Generally, you are in a passive activity if:
- You have a trade or business activity in which you do not
materially participate during the tax year, or
- You have a rental activity, even if you do materially
participate in it (unless you are a real estate professional).
These terms are explained later.
If you have a loss, you must determine your at-risk amount
in the activity. The at-risk rules are explained in the second part of
this publication. After you figure your amount at risk, apply the
rules in this part to find the amount of your passive activity losses
that you can deduct.
In general, you can deduct passive activity losses only from
passive activity income. You carry any excess loss forward to the
following year or years until used, or until deducted in the year you
dispose of your entire interest in the activity in a fully taxable
transaction. See Dispositions, later.
Passive activity credits.
You can subtract passive activity credits only from the tax on net
passive income. Passive activity credits include the general business
credit and other special business credits, such as the credit for fuel
produced from a nonconventional source. Credits that are more than the
tax on income from passive activities are carried forward.
Unallowed passive activity credits, unlike unallowed passive
activity losses, are not deductible when you dispose of your entire
interest in an activity. However, to determine your gain or loss from
the disposition, you can elect to increase the basis of the credit
property by the amount of the original basis reduction for the credit,
to the extent that the credit was not allowed because of the passive
activity limits. You cannot elect to adjust the basis for a partial
disposition of your interest in a passive activity.
See the instructions for Form 8582-CR for more information.
Publicly traded partnership.
You must apply the rules in this part separately to your income or
loss from a passive activity held through a publicly traded
partnership (PTP). You must also apply the limit on passive activity
credits separately to your credits from a passive activity held
through a PTP.
You can offset losses from passive activities of a PTP only against
income or gain from passive activities of the same PTP. Likewise, you
can offset credits from passive activities of a PTP only against the
tax on the net passive income from the same PTP.
For more information on how to apply the passive activity loss
rules to PTPs, and on how to apply the limit on passive activity
credits to PTPs, see Publicly Traded Partnerships (PTPs) in
the instructions for Forms 8582 and 8582-CR, respectively.
Who Must Use
These Rules?
The passive activity rules apply to:
- Individuals,
- Estates,
- Trusts (other than grantor trusts),
- Personal service corporations, and
- Closely held corporations.
Even though the rules do not apply to grantor trusts, partnerships,
and S corporations directly, they do apply to the owners of these
entities.
For information about personal service corporations and closely
held corporations, including definitions and how the passive activity
rules apply to these corporations, see Form 8810
and its instructions.
Closely held corporation.
A closely held corporation can offset net active income with its
passive activity loss. It can also offset the tax attributable to its
net active income with its passive activity credits. However, a
closely held corporation cannot offset its portfolio income (defined,
later, under Passive Activity Income) with its passive
activity loss.
Net active income is the corporation's taxable income figured
without any income or loss from a passive activity or any portfolio
income or loss.
Passive Activities
There are two kinds of passive activities--trade or business
activities in which you do not materially participate during the tax
year and rental activities. Material participation in a trade or
business is discussed, later, under Activities That Are Not
Passive Activities.
Treatment of former passive activities.
A former passive activity is an activity that was a passive
activity in any earlier tax year, but is not a passive activity in the
current tax year. You can deduct a prior year unallowed loss from the
activity up to the amount of your current year net income from the
activity. Treat any remaining prior year unallowed loss like you treat
any other passive loss.
In addition, any prior year unallowed passive activity credits from
a former passive activity offset the allocable part of your current
year tax liability. The allocable part of your current year tax
liability is that part of this year's tax liability that is allocable
to the current year net income from the former passive activity. You
figure this after you reduce your net income from the activity by any
prior year unallowed loss from that activity (but not below zero).
Trade or Business Activities
A trade or business activity is an activity that:
- Involves the conduct of a trade or business (that is,
deductions would be allowable under section 162 of the Internal
Revenue Code if other limitations, such as the passive activity rules,
did not apply),
- Is conducted in anticipation of starting a trade or
business, or
- Involves research or experimental expenditures that are
deductible under Internal Revenue Code section 174 (or that would be
deductible if you chose to deduct rather than capitalize them).
