Chapter 10
Loss Restrictions: Passive Activities and At-Risk Limits

The passive activity laws were intended to discourage tax-shelter investments, but their reach goes beyond tax shelters to cover all real estate investors and persons who invest in businesses as “silent partners” or who are not involved full time in the business. The passive activity rules prevent an investor from deducting what the law defines as a passive loss from salary, self-employment income, interest, dividends, sales of investment property, or retirement income. Such losses are deductible only from income from other passive activities. Losses disallowed by the passive activity rules are suspended and carried forward to later taxable years and become deductible only when passive income is realized or substantially all of the activity is sold.

Casualty and theft losses are not passive losses unless they are of the type usually occurring in a business, such as shoplifting theft losses.

On your tax return, passive income items and allowable deductible items are reported as regular income and deductions. For example, rental income and allowable deductions are reported on Schedule E. However, before you make these entries, you may have to prepare Form 8582, which identifies your passive income and losses and helps you to determine whether passive loss items are deductible.

At-risk rules generally limit losses for an activity to your cash investment and loans for which you are personally liable, as well as certain nonrecourse financing for real estate investments. See 10.17.

10.1 Rental Activities Generally Treated as Passive

Rental activities (real estate or personal property) are automatically treated as passive unless you qualify as a real estate professional (10.3) or the rentals by law are excluded from the rental category and are instead considered to be business activity (see below). If “automatic” passive activity treatment applies, you may not deduct a rental loss against nonpassive income such as salary or investment income unless you can take advantage of the up-to-$25,000 allowance that applies to rental real estate losses (10.2). Even where rental income or loss is not automatically treated as passive because you qualify as a real estate professional or because the activity is excluded from the rental category and treated as a business (see the list below), income or loss will still be “passive” unless you materially participate (10.6) in the business activity.

A loss that is not currently deductible due to the passive loss restrictions is suspended and carried forward indefinitely until there is passive income to offset, or until you dispose of your entire interest in the activity (10.13)

What is a rental activity? Except for activities specifically excluded from the rental category (see the list of rentals treated as businesses below), rentals include all activities in which a customer pays for the use of tangible property (real estate or personal property). Such activities include rentals of apartments and commercial office space (whether long- or short-term); long-term rentals of office equipment, automobiles, and/or a vessel under a bareboat charter or a plane under a dry lease (no pilot or captain and no fuel); and net-leased property. A property is under a net lease if the deductions (other than rents and reimbursed amounts) are less than 15% of rental income or where the lessor is guaranteed a specific return or is guaranteed against loss of income.

Rentals treated as business activity. Although rental activities are generally treated as “passive,” the following six activities are excluded from the category of rental activity and thus losses from these activities are not deductible under the $25,000 rental real estate loss allowance (10.2). The fact that these activities are not treated as rentals does not mean that the passive activity rules are inapplicable. Income or loss from these activities will still be treated as passive income or loss if you fail to meet one of the business material participation tests (10.6).

1. The average period of customer use of the property is seven days or less. Short-term rentals of vacation units, autos, dvds/videocassettes, tuxedos, and hotel and motel rooms are not considered rental activities if the average period of customer use is seven days or less. You figure the average period of customer use for the year by dividing the aggregate number of days in all rental periods that end during the tax year by the number of rentals. Each period during which a customer has a continuous or recurring right to use the property is treated as a separate rental.

   A loss from a seven-day-or-less real estate rental activity is not eligible for the up-to-$25,000 loss allowance (10.2). Since it is not treated as a real estate rental activity, it may not be included in the election to aggregate rental real estate activities under the real estate professional rules (10.3).

2. The average period of customer use of the property is more than seven days but is 30 days or less, and you provide significant personal services. Personal services include only services performed by individuals and do not include (a) services necessary to permit the lawful use of the property; (b) construction or repair services that extend the useful life of the property for a period substantially longer than the average period of customer use; and (c) services that are provided with long-term rentals of high-grade commercial or residential real property such as cleaning and maintenance of common areas, routine repairs, trash collection, elevator service, and security guards.

   Note: For purposes of Exceptions 1 and 2, if more than one class of property is rented as part of the same activity, average period of customer use is figured separately for each class. The average period of customer use (as explained in Exception 1) is multiplied by the ratio of gross rental income from that class to the total rental income from the activity; see the Form 8582 instructions.

3. Regardless of the average period of customer use, extraordinary personal services are provided so that rental is incidental. In a rare case, it may be possible to avoid the passive loss disallowance rule by showing that “extraordinary personal services” were provided to tenants who rented the space primarily to obtain these services. IRS regulations give as examples the use by patients of a hospital’s room and board facilities, which is incidental to the medical services provided, and the use by students of school dormitories, which is incidental to the teaching services provided.

   In one case, an attorney and her husband, a medical doctor, convinced the Tax Court that they met the “personal services” exception by providing legal support services to law firms who leased office space from their LLC. The attorney supervised three clerical employees in providing legal support services to the tenant firms, which included client intake, answering phones and taking messages, conducting legal research, typing briefs and memoranda, binding briefs, photocopying, taking dictation, express mailing, process serving, filing documents at the courthouse and state capital, maintaining a file room, law library, and conference facilities, and providing coffee service. Her husband provided consulting services to the attorneys, reviewing medical malpractice cases, serving as an expert medical witness, helping the attorneys prepare for accreditation reviews of health-care organizations, and providing quality assurance trainings.

   Before the Tax Court, the tenant firms testified that these support services, particularly the legal research, were unique and that they would not have moved into the LLC’s building without them. The Tax Court held that the LLC’s leasing activity was not a rental activity under the extraordinary services exception, but the taxpayers still had to prove that they “materially participated” in the leasing/support activities to avoid passive loss disallowance for the rental losses. They did so by showing that at least 500 hours were spent working on the activity (10.6).

4. Rental is incidental to a nonrental activity. A rental of property is excluded from the rental activity category if the property is held mainly for investment or for use in a business. A rental is considered incidental to an investment activity if the principal purpose of holding the property is to realize gain from its appreciation and the gross rental income from the property for the year is less than 2% of the unadjusted basis or fair market value of the property, whichever is less.

   A rental is incidental to a business activity if (1) you own an interest in the business during the year, (2) the rented property was predominately used in that business during the current year or during at least two of the immediately preceding five tax years, and (3) gross rental income from the property is less than 2% of the lower of the unadjusted basis of the property or its fair market value. Under test (2), a rental may qualify for the exception although it is not rented to the related business in the current year, so long as it was used in the business in two or more of the preceding five years.

5. Providing property to a partnership or S corporation that is not engaged in rentals. If you own an interest in a partnership or S corporation and you contributed property to it as an owner, the contributed property is not considered a rental activity. For example, if as a partner you contribute property to a partnership, your distributive share of partnership income will not be considered as income from a rental activity. However, this exception will not apply if the partnership is engaged in a rental activity.
6. The property is generally allowed for the non-exclusive use of customers during fixed business hours, such as operating a golf course. The customers are treated as licensees, not lessees.

Rental of dwelling unit meeting personal use test is not a passive activity. If you rented out a residential unit that you personally used as a home during the year for more than the greater of 14 days or 10% of the number of days that it was rented to others at a fair market rental price (9.7), the rental is not a passive activity. However, if you had a net loss from the rental, some rental expenses are not deductible on Schedule E under the allocation rules of 9.9.

