee do not count for the above unless the taxpayer employee owns at least 5% of the employer. For joint returns, disregard the spouse’s personal services for the above tests (but do count the spouse’s personal services in determining material participation).
Real Property Trade or Business. A real property trade or business is a trade or business that does any of the following with real estate: develops or redevelops it; constructs or reconstructs it; acquires it; converts it; rents or leases it; operates or manages it; or brokers it. Note that a closely held corporation can qualify as a real estate professional if more than 50% of the gross receipts for its tax year came from real estate trades or businesses in which it materially participated.
2. What is Not a Passive Activity? Generally, the following activities are not passive ones:
A. Trade or business activities in which the taxpayer materially participates.
B. Working interests in an oil or gas well which the taxpayer holds directly or through an entity that does not limit the taxpayer’s liability, regardless of material participation.
C. The rental of a dwelling unit that the taxpayer also used for personal purposes during the year for longer than a specified period (i.e., for more than the greater of (a) 14 days or (b) 10% of the number of days during the year that the home was rented at a fair rental).
D. An activity of trading personal property for the account of those who own interests in the activity.
E. Rental real estate activities in which the taxpayer materially participated as a real estate professional.
3. What is an “activity?” In actuality, business ventures are frequently “amalgamated” courses of action. For example, a movie theater sells tickets for movie exhibition, and operates a concession stand. Also, a manufacturing operation may also own in whole or in part a shipping business which ships the manufactured products. The determination of how many activities a particularly taxpayer is engaged in for purposes of the passive income and loss rules is known as “grouping.” It is important for purposes of determining material participation, the disposition of interests in activities, and for determining percentage ownership under the rules. Generally, a taxpayer can treat one or more trade or business activities, or rental activities as a single activity if those activities form an appropriate economic unit. The relevant factors for finding an appropriate economic unit are: the similarities and differences in the types of trade or businesses; the extent of common control; the extent of common ownership; the geographical location; and the interdependencies between or among activities.
Generally, a taxpayer cannot group a rental of real estate activity with a rental of personal property activity, unless the rental of personal property is provided in connection with the rental of real estate or vice versa. And generally, a taxpayer cannot group a rental activity with a trade or business activity, unless they form an appropriate economic unit and:
a. the rental activity is insubstantial in relation to the trade or business activity,
b. the trade or business activity is insubstantial in relation to the rental activity, or
c. each owner of the trade or business activity has the same ownership interest in the rental activity, in which case the part of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.
Other Grouping Rules.
I. Excluded Activities. Limited partners (and limited entrepreneurs, see below) in one of the following activities may not group such activities with any other activities in other types of businesses:
i. holding, producing, or distributing motion picture films or video tapes;
iii. leasing any § 1245 property (certain types of personal or real property subject to depreciation or amortization);
iv. exploring for, or exploiting, oil and gas resources;
v. exploring for, or exploiting, geothermal deposits.
A limited entrepreneur is a person who: (i) has an interest in an enterprise other than as a limited partner; and (b) does not actively participate in the management of the enterprise.
II. Activities conducted through another entity. A personal service corporation, closely held corporation, partnership or S corporation must follow the grouping rules. The ultimate taxpayer (the partner or shareholder) may group those activities (following the rules herein):
i. with each other;
ii. with activities conducted directly by the taxpayer; or
iii. with activities conducted through other entities.
However, the ultimate taxpayer may not treat activities grouped together by the entity as separate activities.
III. Personal Service and closely held corporation. A taxpayer may group an activity conducted through a personal service corporation or closely held corporation with his/her other activities only to determine whether he or she materially (see Material Participation, above) or significantly participated in those other activities (see Significant Participation Passive Activities, below).
IV. Publicly traded partnerships. A taxpayer may not group activities conducted through a publicly traded partnership with any other activity, including an activity conducted through another publicly traded partnership.
V. Partial dispositions. If a taxpayer disposes substantially all of an interest in an activity during the year, the taxpayer may treat the disposed part as a separate activity, so long as the taxpayer can show with reasonable certainty:
i. the amount of deductions and credits disallowed in prior years under the passive activity rules that is allocable to the part of the activity disposed of, and
ii. the amount of gross income and any other deductions and credits for the current year that is allocable to the part of the activity disposed of.