A trade or business activity does not include a rental activity
or the rental of property that is incidental to an activity of holding
the property for investment.
You generally report trade or business activities on Schedule C,
C-EZ, F, or in Part II or III of Schedule E.
Rental Activities
A rental activity is a passive activity even if you materially
participated in that activity, unless you materially participated as a
real estate professional. See Real Estate Professional,
later, under Activities That Are Not Passive Activities. An
activity is a rental activity if tangible property (real or personal)
is used by customers or held for use by customers, and the gross
income (or expected gross income) from the activity represents amounts
paid (or to be paid) mainly for the use of the property. It does not
matter whether the use is under a lease, a service contract, or some
other arrangement.
Exceptions.
Your activity is not a rental activity if any of the
following apply.
- The average period of customer use of the property is 7 days
or less. You figure the average period of customer use by dividing the
total number of days in all rental periods by the number of rentals
during the tax year. If the activity involves renting more than one
class of property, multiply the average period of customer use of each
class by a fraction. The numerator of the fraction is the gross rental
income from that class of property, and the denominator is the
activity's total gross rental income. The activity's average period of
customer use will equal the sum of the amounts for each class.
- The average period of customer use of the property, as
figured in (1), above, is 30 days or less and you provide significant
personal services with the rentals. Significant personal services
include only services performed by individuals. They do not include:
- Services needed to permit the lawful use of the property,
- Services to repair or improve property that would extend its
useful life for a period substantially longer than the average rental,
and
- Services that are similar to those commonly provided with
long-term rentals of real estate, such as cleaning and maintenance of
common areas or routine repairs.
- You provide extraordinary personal services in connection
with customer use. Services are extraordinary personal services if
individuals perform them, and the customer's use of the property is
incidental to their receipt of the services.
- The rental is incidental to a nonrental activity. The rental
of property is incidental to an activity of holding property for
investment if the main purpose of holding the property is to realize a
gain from its appreciation and the gross rental income from the
property is less than 2% of the smaller of the property's unadjusted
basis or fair market value. The unadjusted basis of property is its
cost not reduced by depreciation or any other basis adjustment. The
rental of property is incidental to a trade or business activity if
all of the following apply.
- You own an interest in the trade or business activity during
the year.
- The rental property was used mainly in that trade or
business activity during the current year, or during at least 2 of the
5 preceding tax years.
- Your gross rental income from the property is less than 2%
of the smaller of its unadjusted basis or fair market value.
- You customarily make the rental property available during
defined business hours for nonexclusive use by various customers.
- You provide the property for use in a nonrental activity in
your capacity as an owner of an interest in the partnership, S
corporation, or joint venture conducting that activity.
If you meet any of the exceptions listed above, see the
instructions for Form 8582 for information about how to report any
income or loss from the activity.
Rental real estate activities.
If you or your spouse actively participated in a passive rental
real estate activity, you can deduct up to $25,000 of loss from the
activity from your nonpassive income. This special allowance is an
exception to the general rule disallowing losses in excess of income
from passive activities. Similarly, you can offset credits from the
activity against the tax on up to $25,000 of nonpassive income after
taking into account any losses allowed under this exception.
If you are married, filing a separate return, and lived apart from
your spouse for the entire tax year, your special allowance cannot be
more than $12,500. If you lived with your spouse at any time during
the year and are filing a separate return, you cannot use the special
allowance to reduce your nonpassive income or tax on nonpassive
income.
The maximum special allowance is reduced if your modified adjusted
gross income exceeds certain amounts. See Phaseout rule,
later.
Example.
Kate, a single taxpayer, has $70,000 in wages, $15,000 income from
a limited partnership, a $26,000 loss from rental real estate
activities in which she actively participated, and less than $100,000
of modified adjusted gross income. She can use $15,000 of her $26,000
loss to offset her $15,000 passive income from the partnership.