Grouping rental and nonrental business activities. Where you conduct rental as well as nonrental business activities, you may not group a rental activity with a nonrental activity, unless they form an appropriate economic unit and one of the activities is considered insubstantial in relation to the other. No guidelines are provided for determining what is “substantial” or “insubstantial.”

Under an exception, a rental of property to a business may be grouped together with the business, although one activity is not insubstantial to the other, provided each business owner has the same proportionate ownership in the rental activity and the activities are an appropriate economic unit.

Real property rentals and personal property rentals. An activity involving the rental of realty and one involving the rental of personal property may not be treated as a single activity, unless the personal property is provided in connection with the real property or the realty is provided in connection with the personal property.

10.2 Rental Real Estate Loss Allowance of up to $25,000

If you are not a real estate professional (10.3) but you actively participate by performing some management role in a real estate rental venture, you may deduct up to $25,000 of a real estate rental loss against your regular, nonpassive income such as wages. Your rental loss is still “passive”, but the allowance lets you deduct the loss (up to $25,000) as if it were a nonpassive loss. The allowance is phased out if your modified adjusted gross income (MAGI) is between $100,000 and $150,000. You generally take the allowance into account on Schedule E, but Form 8582 is sometimes required (10.12).

If you are married filing separately, you are not eligible for the special loss allowance unless you lived apart for the entire year, and in that case, the allowance is limited to $12,500; see below.

The allowance applies only to real estate rentals not excluded from the rental category by the rules at 10.1. For example, short-term vacation home rentals averaging seven days or less do not qualify for the allowance. The allowance applies only to real estate rentals, not to any rentals of equipment or other personal property.

A trust may not qualify for the $25,000 allowance. Thus, you may not circumvent the $25,000 ceiling or multiply the number of $25,000 allowances by transferring rental real properties to one or more trusts.

Married filing separately. If you file separately and at any time during the taxable year live with your spouse, you are not allowed to claim any allowance. If you are married but live apart from your spouse for the entire year and file a separate return, the $25,000 allowance and the adjusted gross income phase-out range are reduced by 50%. Thus, the maximum allowance on your separate return is $12,500 and this amount is phased out by 50% of MAGI over $50,000. Therefore, if your MAGI exceeds $75,000, no allowance is allowed.

Active participation test must be met. To qualify for the allowance, you must meet an active participation test. Having an agent manage your property does not prevent you from meeting the test, but you must show that you or your spouse participates in management decisions, such as selecting tenants, setting rental terms, and reviewing expenses. The IRS may not recognize your activity as meeting the test if you merely ratify your manager’s decisions. You (together with your spouse) must also have at least a 10% interest in the property. Limited partners are not considered active participants and do not qualify for the allowance.

If a decedent actively participated in property held by an estate, the estate is deemed to actively participate for the two years following the death of the taxpayer.

Figuring the $25,000 allowance. First match income and loss from all of your passive rental real estate activities in which you actively participate. A net loss from these activities is then applied against net passive income (if any) from other activities and if there is a remaining loss, that loss is deductible under the $25,000 allowance. Keep in mind that rental income or loss from renting a personal residence is disregarded in figuring the $25,000 allowance if the rental is not a passive activity, and it is not a passive activity if your personal use of the home during the year exceeds the greater of 14 days or 10% of the days the home is rented at a fair market rental amount (9.7). The allowance may not be used against carryover losses from prior taxable years when you were not an active participant.

Phaseout of the allowance. The maximum loss allowance of $25,000 ($12,500 if married filing separately and living apart for the entire year) is reduced by 50 cents for every dollar of modified adjusted gross income (MAGI) over $100,000 (or $50,000 if married filing separately).

Modified adjusted gross income (MAGI). For purposes of the allowance phaseout, MAGI is adjusted gross income shown on your return, but you should disregard:

• Any passive activity income or loss.
• Any loss allowed for real estate professionals (10.3).
• Taxable Social Security and railroad retirement payments (34.3). For example, if your adjusted gross income on Form 1040 is $90,000, and that includes $5,000 of taxable Social Security benefits, your modified adjusted gross income is $85,000 for purposes of the allowance phaseout.
• Deductible IRA contributions (Chapter 8).
• Deductible tuition and fees (33.13).
• The deduction on Form 1040 for one-half of self-employment tax liability (45.3).
• Deductible student loan interest (33.13).
• Overall loss from a publicly traded partnership (see instructions to Form 8582).
• Excluded interest on U.S. savings bonds used for paying tuition in the year the bonds are redeemed. If you are allowed to exclude the interest from income for regular tax purposes (33.4), the interest must still be included for purposes of the allowance phaseout.
• Employer-provided adoption assistance that is a tax-free fringe benefit (Chapter 3). The assistance must be included in MAGI for purposes of applying the allowance phaseout rule.
• The domestic production activities deduction (40.23).

A rental loss that is carried over because it exceeds the allowance may be deductible in a later year if you continue to meet the active participation test.

Real estate allowance for tax credits. On Form 8582-CR, a deduction equivalent of up to $25,000 may allow a credit that otherwise would be disallowed. You must meet the active participation test in the year the credit arose. The $25,000 allowance is generally subject to the regular MAGI phaseout rule. The special allowance applies to low-income housing and rehabilitation credits even if you do not meet the active participation test.

The deduction equivalent of a credit is the amount which, if allowed as a deduction, would reduce your tax by an amount equal to the credit. For example, a tax credit of $1,000 for a taxpayer in the 25% bracket equals a deduction of $4,000 and would come within the $25,000 allowance provided you actively participated. In the 25% bracket, the equivalent of a $25,000 deduction is a tax credit of $6,250 ($25,000 × 25%). Thus, if you have a rehabilitation credit of $7,000 and you are in the 25% bracket, the $25,000 allowance may allow you to claim $6,250 of the credit, while the balance of the credit would be carried forward to the following year.

If in one year you have both losses and tax credits, the $25,000 allowance applies first to the losses, then to tax credits from rental real estate with active participation, then to tax credits for rehabilitation or low-income housing placed in service before 1990, and finally to tax credits for low-income housing placed in service after 1989.

The allowance and net operating losses. If losses are allowed by the $25,000 allowance but your nonpassive income and other income are less than the loss, the balance of the loss may be treated as a net operating loss and may be carried back and forward; see 40.18 for further details.

10.3 Real Estate Professionals

Real estate rental activities are automatically passive (10.1) for all taxpayers except qualifying real estate professionals. You qualify as a real estate professional if you meet both parts of Test 1 below. If you qualify under Test 1, any rental real estate activity in which you materially participate (Test 2) is not a passive activity. Income or loss from the rental real estate is reported as nonpassive on Schedule E (Form 1040).

You need reliable records to substantiate your hours worked in real property businesses in order to qualify as a real estate professional (Test 1 below), as well as to substantiate your participation in your rental real estate activities (Test 2).

Test 1: Qualifying as a real estate professional. There are two parts to Test 1, and you must meet both of them for the tax year for you to qualify:

1. More than 50% of your personal services in all of your businesses must be performed in real property businesses in which you materially participate (10.6). For this purpose, a real property business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation, management, leasing, or brokerage trade or business. Real estate financing is not included. Personal services performed as an employee are not treated as performed in a real estate business unless you are considered a “more than 5% owner” in the employer. That is, you must own more than 5% of the outstanding stock or more than 5% of total combined voting powers of all stock issued by the corporation. In a noncorporate employer such as a partnership, you must own more than a 5% capital or profit interest.