4. Is the income from the passive activity “passive activity income?” Generally, passive activity income includes all income from passive activities and generally includes gain from the disposition of an interest in a passive activity or the disposition of property used in a passive activity.
Passive activity income does not include:
A. Income from an activity that is not a passive activity;
B. Portfolio income. Portfolio income includes interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business, and it includes gain or loss from the disposition of property that produces these types of income or that is held for investment. The exclusion for portfolio income does not apply to self-charged interest treated as passive activity income.
C. Personal services income. Personal services income includes salaries, wages, commissions, self-employment income from trade or business activities in which the taxpayer materially participates, deferred compensation, taxable social security and other retirement benefits, and payments from partnerships to partners for personal services.
D. Income from positive section 481 adjustments allocated to activities other than passive activities (i.e., adjustments that must be made due to changes in accounting method).
E. Income or gain from investments of working capital.
F. Income from an oil or gas property if you treated any loss from a working interest in the property for any tax year beginning after 1986 as a nonpassive loss.
G. Any income from intangible property, such as a patent, copyright, or literary, musical, or artistic composition, if the taxpayer’s personal efforts significantly contributed to the creation of the property.
H. Any other income that must be treated as nonpassive income.
I. Overall gain from any interest in a publicly traded partnership.
J State, local and foreign income tax refunds.
K. Income from a covenant not to compete.
L. Reimbursement of a casualty or theft loss included in gross income to recover all or part of a prior year loss deduction, if the loss deduction was not a passive activity deduction.
M. Alaska Permanent Fund dividends.
N. Cancellation of debt income, if at the time the debt is discharged the debt is not allocated to passive activities under the interest expense allocation rules.
DISPOSITION OF PROPERTY INTERESTS. A disposition (i.e., transfer, grant, sale or assignment) of an interest in a passive activity gives rise to two distinct tax issues: (a) what is the gain or loss on the disposition of the interest itself, and when and how much of it can be recognized? and (b) when is the loss, and how much of it, associated with the passive activity’s operations, allowed? It is crucial to separate these two issues when applying the passive income and loss rules related to dispositions.
a. Gain or Loss on Disposition. With regard to issue (A), the general rule is that gain on the disposition of an interest in property is passive activity income if, at the time of the disposition, the property was used in a passive activity. Gain, is generally not passive activity income if, at the time of disposition, the property was used in an activity that was not passive. Note, however, that the capital loss rules limit the amount of loss that a taxpayer may recognize on the disposition of a passive activity interest (generally $3000 for individuals/$1500 for married individuals filing separately, see IRS Publication 544).
i. Exception for Substantially Appreciated Property/Nonpassive Activity. Even if the property-related activity was nonpassive, the gain is still deemed passive activity income if its fair market value at the time of disposition was more than 120% of its adjusted basis and either of the following applies:
(A) The taxpayer used the property in a passive activity for 20% of the time the taxpayer held the interest in the property.
(B) The taxpayer used the property in a passive activity for the entire 24-month period before its disposition.
If neither (A) nor (B) applies, the gain is not passive activity income. However, it’s treated as portfolio income only if the taxpayer held the property for investment for more than half of the time the taxpayer held it in nonpassive activities. For this purpose, treat property held through a corporation (other than an S corporation) or other entity whose owners receive only portfolio income as property held in a nonpassive activity and as property held for investment. The exception is limited in cases where the property was used in more than one activity during the 12-month period preceding its disposition (i.e., the exception applies only to the gain allocated to the passive activity per the rules above).
ii. Disposition of Property Converted To Inventory. A special rule applies where the taxpayer disposes of property that the taxpayer converted to inventory from use in another activity. In this case, the taxpayer disregards the property’s use as inventory and treats it as if it were still used in that other activity at disposition. Three conditions must be met: at disposition, the taxpayer held his/her interest in the property in a dealing activity (i.e., mainly for sale to customers in the ordinary course of a trade or business); the taxpayer’s other activities included a nondealing activity in which the taxpayer used the property for more than 80% of the period the taxpayer held it; and the taxpayer did not acquire or hold the interest in the property for the main purpose of selling it to customers in the ordinary course of a trade or business.
iii. Partners and S Corporation Shareholders. In general, gain or loss on the disposition of a partnership interest must be allocated to each trade or business, rental, or investment activity in which the partnership owns an interest. These rules also apply to the disposition of stock in an S corporation.
