10.8 Determining Passive or Nonpassive Income and Loss

The purpose of the passive loss rules is to prevent you from deducting passive losses from nonpassive income. Passive losses are losses from business activities in which you do not materially participate (10.6) or losses from rental activities that are not deductible under the $25,000 allowance (10.2) or which do not qualify you as a real estate professional (10.3). In some cases passive income may be recharacterized as nonpassive income (10.9).

Where you do not materially participate in a business activity, passive income or loss is determined by matching income and expenses of that activity. Portfolio income (see below) earned by the activity or any pay that you earn is not included to determine passive income or loss.

Portfolio income.

Portfolio income is nonpassive income and broadly defined as income that is not derived in the ordinary course of business of the activity. Portfolio income includes interest, dividends, annuities, and royalties from property held for investment. However, interest income on loans and investments made in the business of lending money or received on business accounts receivable is generally not treated as portfolio income; see 10.9 for special recharacterization rules. Similarly, royalties derived from a business of licensing property are not portfolio income to the person who created the property or performed substantial services or incurred substantial costs.

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Portfolio Income Accounting
You cannot deduct passive losses from portfolio income. The tax law broadly defines “portfolio income” to include nonbusiness types of income including interest, dividends, and profits on the sale of investment property.
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Portfolio income also includes gains from the sale of properties that produce portfolio income or are held for investment.

Expenses allocable to portfolio income, including interest expenses, do not enter into the computation of passive income or loss.

Sale of property used in activity.

Gain or loss realized on the sale of property used in the activity is generally treated as passive income/loss if at the time of disposition the activity was passive. Under this rule, if you have a gain that you are reporting on the installment method, the treatment of installment payments depends on your status at the time of the initial sale. If you were not a material participant in the year of sale, installment payments in a later year are treated as passive income, even if you become a material participant in the later year. However, an exception to the year-of-sale status rule applies to certain sales of property formerly used in a passive activity (10.16).

Although gain on the sale of property is generally passive income if the activity is passive at the time of sale, there is an exception that could recharacterize the gain as nonpassive income if the property was formerly used in a nonpassive activity (10.16).

Compensation for personal services is not passive activity income.

The term “compensation for personal services” includes only (1) earned income, including certain payments made by a partnership to a partner and representing compensation for the services of the partner; (2) amounts included in gross income involving the transfer of property in exchange for the performance of services; (3) amounts distributed under qualified plans; (4) amounts distributed under retirement, pension, and other arrangements for deferred compensation of services; and (5) Social Security benefits includible in gross income.

Passive activity gross income also does not include (1) income from patent, copyright, or literary, musical, or artistic compositions, if your personal efforts significantly contributed to the creation of the property; (2) income from a qualified low-income housing project; (3) income tax refunds; and (4) payments on a covenant not to compete.

Passive activity deductions.

Deductible expenses that offset passive income of an activity must be related to the passive activity, such as real property taxes. The following are not considered passive activity deductions:

Casualty and theft losses if similar losses do not recur regularly in the activity.
Charitable deductions.
Miscellaneous itemized deductions subject to the 2% AGI floor.
State, local, and foreign income taxes.
Carryovers of net operating losses or capital losses.
Expenses clearly and directly allocable to portfolio income.
Loss on the sale of property producing portfolio income.
Loss on the sale of your entire interest in a passive activity to an unrelated party. The loss is allowed in full (10.13).

Interest deductions.

Interest expenses attributable to passive activities are treated as passive activity deductions and are not subject to the investment interest limitations. For example, if you have a net passive loss of $100, of which $40 is attributable to interest expenses, the entire $100 is a passive loss; the $40 is not subject to the investment interest limitation (15.10). Similarly, income and loss from a passive activity is generally not treated as investment income or loss in figuring the investment interest limitation.

If you rent out a vacation home that you personally use for more than the greater of 14 days or 10% of the fair market rental days (9.7), you may treat the residence as a qualified second residence under the mortgage interest rules (15.1). Interest on such a qualifying second home is generally fully deductible, and the deductible interest (15.1) is not treated as a passive activity deduction. The rental portion of the interest is deducted on Schedule E of Form 1040 and the personal-use portion on Schedule A if itemized deductions are claimed (9.9).

Self-charged management fees or interest.

For an individual with interests in several business entities, the payment of management fees by one of the entities to another is in effect a payment by the owner to himself. However, if the taxpayer materially participates in the entity providing the management services but not in the entity that pays the fees, the passive loss rules prevent the “self-charged” expense from offsetting the nonpassive fee income. IRS final regulations allow a netting deduction only for self-charged interest but not for any other self-charged expense.

EXAMPLE
As an employee of his S corporation, Hillman provided real estate management services to rental real estate partnerships in which he had invested. On his personal return, he reported the management fees as passed-through S corporation income and deducted his allocable share of the fee payments by the partnership. The IRS disallowed the deduction: Since Hillman materially participated in the S corporation but not the partnerships, the fee payments by the partnerships were passive activity expenses that could not be deducted against the S corporation’s nonpassive fee income. The fact that IRS regulations allow a deduction for self-charged interest does not mean that other self-charged passive expenses should also be deductible.
The Tax Court agreed with Hillman that there is no difference between interest and other self-charged expenses. The legislative history indicates a Congressional intent to allow deductions for self-charged expenses because they do not result in a net accretion to the taxpayer’s wealth.
However, the Fourth Circuit, while sympathetic to Hillman’s situation, reversed the Tax Court. Nothing in the tax law allows self-charged expenses to be deducted against nonpassive income. Although there is no reason why management fees should be distinguished from interest, the legislative history on self-charged expenses specifically mentioned only interest as an exception to the general statutory rule. The Congressional Committee reports that gave the IRS discretion to provide a deduction for other self-charged expenses did not limit that discretion. Unless the IRS changes its regulations, relief must come from Congress. The Fourth Circuit noted that while the denial of a deduction in this situation appears harsh, the deduction is not completely lost; the fee payments may be carried forward to later years as a passive expense.
After the Fourth Circuit ruled against him, Hillman went back to the Tax Court and tried an alternative argument in an attempt to deduct the management fees paid by the partnerships. He argued that the fees were nonpassive deductions that could offset the nonpassive income from the S corporation because the payment of the fees, by itself, constituted a separate business distinguishable from the passive rental activities of the partnerships. The Tax Court disagreed. The management fees were incurred in connection with the rental activities and thus were passive deductions. The Tax Court again acknowledged the unfairness of denying a deduction for the “self-charged” fees. Hillman’s plight is lamentable, but as the Fourth Circuit ruled, relief can only come from Congress if the IRS does not liberalize its regulation on self-charged expenses.
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