2. More than 750 hours of your services are in real property businesses in which you materially participate (10.6). You must be able to estabish that you materially participate (under the tests at 10.6) in a real property business in order to count your work in that business towards the 750-hour threshold.

   In one case, a taxpayer claimed that when he was not at his full-time job he was “on call” for working on his four rental properties because he could have been called to do work at any time on the properties, and he argued that the “on call” hours should count towards the 750-hour test. Without the “on call” hours, he could substantiate only 645.5 hours of work on the rentals. The Tax Court held that even if the taxpayer was “on call,” on call hours do not count towards the 750-hour test, since the law requires that the taxpayer actually perform over 750 hours of service.

For purposes of determining hours of material participation under (1) and (2) above, each interest in rental real estate property is treated as a separate activity unless you elect to treat all of your interests as one rental activity. The election to aggregate can make it easier to prove material participation as discussed below. If, under the rules in 10.1, you group a rental real estate activity with a business activity, that rental activity is not treated as rental real estate for purposes of the real estate professional rules.

For a married couple filing jointly, both the “50% of services test” and the “750 hours test” must be met by one of the spouses individually, without regard to the other spouse’s services.

Attorneys who specialize in real estate practice while participating in a rental business may not treat the legal practice as material participation for purposes of qualifying as real estate professionals.

A closely held C corporation qualifies under the real estate professional rules if in a taxable year more than 50% of the gross receipts of the corporation are from a real property business in which the corporation materially participates (10.15).

Test 2: Rental real estate activity material participation. If you qualify as a real estate professional under Test 1 above, you must still show that you materially participate (10.6) in your rental real estate activity(ies) to avoid passive activity treatment. If you have more than one rental real estate activity and elect to aggregate (see below), total participation in all of the activities is combined in applying the material participation tests in 10.6. If an election to aggregate has not been made, material participation must be determined separately for each rental property.

Election to aggregate rental real estate activities. For purposes of Test 2 (rental real estate material participation), you may elect to aggregate all of your rental real estate activities for any year you qualify under Test 1 as a real estate professional. You elect to aggregate by attaching a statement to your original tax return for the year. The required election statement must contain a declaration that you are a qualifying real estate professional and are treating all of your rental real estate activities as a single activity under Internal Revenue Code Section 469(c)(7)(A). The election is binding for all future years in which you qualify as a real estate professional, even if there are intervening years in which you do not qualify. In the nonqualifying years, the election has no effect. You may not revoke the election in a later year unless there has been a material change in circumstances that you explain in a statement attached to your original return for the year of revocation. That the election no longer gives you a tax advantage is not a basis for a revocation.

If the election to aggregate is made and there is net income for the aggregated activity, the income may be offset by prior-year suspended losses from any of the aggregated rental real estate activities regardless of which of the rental activities produced the income.

Late elections. If you do not make the election to aggregate on your original return, Revenue Procedure 2011-34 allows you to make a late election on an amended return if you (1) had reasonable cause for not meeting the original deadline; (2) took positions on your tax returns as if the election to aggregate had been timely made—consistent filing is required for all years including and following the year the requested aggregation is to be effective; and (3) timely filed all the returns that would have been affected by the election had it been timely made. Returns filed within six months of the original due date (without extensions) are treated as timely filed for this purpose.

If you meet tests 1–3, you should attach a statement to an amended return for the most recent tax year and mail it to the IRS service center where your current year return will be filed. The statement must include the required aggregation declaration that you are a qualified real estate professional and are making the election to aggregate pursuant to Code Section 469(c)(7)(A). It must also declare that tests 1–3 have been met and explain what the reasonable cause was for not making a timely election. The statement must be dated and signed under penalties of perjury. At the top, write “FILED PURSUANT TO REV. PROC. 2011-34.” Even if the IRS grants relief to make the late election, the IRS can later challenge whether you met the real estate professional and material participation tests, or whether the eligibility requirements of Revenue Procedure 2011-34 were met.

Rental loss allowance may apply to nonqualifying rental activity. A real estate professional may also be able to claim all or part of the $25,000 rental loss allowance (10.2). For example, you are a real estate professional and meet the material participation test for one rental real estate activity but not for another and do not elect to aggregate. Losses from the nonqualifying activity can qualify for the rental allowance. Furthermore, suspended prior year losses from the qualifying activity may also be deductible under the rental loss allowance, as illustrated in the Example below.

Interests in S corporations and partnerships. Your interest in rental real estate held by a partnership or an S corporation is treated as a single interest in rental real estate if the entity grouped its rental real estate as one rental activity. If not, each rental real estate activity of the entity is treated as a separate interest in rental real estate. However, you may elect to treat all interests in rental real estate, including the rental real estate interests held by an S corporation or partnership, as a single rental real estate activity.

If you hold a 50% or greater interest in the capital, income, gain, loss, deduction, or credit in a partnership or S corporation for the taxable year, each interest in rental real estate held by the entity is treated as a separate interest in rental real estate, regardless of the entity’s grouping of activities. However, you may elect to treat all interests in rental real estate, including your share of the rental real estate interests held by the entities, as a single rental real estate activity.

Limited partners. Generally, a person who has a limited partnership interest (10.11) in rental real estate must establish material participation by participating for more than 500 hours during the year (Test 1 in 10.6) or meeting Test 5 or Test 6 in 10.6. These material participation tests also generally apply if an election is made to aggregate limited partnership interests in rental real estate with other rental real estate interests. However, the requirement that material participation can be established only under Tests 1, 5, or 6 may be avoided under a de minimis exception, which applies if the election to aggregate is made and less than 10% of the gross rental income for the taxable year from all rental real estate activities is attributed to limited partnership interests. In such a case, you may make the election to aggregate all rental real estate activities and determine material participation for the aggregated activity under any of the seven material participation tests (10.6).

10.4 Participation May Avoid Passive Loss Restrictions

To avoid passive activity treatment of income and loss from a business investment, you must show material participation in that activity. The word “activity” does not necessarily relate to one specific business. If you invest in several businesses, you may be able to treat all or some of those activities as one activity or treat each separately.

Determining aggregate or separate treatment for your activities is discussed in 10.5 and material participation tests are discussed in 10.6.

For a rental activity, material participation tests apply only if you are trying to qualify for the passive activity exception for real estate professionals (10.3). For other rental real estate operators or investors, an “active” participation test that requires only certain management duties may allow you to deduct rental losses of up to $25,000 (10.2).

10.5 Classifying Business Activities as One or Several

If you are in more than one activity, determining aggregate or separate treatment is important for:

• Deducting suspended losses when you dispose of an activity. If the activity is considered separate from the others, you may deduct a suspended loss incurred from that activity when you dispose of it. If it is not separate from the others, the suspended loss is deductible only if you dispose of substantially all of your investment (10.13).
• Applying the material participation rules (10.6). If activities are separate and apart from each other, the material participation tests are applied to each activity separately. If the activities are aggregated as one activity, material participation in one activity applies to all.
• Determining if you meet the 10% interest requirement for active participation (10.2).

Grouping activities together. You may use any reasonable method under the facts and circumstances of your situation to determine if several business activities should be grouped together or treated separately. To be grouped together, the IRS says that the activities should be “an appropriate economic unit” for measuring gain or loss. For making this determination, the IRS sets these general guidelines: (1) similarities and differences in types of business; (2) the extent of common control; (3) geographic location; (4) the extent of common ownership; and (5) interdependencies among the activities. Interdependency is measured by the extent to which several business activities buy or sell among themselves, use the same products or services, have the same customers and employees, or use a single set of books and records.