If the taxpayer does not dispose of the entire interest, the gain or loss allocated to a passive activity is treated as a passive activity income or deduction in the year of disposition. This includes any gain recognized on a distribution of money from the partnership that the taxpayer received in excess of the adjusted basis of the taxpayer’s partnership interest.
iv. Dispositions by Gift. The basis of a gifted transferred interest in a passive activity must be increased by the amount of passive activity which are allocable to the interest given away. The losses which are unused at the time of disposition cannot be deducted in any tax year (see below).
v. Partial Dispositions. If a taxpayer disposes of substantially all of an activity during the tax year, the taxpayer may treat the part of the activity disposed of as a separate activity.
b. Loss Allowance from Operations. The general rule is that the excess passive activity losses (i.e., those that are disallowed because they exceed the limitations) from the operations of the activity in a given year are allowed in full in the tax year in which the taxpayer disposes of the entire interest in the passive (or formerly passive) activity. This requires a complete disposition of the interest in the activity in a transaction in which all realized gain or loss is recognized, and the transferee must not be a related person.
i. Disposition by Installment Sale. To determine the amount of operational losses that are allowable in a given year of an installment sales contract, multiply the entire outstanding unalllowed losses by the fraction:
[A] Numerator: gain recognized in the current year
[B] Denominator: total gain from the sale minus all gain recognized in prior years.
ii. Partners and S Corporation Shareholders. As indicated above, the gain or loss on the disposition of a partnership interest must be allocated to each trade or business, rental, or investment activity in which the partnership owns an interest (also applicable to the disposition of stock in S corps). If the taxpayer disposes of the entire interest in a partnership, the passive activity losses from the partnership that have not been allowed generally are allowed in full. They are also allowed if the partnership (other than a PTP) disposes of all the property used in that passive activity.
iii. Dispositions by Gift. Unused passive activity losses allocable to an interest in a passive activity that is given away cannot be deducted in any tax year.
iv. Dispositions by Death. Unused passive activity losses are allowed as a deduction against the decedent’s income in the year of death to the extent they exceed the amount by which the transferee’s basis in the passive activity has been increased under the rules for determining the basis of the property acquired from a decedent.
iv. Partial Dispositions. The grouping rule related to partial dispositions is also applicable with regard to operating losses: a disposition of substantially all of an activity during a tax year allows the taxpayer to treat the part of the activity disposed of as a separate activity.
5. Is the loss from the passive activity a “passive activity loss?” Generally, a passive activity loss includes all deductions from the current year’s passive activities and all deductions from passive activities that were disallowed under the passive loss rules in prior tax years and carried forward to the current tax year. They also include losses from dispositions of property used in a passive activity at the time of the disposition and losses from a disposition of less than the taxpayer’s entire interest in a passive activity.
Passive activity losses do not include the following:
A. Deductions for expenses (other than interest expense) that are clearly and directly allocable to portfolio income.
B Qualified home mortgage interest, capitalized interest expenses, and other interest expenses other than self-charged interest treated as a passive activity deduction or other interest expense properly allocable to passive activities.
C. Losses from dispositions of property that produce portfolio income or property held for investment.
D. State, local and foreign income taxes.
E. Misc. itemized deductions that may be disallowed because of the 2%-of-adjusted-gross-income limit.
F. Charitable contribution deductions.
G. Net operating loss deductions.
H. Percentage depletion carryovers for oil and gas wells.
I. Capital loss carrybacks and carryovers.
J Deductions and losses that would have been allowed for tax years beginning before 1987 but for basis or at-risk limits.
K Net negative section 481 adjustments allocated to activities other than passive activities.