You must report new groupings and regroupings to the IRS. You must file a statement with your return for the first year in which you originally group two or more activities together. The statement must identify the activities (including, if applicable, the employer identification number (EIN)) and must specifically state that the grouped activities are an appropriate economic unit as discussed in the previous paragraph. You also must file a statement with your return for any year in which you add a new activity to an existing group, or for any year in which you regroup activities. When activities are regrouped, the statement must explain how a material change in the facts and circumstances has made the original grouping “clearly inappropriate.” See the instructions to Form 8582 and Revenue Procedure 2010-13 for further details on these disclosure requirements.

Rental activities. Rental activities may not be grouped with business activities unless one of the exceptions discussed in 10.1 applies.

IRS may regroup activities. The IRS may regroup your activities if your grouping does not reflect one or more appropriate economic units and a primary purpose of the grouping is to circumvent the passive loss rules.

Partnerships and S corporations. A partnership or S corporation must group its activities under the facts and circumstances test. Once a partnership or S corporation determines its activities, the partners or shareholders are bound by that decision and may not regroup them. The partners and shareholders then apply the facts and circumstances test to combine the partnership or S corporation activities with, or separate them from, their other activities.

Special rule for certain limited partners and limited entrepreneurs. A limited entrepreneur is a person with an ownership interest who does not actively participate in management. A limited entrepreneur or limited partner in films, videotapes, farming, oil and gas, or the renting of depreciable property generally may combine each such activity only with another of such activities in the same type of business, and only if he or she is a limited entrepreneur or partner in both. Grouping of such activities with other activities in the same type of business in which he or she is not a limited partner or entrepreneur is allowed if the grouping is appropriate under the general facts and circumstances test.

10.6 Material Participation Tests for Business

The IRS has seven tests for determining material participation in a business. Some tests require only a minimum amount of work, such as 500 hours a year, and others only 100 hours. You need to meet only one of the seven tests to qualify as a material participant. If you do, then the income and loss from that business is treated as nonpassive.

The tests apply whether you do business as a sole proprietor or in an S corporation or partnership. Losses and credits passed through S corporations and partnerships are subject to passive activity rules.

If you are a limited partner, the law presumes that you are not a material participant in the activities of the limited partnership, but IRS regulations provide a limited opportunity to show that you materially participate. Only three of the seven material participation tests are available to you; see 10.11.

The impact of the IRS participation rules on your tax position will depend on whether the particular activity produces income or loss. If you have passive activity losses from other activities, you may prefer to have a profitable business activity treated as a passive activity in order to offset the income by the losses from passive activities. On the other hand, if the business activity operates at a loss and you do not have passive income from other sources, you may want to meet the material participation test for that business activity in order to claim current loss deductions. IRS strategy in reviewing your activities would be the opposite. If your return were under audit, an agent would attempt to prevent you from treating income from a business activity as passive. For example, the IRS, by applying Tests 5 and 6, can prevent a retired person from treating post-retirement income from a prior business or profession as passive income that could offset passive losses from another activity. If you realize a loss in one passive activity, Test 4 may prevent you from generating passive income by merely reducing your participation in another activity.

Material participation results in nonpassive treatment. There are two key terms: material participation and significant participation. If you materially participate by meeting one of the seven IRS tests, your activity is not a passive activity. For example, under Test 1, work for more than 500 hours in an activity is considered material participation. Under Test 4, significant participation is work for more than 100 hours but less than 500 hours at an activity in which you do not otherwise materially participate. The IRS applies a significant participation rule to convert passive activity income into nonpassive income and to convert several significant participation activities into material participation if the total participation in those activities exceeds 500 hours; see Test 4.

IRS Tests for Material Participation

If you meet one of the following tests for the year in question, you are considered to have materially participated in that activity, and therefore the activity is considered nonpassive for that year. Tests 5 and 6 prevent retired individuals from treating post-retirement income as passive income.

Rules for limited partners and members of LLCs and LLPs are at 10.11. For participation rules for personal service and closely held corporations, see 10.15.

Work by you or your spouse that counts as participation. Apart from the exceptions listed below, any work you do in a business in which you have an ownership interest is treated as “participation.” If you are married, work by your spouse in the activity during the tax year is generally treated as participation by you. This is true even if your spouse does not own an interest in the business or if you file separately. However, this favorable spousal participation rule does not apply if you and your spouse elect to treat your jointly owned business as a qualified joint venture, thereby requiring each of you to report your respective shares of the business income, deductions, credits, gains, and losses on Schedule E; see 9.1 and the Schedule E instructions.

Do not count the following types of work as participation:

1. Work that is not of a type customarily done by an owner of an activity, if one of the principal reasons for the performance of the work is to avoid the passive loss rules (see the Example below).
2. An investor’s review of financial statements or analysis that is unrelated to day-to-day management or operation of the activity.

10.7 Tax Credits of Passive Activities Limited

You may generally not claim a tax credit from a passive activity unless you report and pay taxes on income from a passive activity. Furthermore, the tax allocated to that income must be at least as much as the credit. If the tax credit exceeds your tax liability on income allocable to passive activities, the excess credit is not allowed. Use Form 8582-CR to figure the allowable credit. Suspended credits are not allowed when property is disposed of. The credits may be used only when passive income is earned.

Credits for real estate activities. More favorable tax credit rules apply to real estate activities (10.2).

Basis adjustment for suspended credits. If the basis of property was reduced by tax credits, you may elect on Form 8582-CR to add back a suspended credit to the basis when your entire interest in an activity is disposed of. If the property is disposed of in a transaction that is not treated as a fully taxable disposition (10.13), then no basis adjustment is allowed.

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 on Form 8582 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.

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) wages, salaries and other 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. On Form 8582, you can offset passive income of an activity with deductible expenses that are related to the activity, such as real property taxes. Deductible expenses from prior years that were disallowed by the passive loss rules and carried forward to the current year are added to the current year deductions. 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% of 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.

10.9 Passive Income Recharacterized as Nonpassive Income

There is an advantage in treating income as passive income when you have passive losses that may offset the income. However, the law may prevent you from treating certain income as passive income. The conversion of passive income to nonpassive income is technically called “recharacterization.” This may occur when you do not materially participate in the business activity, but are sufficiently active for the IRS to consider your participation as significant. Recharacterization may also occur when you rent property to a business in which you materially participate, rent nondepreciable property, or sell development rental property.

Significant participation. The IRS compares income and losses from all of your activities in which you work more than 100 hours but less than 500 and that are not considered material participation under the law. If you show a net aggregate gain, part of your gain is treated as nonpassive income according to the computation illustrated in the following Example.

Net interest income from passive equity-financed lending. Gross income from “equity-financed lending activity” is treated as nonpassive income to the extent of the lesser of the equity-financed interest income or net passive income. An activity is an “equity-financed lending activity” for a tax year if (1) the activity involves a trade or business of lending money and (2) the average outstanding balance of the liabilities incurred in the activity for the tax year does not exceed 80% of the average outstanding balance of the interest-bearing assets held in the activity.

Incidental rental of property by development activity. Where gains on the sale of rental property are attributable to recent development, passive income treatment may be lost if the sale comes within the following tests: (1) the rental started less than 12 months before the date of disposition; and (2) you materially participated or significantly participated in the performance of services enhancing the value of the property. The 12-month period starts at the completion of the development services that increased the property’s value.

Self-rental rule: Renting to your business. If you rent a building to your business, the rental income, normally treated as passive income, may be recharacterized by the IRS as nonpassive income where you also have losses from other rentals. Recharacterization prevents you from deducting the rental losses against the net rental income. Although not specifically written into the law, the recharacterization rules are incorporated in IRS regulations. For the recharacterization rule to apply, you must “materially participate” in the business renting the property; see the following Examples. The Tax Court and several federal appeals courts have upheld the IRS recharacterization rule.

Rental of property with an insubstantial depreciable basis. This rule prevents you from generating passive rental income with vacant land or land on which a unit is constructed that has a value substantially less than the land. If less than 30% of the unadjusted basis (5.16) of rental property is depreciable, and you have net passive income from rentals (taking into account carried-over passive losses from prior years), the net passive income is treated as nonpassive income.

Licensing of intangible property. Your share of royalty income in a partnership, S corporation, estate, or trust is treated as nonpassive income if you invested after the organization created the intangible property, performed substantial services, or incurred substantial costs in the development or marketing of it. See Publication 925 for further details.

10.10 Working Interests in Oil and Gas Wells

Working interests are not treated as passive activities provided your liability is not limited. This is true whether you hold your interest directly or through an entity. As long as you have unlimited liability, the working interest is not a passive activity even if you do not materially participate in the activity. A working interest is one burdened with the financial risk of developing and operating the property, such as a share in tort liability (for example, uninsured losses from a fire); some responsibility to share in additional costs; responsibility for authorizing expenses; receiving periodic reports about drilling, completion, and expected production; and the possession of voting rights and rights to continue operations if the present operator steps out.

Limited liability. If you hold a working interest through any of the following entities, the entity is considered to limit your liability and you are subject to the passive loss rules: (1) a limited partnership interest in a partnership in which you are not a general partner; (2) stock in a corporation; or (3) an interest in any entity other than a limited partnership or corporation that, under applicable state law, limits the liability of a holder of such interest for all obligations of the entity to a determinable fixed amount.

Working interests are considered on a well-by-well basis. Rights to overriding royalties or production payments, and contract rights to extract or share in oil and gas profits without liability for a share of production costs, are not working interests.

10.11 Partners and Members of LLCs and LLPs

As a general partner, your share of partnership income or loss during the partnership year ending within your tax year is passive or nonpassive, depending on whether you materially participated under any of the seven IRS tests(10.6) in the partnership activities during the year. Limited partners have a reduced ability to show material participation as discussed below. On Schedule K-1 of Form 1065, the partnership will identify each activity it conducts and specify the income, loss, deductions, and credits from each activity.

Not treated as passive income are payments for services and certain guaranteed payments made in liquidation of a retiring or deceased partner’s interest unless attributed to unrealized receivables and goodwill at a time the partner was passive.

Gain or loss on the disposition of a partnership interest may be attributed to different trade, investment, or rental activities of the partnership. The allocation is made according to a complicated formula included in IRS regulations.

Payments to a retired partner. Gain or loss is treated as passive only to the extent that it would be treated as such at the start of the liquidation of the partner’s interest.

Limited partners. Under IRS regulations, a limited partner has only a limited opportunity to establish material participation. A limited partner may use only three of the seven tests to establish material participation and thereby avoid passive treatment for the partnership income or loss:

1. The limited partner participates for more than 500 hours during the tax year; see Test 1 (10.6), or
2. The limited partner materially participated in the partnership during prior years under either Test 5 or Test 6 (10.6).

To determine material participation in rental real estate activities under the special rules for real estate professionals, a limited partner must meet Test 1, Test 5, or Test 6 (10.6), but see the de minimis exception at 10.3.

A limited partner is not considered to be an “active participant” and thus does not qualify for the $25,000 rental loss allowance (10.2).

Who is a limited partner? The current regulations treat a partner other than a general partner as a limited partner if his or her liability is limited under state law. However, the focus would shift from limited liability to management rights under regulations that the IRS proposed in 2011 but had not finalized when this book was completed. The IRS acknowledged that a new test for determining limited partner status is necessary given the emergence of LLCs and changes in state law that allow limited partners to make management decisions while retaining limited liability.

Under the proposed regulations, a taxpayer’s interest in an entity that is classified as a partnership is treated as a limited partnership interest if the taxpayer does not have rights to manage the partnership under both the governing agreement and under the law of the jurisdiction in which the partnership was organized. A taxpayer who is treated as a limited partner under this definition would have to establish material participation under Test 1, 5, or 6 as noted above. A taxpayer who has management rights and who is not treated as a limited partner would be able to establish material participation under any of the seven material participation tests described in 10.6. The e-Supplement at jklasser.com will report any change in the status of the proposed regulations.

LLC and LLP members. The Tax Court and the Court of Federal Claims rejected IRS attempts to treat LLC and LLP members as limited partners under the regulations that focus on limited liability. These court decisions allowed an LLC or LLP member to apply any of the IRS’ seven tests for material participation (10.6).

The IRS acquiesced after the result in the Court of Federal Claims case and announced that it would no longer litigate similar cases. This was followed by the release of the 2011 proposed regulations discussed above.

10.12 Form 8582 and Other Tax Forms

The purpose of Form 8582 is to assemble in one place items of income and expenses from passive activities in order to determine the effect of the passive loss rules on these items. Note that if you actively participate in a rental real estate activity and therefore qualify for the special loss allowance of up to $25,000, you may not have to complete Form 8582; see the conditions under “Schedule E” below.

After Form 8582 is completed, the income and allowable deductions are reported as regular income and deductions in appropriate schedules attached to your tax return. For example, net profits of a self-employed person who is not active in the business are reported on Schedule C, sales of capital assets of a passive activity are reported on Form 8949 and Schedule D, your share of partnership income and allowable deductions is reported on Schedule E, and rental income and allowable deductions are reported on Schedule E.

Forms 8949 & Schedule D or Form 4797. Gains or losses from the sale of assets from a passive activity or from the sale of a partial interest that is less than “substantially all” of your entire interest in a passive activity are reported on Form 8949/Schedule D (capital assets) or on Form 4797 ( business property). The gain is also entered on Form 8582. Losses must first be entered on Form 8582 to see how much, if any, is allowable under the passive loss restrictions before an amount can be entered as a loss on Form 8949/Schedule D or Form 4797.

Partial dispositions. A disposition of an insubstantial part of your interest in the activity does not allow a deduction of suspended passive losses from prior years. When you dispose of your entire interest in a passive activity to a nonrelated party in a fully taxable transaction, your losses for the year plus prior year suspended losses from the activity are fully deductible. The same rule applies to a partial disposition only if you are disposing of substantially all of the activity and you have proof of the current year and prior year suspended losses allocable to the disposed-of portion. You net the gain or loss from the disposition with the net income or loss from current year operations and any prior year suspended passive losses. If the netting gives you an overall gain, you enter the gain from the sale, the current year income or loss, and any prior year unallowed losses on the appropriate lines of the Worksheets attached to Form 8582; see the Form 8582 instructions. If you have an overall loss after the netting, you do not file Form 8582; all losses including prior year unallowed losses are reported on the normally used forms and schedules (Schedule E, Form 8949 and Schedule D, or Form 4797).

Schedule E. If you have a net profit from rental real estate or other passive activity reported on Schedule E and you also have losses from other passive activities, the income reported on Schedule E is also entered on Form 8582.