L. Casualty and theft losses, unless losses similar in cause and severity recur regularly in the activity.
M. The deduction for one-half of self-employment tax.
6. Is the passive activity income subject to the recharacterization rules?
Net income from certain passive activities must be excluded in the calculation of total passive income or losses. The excluded net income items are said to be “recharacterized.” The following net income from passive activities may be subject to recharacterization:
A. significant participation passive activities;
B. rental of property when less than 30% of the unadjusted basis of the property is subject to depreciation;
C. equity-financed lending activities;
D. rental of property incidental to development activities;
E. rental of property to nonpassive activities; and
F. licensing of intangible property by pass-through entities.
The first step in applying the recharacterization rules is to net the income and losses from each activity above. If the result is a net loss, the loss need not be recharacterized. If the result is a net income for any of the above activities, the net income cannot be added into the passive income/loss equation. Instead, it must be recharacterized and cannot be reported as passive income.
Exceptions and Qualifications to the Recharacterization Rules.
A. There is an exception for significant participation activity (see below)
B. Limit on recharacterized passive income. The total amount that the taxpayer must recharacterize as nonpassive income for “significant participation passive activities,” the rental of nondepreciable property, and equity-financed lending activities cannot exceed the greatest amount that the taxpayer will treat as nonpassive income under any one of the applicable rules.
C. Investment income and investment expense is recharacterized as nonpassive income from the rental of nondepreciable property, equity-financed lending activity, or licensing of intangible property by a pass-through entity.
Significant Participation Passive Activities. “Significant participation passive activity” refers to any trade or business activity in which the taxpayer participates for more than 100 hours in the tax year but did not materially participate. If the taxpayer’s gross income from all significant participation passive activities is more than the taxpayer’s deductions from those activities, a part of the net income from each significant participation passive activity is treated as nonpassive income.
Corporations. An activity of a personal service corporation or closely held corporation is a significant participation passive if both of the following statements are true:
a. the corporation is not treated as materially participating in the activity for the year; and
b. one or more individuals, each of whom is treated as significantly participating in the activity, directly or indirectly hold (in total) more than 50% (by value) of the corporation’s outstanding stock.
Rental of Nondepreciable Property. Net passive income (including prior year unallowed losses) from renting property in a rental activity must be recharacterized as nonpassive income if less than 30% of the unadjusted basis of the property is subject to depreciation (e.g., improvements on land).
Equity-Financed Lending Activities. Gross-income from equity-financed lending activities are subject to recharacterization. The lesser of the net passive income or the equity-financed interest income is nonpassive income.
Rental of Property Incidental to a Development Activity. Net passive income from this type of activity will be treated as nonpassive income if all of the following apply:
1. The taxpayer recognizes gain from the sale, exchange, or other disposition of the rental property during the tax year;
2. The taxpayer starts to rent the property less than 12 months before disposition; and
3. The taxpayer materially or significantly participates for any tax year in an activity that involves the performance of services for the purpose of enhancing the value of the property (or any other item of property if the basis of the disposed of property is determined in whole or in part by reference to the basis of the former item).
Rental of Property to a Nonpassive Activity. Net rental income is recharacterized as nonpassive income if the taxpayer rents property to a trade or business activity in which the taxpayer materially participates. This rule does not apply to:
a. property rentals under binding written agreement entered before 2/19/88; and
b. property rental incidental to a development activity (described above).
Licensing of Intangible Property by Pass-Through Entities. Net royalty income from intangible property held by a pass-through entity in which the taxpayer owns an interest may be treated as nonpassive royalty income, if the taxpayer acquired the interest in the pass-through entity after the partnership, S corporation, estate, or trust created the intangible property or performed substantial services or incurred substantial costs for developing or marketing the intangible property. This rule does not apply if:
a. the expenses reasonably incurred by the entity in developing or marketing the property exceeds 50% if the gross royalties from licensing the property that are includable in your gross income for the tax year; or
b. the taxpayer’s share of the expenses reasonable incurred by the entity in developing or marketing the property for all tax years exceed 25% of the fair market value of the taxpayer’s interest in the intangible property at the time the taxpayer acquired the taxpayer’s interest in the entity. For this purpose, capital expenditures are taken into account for the entity’s tax year in which the expenditure is chargeable to a capital account, and the taxpayer’s share of the expenditure is figured as if it were allowed as a deduction of the tax year.