If you have a net loss on Schedule E (on Line 21) from a rental real estate activity subject to the passive activity rules, the loss generally must be entered on Form 8582. If a loss is allowable after application of the passive loss limits, the allowable amount from Form 8582 is entered on Line 22 of Schedule E as your deductible rental loss.

` You do not have to complete Form 8582 if you qualify for the rental real estate loss allowance of up to $25,000 (you actively participated in the rental activity; see 10.2 ) and you meet all of these conditions:

• Your only passive activities are rental real estate activities and you have no suspended prior year passive losses from these or any other passive activities;
• You have no credits related to passive activities;
• Your overall net loss from the rental real estate activities is $25,000 or less ($12,500 or less if married filing separately and you lived apart from your spouse all year);
• Your modified adjusted gross income is $100,000 or less ($50,000 or less if married filing separately and you lived apart from your spouse all year); and
• You do not own any interest in a rental real estate activity as a limited partner or beneficiary of a trust or estate.

If you meet the above conditions, your rental real estate losses are not limited by the passive activity rules and you do not need to complete Form 8582. Enter the loss from Line 21 of Schedule E as the deductible rental real estate loss on Line 22.

If you have a loss from a passive interest in a partnership, trust, estate, or S corporation, you first determine on Form 8582 whether the loss is deductible on Schedule E.

Schedule F. A passive activity farm loss is entered on Form 8582 to determine the deductible loss. If only part of the loss is allowed, only that portion is claimed on Schedule F. A net profit from passive farm activities is also entered on Form 8582 to offset losses from other passive activities.

Other tax forms. Other forms tied to Form 8582 are Form 4797 (sale of business assets or equipment), Form 4835 (farm rental income), and Form 4952 (investment interest deductions). For further details see Form 8582 and its instructions.

10.13 Suspended Losses Allowed on Disposition of Your Interest

Losses and credits that may not be claimed in one year because of the passive activity limitations are suspended and carried forward to later years. The carryover lasts indefinitely, until you have passive income against which to claim the losses and credits. No carryback is allowed. What if you have suspended losses from a business and in a later year you materially participate in the business so it is no longer a passive activity? If the activity is not passive in the current year, and you have net income from the activity for the year, you can offset that income with the suspended losses. Any remaining suspended losses continue to be carried forward to future years. Generally, you may deduct in full your remaining suspended losses when you sell your entire interest in the activity; see below.

Allocation of suspended loss. If your suspended loss is incurred from several activities, you allocate the loss among the activities using the worksheets accompanying Form 8582. The loss is allocated among the activities in proportion to the total loss. If you have net income from significant participation activities (see Test 4 (10.6)), such activities may be treated as one single activity in making the allocation; see the instructions to Form 8582.

Disposition of entire interest in passive activity. If you sell your entire interest in an activity to a nonrelated person in a fully taxable transaction, you can claim the suspended losses from the activity. On a qualifying disposition, the suspended losses plus any current year income or loss from the activity are combined with the gain or loss from the sale; see the Examples below and follow the instructions to Form 8582 for reporting the net gain or loss.

A “fully taxable transaction” is one in which you recognize all the realized gain or loss. In some cases, it may be unclear if a fully taxable transaction has occurred. The IRS treats an abandonment of property as a qualifying disposition that releases suspended losses.

IRS Chief Counsel has held that there is a fully taxable disposition when you sell at a gain rental property that previously had been your principal residence and the gain is not taxable under the home sale exclusion (29.1). A taxpayer had $30,000 in suspended passive losses from three years of rentals when the home was sold to an unrelated party for a $100,000 gain. Since gain or loss on a disposition must be “recognized” for there to be a “fully taxable transaction,” the issue before the IRS was whether tax-free home sale gain is “recognized.” Chief Counsel held that the taxpayer’s home sale gain was realized and recognized; it was simply excluded from income because of the specific exclusion provision. The $30,000 in suspended losses were deductible in the year of sale. Since the $100,000 home sale gain was excluded from income, it was not considered passive income from the rental property and did not offset the $30,000 of suspended losses.

IRS Chief Counsel has also held that a foreclosure on rental real estate subject to recourse debt is a fully taxable transaction, even though the taxpayer avoids tax on the cancellation of his debt because he is insolvent (11.8). A foreclosure is treated as a sale for tax purposes (31.9); here, the taxpayer realized a $25,000 gain on the foreclosure. He also had cancellation of debt income of $75,000, which was not taxed because of the insolvency exclusion. Chief Counsel concluded that since a foreclosure is a taxable sale, a foreclosure of property constituting the taxpayer’s interest in the rental property qualifies as a fully taxable transaction under the passive activity disposition rules. This is so whether or not the taxpayer avoids tax on cancellation of debt income due to the insolvency exclusion.

Partial disposition. If you dispose of substantially all of your interest in an activity, you may treat the part disposed of as a separate activity, thereby allowing the deduction of suspended losses. You must show: (1) the amount of prior year suspended deductions and credits allocable to that part of the activity, and (2) the amount of gross income and any other deductions and credits allocable to that part of the activity for the year of disposition.

If the part disposed of is less than substantially all of your interest, suspended losses are not allowed. Gain or loss will be treated as part of the net income or loss from the activity for the year.

Gifts. When a passive activity interest is given away, you may not deduct suspended passive losses. The donee’s basis in the property is increased by the suspended loss if he or she sells the property at a gain. If a loss is realized by the donee on a sale of the interest, the donee’s basis may not exceed fair market value of the gift at the time of the donation.

Death. On the death of an investor in a passive interest, suspended losses are deductible on the decedent’s final tax return, to the extent the suspended loss exceeds the amount by which the basis of the interest in the hands of the heir is increased.

Installment sales. If you sell your entire interest in a passive activity at a profit on the installment basis, suspended losses are deducted over the installment period in the same ratio as the gain recognized each year bears to the gain remaining to be recognized as of the start of the year. For example, if you realize a gain of $10,000 and report $2,000 of gain each year for five years, in the year of sale you report 20% of your total gain under the installment method, and 20% of your suspended losses are also allowed. In the second year, you report $2,000 of the remaining $8,000 gain and 25% of the remaining losses ($2,000 ÷ $8,000) are allowed.

10.14 Suspended Tax Credits

If you have tax credits that were barred under the passive activity rules, they may be claimed only in future years when you have tax liability attributable to passive income. However, in the year you dispose of your interest, a special election may be available to decrease your gain by the amount of your suspended credit; see below.

Basis election for suspended credits. If you qualify for an investment credit (under transition rules) or a rehabilitation credit, you are required to reduce the basis of the property even if you are unable to claim the credit because of the passive activity rules. If this occurs and you later dispose of your entire interest in the passive activity, including the property whose basis was reduced, your gain will be increased by virtue of the basis reduction although you never benefitted from the credit. To prevent this, you may reduce the taxable gain by electing to increase the pre-transfer basis of the property by the amount of the unused credit. The election is made on Form 8582-CR.

10.15 Personal Service and Closely Held Corporations

To prevent avoidance of the passive activity rules through use of corporations, the law imposes restrictions on income and loss offsets in closely held C corporations and personal service corporations.

Unless the material participation tests discussed in this section are met, the activities of a personal service corporation or a closely held corporation are considered passive activities, subject to the restrictions on loss deductions and tax credits. For purposes of these passive activity rules, a closely held C corporation is a corporation in which more than 50% in value of the stock is owned by five or fewer persons during the last half of the tax year.

A personal service corporation is a C corporation the principal activity of which is the performance of personal services by the employee-owners. Personal services are services in the fields of health, law, engineering, architecture, accounting, actuarial sciences, performing arts, or consulting. An employee-owner is any employee who on any day in the tax year owns any stock in the corporation. If an individual owns any stock in a corporation which in turn owns stock in another corporation, the individual is deemed to own a proportionate part of the stock in the other corporation. Further, more than 10% of the corporation’s stock by value must be owned by owner-employees for the corporation to be a personal service corporation.

Form 8810 must be used. Personal service corporations and closely held corporations use Form 8810 to figure the amount of the passive activity loss or credit that is allowed on the corporation’s tax return for the year.

Material participation. A personal service corporation or closely held corporation is treated as materially participating in an activity during a tax year only if either:

1. One or more stockholders are treated as materially participating in the activity and they directly or indirectly hold in the aggregate more than 50% of the value of the corporation’s outstanding shares; or
2. The corporation is a closely held corporation and in the 12-month period ending on the last day of the tax year, the corporation had at least one full-time manager, three full-time employees, none of whom own more than 5% of the stock, and business deductions exceeded 15% of gross income from the activity.

A stockholder is treated as materially participating or significantly participating in the activity of a corporation if he or she satisfies one of the seven tests for material participation (10.6). For purposes of applying the significant participation test (Test 4 at 10.6), an activity of a personal service or closely held corporation will be treated as a significant participation activity for a tax year only if:

1. The corporation is not treated as materially participating in the activity for the tax year; and
2. One or more individuals, each of whom is treated as significantly participating in the activity directly or indirectly, hold in the aggregate more than 50% of the value of the outstanding stock of the corporation. Furthermore, in applying the seven participation tests, all activities of the corporation are treated as activities in which the individual holds an interest in determining whether the individual participates in an activity of the corporation; and the individual’s participation in all activities other than activities of the corporation is disregarded in determining whether his or her participation in an activity of the corporation is treated as material participation under the significant participation test (Test 4).

Closely held corporation’s computation of passive loss. Even if a closely held corporation does not meet the material participation tests above, it still qualifies for a slight break from the passive loss restrictions. On Form 8810, a closely held corporation may use passive activity deductions to offset not only passive activity gross income but also net active income. Generally, net active income is taxable income from business operations, disregarding passive activity income and expenses, and also disregarding portfolio income and expenses (10.8). Passive activity losses cannot offset portfolio income.

If a corporation stops being closely held, its passive losses and credits from prior years are not allowable against portfolio income but continue to be allowable only against passive income and net active income.

Tax liability on net active income may be offset by passive activity credits.

10.16 Sales of Property and of Passive Activity Interests

Gain on the sale or disposition of property is generally passive or nonpassive, depending on whether your activity is passive or nonpassive in the year of sale or disposition. Thus, gain on the sale of property used in a rental activity is generally treated as passive income, as is the gain on property used in a nonrental business if you did not materially participate in the business in the year of sale. On the other hand, gain on the sale of property is generally nonpassive if the property was used in a business that you materially participated in during the year of sale. However, exceptions described below may change this treatment.

Where you transact an installment sale, treatment of gain in later years depends on your status in the year of sale. For example, if you were considered a material participant in a business, all gain is treated as nonpassive income, including gain for later installments. If you were in a rental activity or were not a material participant in a nonrental business, the gain is treated as passive income, unless the exceptions in this section apply.

Gain on substantially appreciated property formerly used in nonpassive activity. Even if an activity is passive in the year that you sell substantially appreciated property, gain on the sale is treated as nonpassive unless the property was used in a passive activity for either 20% of its holding period or the entire 24-month period ending on the date of the disposition. Property is substantially appreciated if fair market value exceeds 120% of its adjusted basis.

Property used in more than one activity in a 12-month period preceding disposition. You are required to allocate the amount realized on the disposition and the adjusted basis of the property among the activities in which the property was used during a 12-month period preceding the disposition. For purposes of this rule, the term “activity” includes personal use and holding for investment. The allocation may be based on the period for which the property is used in each activity during the 12-month period. However, if during the 12-month period the value of the property does not exceed the lesser of $10,000 or 10% of the value of all property used in the activity at the time of disposition, gain may be allocated to the predominant use.

Disposition of partnership and S corporation interests. Gain or loss from the disposition of an interest in a partnership and S corporation is generally allocated among the entity’s activities in proportion to the amount that the entity would have allocated to the partner or shareholder for each of its activities if the entity had sold its interest in the activities on the “applicable valuation date” chosen by the entity, either the date of the disposition or the beginning of the entity’s taxable year in which the disposition occurs.

Gain is allocated only to appreciated activities. Loss is allocated only to depreciated activities. The entity may select either the beginning of its tax year in which the holder’s disposition occurs or the date of the disposition as the applicable valuation date.

Claiming suspended loss on disposition of interest in passive activity. A fully taxable sale of your entire interest or of substantially all of your interest to a nonrelated person will allow you to claim suspended loss deductions from the activity (10.13).

Dealer’s sale of property similar to property sold in the ordinary course of business. IRS regulations set down complex tests that determine whether the result of the sale is treated as passive or nonpassive income or loss.

10.17 At-Risk Limits

The at-risk rules prevent investors from claiming losses in excess of their actual tax investment by barring them from including nonrecourse liabilities as part of the tax basis for their interest. Almost all ventures are subject to the at-risk limits. Real estate placed in service after 1986 is subject to the at-risk rules as well, but most real estate nonrecourse financing can qualify for an exception (10.18).

Losses disallowed under the at-risk rules are carried over to the following year (10.21).

Form 6198. If you have amounts that are not at risk, you must file Form 6198 to figure your deductible loss. A separate form must be filed for each activity. However, if you have an interest in a partnership or S corporation that has more than one investment in any of the following four categories, the IRS allows you to aggregate all of the partnership or S corporation activities within each category. For example, all partnership or S corporation films and videotapes may be treated as one activity in determining amounts at risk; see the instructions to Form 6198.

1. Holding, producing, or distributing motion picture films or videotapes;
2. Exploring for or exploiting oil or gas properties;
3. Exploring for, or exploiting, geothermal deposits (for wells commenced on or after October 1, 1978); and
4. Farming. For this purpose, farming is defined as the cultivation of land and the raising or harvesting of any agricultural or horticultural commodity—including raising, shearing, breeding, caring for, or management of animals. Forestry and timber activities are not included, but orchards bearing fruits and nuts are within the definition of farming. Certain activities carried on within the physical boundaries of the farm may not necessarily be treated as farming.

In addition to the previous categories, the law treats as a single activity all leased depreciable business equipment (Section 1245 property) that is placed in service during any year by a partnership or S corporation.

Exempt from the at-risk rules are C corporations which meet active business tests and are not in the equipment leasing business or any business involving master sound recording, films, videotapes, or other artistic, literary, or musical property. For details on the active business tests, as well as a special at-risk exception for equipment leasing activities of closely held corporations, see IRS Publication 925.

The at-risk limitation applies only to tax losses produced by expense deductions that are not disallowed by reason of another provision of the law. For example, if a prepaid interest expense is deferred under the prepaid interest limitation (15.14), the interest will not be included in the loss subject to the risk limitation. When the interest accrues and becomes deductible, the expense may be considered within the at-risk provision. Similarly, if a deduction is deferred because of farming syndicate rules, that deduction will enter into the computation of the tax loss subject to the risk limitation only when it becomes deductible under the farming syndicate rules.

Effect of passive loss rules. Where a loss is also subject to the at-risk rules, you apply the at-risk rules first. If the loss is deductible under the at-risk rules, the passive activity rules then apply. On Form 6198 (at risk), you figure the deductible loss allowed as at risk and then carry the loss over to Form 8582 to determine the passive activity loss.

10.18 What Is At Risk?

The following amounts are considered at risk in determining your tax position in a business or investment:

• Cash;
• Adjusted basis of property that you contribute; and
• Borrowed funds for which you are personally liable for repayment.

Personal liability alone does not assure that the borrowed funds are considered at risk. The lender generally must have no interest in the venture other than as a creditor and must not be related to a person (other than the borrower) with an interest in the activity other than that of a creditor. Under final IRS regulations, a lender or person related to the lender is considered to have an interest other than that of a creditor only if the person has a capital interest in the activity or an interest in the net profits of the activity. However, even if the lender has such an interest, a loan after May 3, 2004, for which you are personally liable is treated as at risk if: (1) the loan is secured by real estate used in the activity and (2) the loan, were it nonrecourse, would be qualified nonrecourse financing, as discussed below.

At-risk basis is figured as of the end of the year. Any loss allowed for a year reduces the at-risk amount as of the start of the next year. Therefore, if a loss exceeds your at-risk investment, the excess loss will not be deductible in later years unless you increase your at-risk investment; see the Example below and 10.21.

Qualified nonrecourse financing for real estate considered at risk. Generally, you are not considered at risk for nonrecourse financing, that is, loans for which you are not personally liable, unless the loan is secured by property not used in the activity. However, you are considered to be at risk for qualified nonrecourse financing. This is financing from an unrelated commercial lender or government agency for which no one is personally liable and which is secured by real estate used in the activity. The debt obligation must not be convertible to an ownership interest. In determining whether the financing is secured only by real property used in the activity, you can ignore security that is property valued at less than 10% of the total value of all property securing the financing, as well as property that is incidental to the activity of holding real property. Loans from the seller or promoter do not qualify. Third-party nonrecourse debt from a related lender, other than the seller or promoter, may also be treated as at risk, providing the terms of the loan are commercially reasonable and on substantially the same terms as loans involving unrelated persons.

Pledges of other property. If you pledge personally owned real estate used outside the activity to secure a nonrecourse debt and invest the proceeds in an at-risk activity, the proceeds may be considered part of your at-risk investment. The proceeds included in basis are limited by the fair market value of the property used as collateral (determined as of the date the property is pledged as security) less any prior (or superior) claims to which the collateral is subject.

Partners. A partner is treated as at-risk to the extent that basis in the partnership is increased by the share of partnership income. That partnership income is then used to reduce the partnership’s nonrecourse indebtedness will have no effect on a partner’s amount at risk. If the partnership makes actual distributions of the income in the taxable year, the amount distributed reduces the partner’s amount at risk. A buy-sell agreement, effective at a partner’s death or retirement, is not considered for at-risk purposes.

10.19 Amounts Not At Risk

The following may not be treated as part of basis for at-risk purposes in determining your tax position in a business or investment:

• Liabilities for which you have no personal liability, except in the case of certain real estate financing (10.18).
• Liabilities for which you have personal liability, but the lender also has a capital or profit-sharing interest in the venture; but see the exception in 10.18.
• Recourse liabilities convertible to a nonrecourse basis.
• Money borrowed from a relative listed in 5.6 who has an interest in the venture, other than as a creditor, or from a partnership in which you own more than a 10% interest.
• Funds borrowed from a person whose recourse is solely your interest in the activity or property used in the activity.
• Amounts for which your economic loss is limited by a nonrecourse financing guarantee, stop-loss agreement, or other similar arrangement.
• Investments protected by insurance or loss reimbursement agreement between you and another person. If you are personally liable on a mortgage but you separately obtain insurance to compensate you for any mortgage payments, you are at risk only to the extent of the uninsured portion of the personal liability. You may, however, include as at risk any amount of premium paid from your personal assets. Taking out casualty insurance or insurance protecting you against tort liability is not considered within the at-risk provisions, and such insurance does not affect your investment basis.

Limited partner’s potential cash call. Under the terms of a partnership agreement, limited partners may be required to make additional capital contributions under specified circumstances. Whether such a potential cash call increases the limited partner’s at-risk amount has been a matter of dispute.

In one case, the IRS and Tax Court held that a limited partner was not at risk with respect to a partnership note where, under the terms of the partnership agreement, he could be required to make additional capital contributions if the general partners did not pay off the note at maturity. The possibility of such a potential cash call was too uncertain; the partnership might earn profits to pay off the note and even if there were losses, the general partners might not demand additional contributions from the limited partners.

However, a federal appeals court reversed, holding that the limited partner was at risk because his obligation was mandatory and “economic reality” insured that the general partners would insure their rights by requiring the additional capital contribution.

In another case, limited partners relied upon the earlier favorable federal appeals court decision to argue that they were at risk where they could be required by the general partners to make additional cash contributions, but only in order to cover liabilities or expenses that could not be paid out of partnership assets. So long as the partnership was solvent, the limited partners could “elect out” of the call provision. Because of this election, the Tax Court held that the limited partners’ obligation was contingent, rather than unavoidable as in the earlier federal appeals court case. Thus, the cash call provision did not increase their at-risk amount.

10.20 At-Risk Investment in Several Activities

If you invest in several activities, each is generally treated separately when applying the at-risk limitation on Form 6198. You generally may not aggregate basis, gains, and losses from the activities for purposes of at-risk limitations. Thus, income from one activity may not be offset by losses from another; the income from one must be reported while the losses from the other may be nondeductible because of at-risk limitations.

However, you may aggregate activities that are part of a business you actively manage. Activities of a business carried on by a partnership or S corporation qualify if 65% or more of losses for the year are allocable to persons who actively participate in management.

The law allows partnerships and S corporations to treat as a single activity all depreciable equipment (Section 1245 property) that is leased or held for lease and placed in service in any tax year. Furthermore, you may aggregate all partnership or S corporation activities within the four categories of films and videotapes, oil and gas properties, geothermal properties, and farms (10.17).

10.21 Carryover of Disallowed Losses

A loss disallowed in a current year by the at-risk limitation may be carried over and deducted in the next taxable year, provided it does not fall within the at-risk limits or the passive loss limits in that year. The loss is subject to an unlimited carryover period until there is an at-risk basis to support the deduction. This may occur when additional contributions are made to the business or when the activity has income which has not been distributed.

Gain from the disposition of property used in an at-risk activity is treated as income from the activity. In general, the reporting of gain will allow a deduction for losses disallowed in previous years to be claimed in the year of disposition.

10.22 Recapture of Losses Where At Risk Is Less Than Zero

To prevent manipulation of at-risk basis after a loss is claimed, there is a special recapture rule. If the amount at risk in an activity is reduced to below zero because of a distribution or a change in the status of an indebtedness from recourse to nonrecourse, income may be realized to the extent of the negative at-risk amount. The taxable amount may not exceed the amount of losses previously deducted.

The recaptured amount is not treated as income from the activity for purposes of determining whether current or suspended losses are allowable. Instead, the recaptured amount is treated as a deduction allocable to that activity in the following year. See IRS Publication 925 for further details.