Because she actively participated in her rental real estate
activities, she can use the remaining $11,000 rental real estate loss
to offset $11,000 of her nonpassive income (wages).
Active participation.
Active participation is not the same as material participation,
defined later. Active participation is a less stringent standard than
material participation. For example, you may be treated as actively
participating if you make management decisions in a significant and
bona fide sense. Management decisions that count as active
participation include approving new tenants, deciding on rental terms,
approving expenditures, and similar decisions.
Only individuals can actively participate in rental real estate
activities. However, a decedent's estate is treated as actively
participating for its tax years ending less than 2 years after the
decedent's death, if the decedent would have satisfied the active
participation requirement for the activity for the tax year the
decedent died.
A decedent's qualified revocable trust can also be treated as
actively participating if both the trustee and the executor (if any)
of the estate choose to treat the trust as part of the estate. The
choice applies to tax years ending after the decedent's death and
before:
- 2 years after the decedent's death if no estate tax return
is required, or
- 6 months after the estate tax liability is finally
determined if an estate tax return is required.
The choice is irrevocable and cannot be made later than the due
date for the estate's first income tax return (including any
extensions).
Limited partners are not treated as actively participating in a
partnership's rental real estate activities.
You are not treated as actively participating in a rental real
estate activity unless your interest in the activity (including your
spouse's interest) was at least 10% (by value) of all interests in the
activity throughout the year.
Active participation is not required to take low-income housing and
rehabilitation investment credits from rental real estate activities.
Example.
Mike, a single taxpayer, had the following income and loss during
the tax year:
| Salary |
$42,300 |
| Dividends |
300 |
| Interest |
1,400 |
| Rental loss |
(4,000) |
The rental loss came from a house Mike owned. He advertised and
rented the house to the current tenant himself. He also collected the
rents and either did the repairs or hired someone to do them.
Even though the rental loss is a loss from a passive activity, Mike
can use the entire $4,000 loss to offset his other income because he
actively participated.
Phaseout rule.
The maximum special allowance of $25,000 ($12,500 for married
individuals filing separate returns and living apart at all times
during the year) is reduced by 50% of the amount of your modified
adjusted gross income that is more than $100,000 ($50,000 if you are
married filing separately). If your modified adjusted gross income is
$150,000 or more ($75,000 or more if you are married filing
separately), you generally cannot use the special allowance.
Modified adjusted gross income
for this
purpose is your adjusted gross income figured without the following:
- Taxable social security and tier 1 railroad retirement
benefits,
- Deductible contributions to individual retirement accounts
(IRAs) and section 501(c)(18) pension plans,
- The exclusion from income of interest from qualified U.S.
savings bonds used to pay qualified higher education expenses,
- The exclusion from income of amounts received from an
employer's adoption assistance program,
- Passive activity income or loss included on Form 8582,
- Any rental real estate loss allowed because you materially
participated in the rental activity as a real estate professional (as
discussed, later, under Activities That Are Not Passive
Activities),
- Any overall loss from a publicly traded partnership (see
Publicly Traded Partnerships (PTPs) in the instructions for
Form 8582),
- The deduction for one-half of self-employment tax, or
- The deduction allowed for interest on student loans.
Example.
During 2000 John was unmarried and was not a real estate
professional. For 2000 he had $120,000 in salary, and a $31,000 loss
from his rental real estate activities in which he actively
participated. His modified adjusted gross income is $120,000. When he
files his 2000 return, he may deduct only $15,000 of his passive
activity loss. He must carry over the remaining $16,000 passive
activity loss to 2001. He figures his deduction and carryover as
follows:
| Adjusted gross income, modified as
required |
$120,000 |
| Minus amount not subject to phaseout |
100,000 |
| Amount subject to phaseout rule |
$20,000 |
| Multiply by 50% |
x 50% |
| Required reduction to special allowance |
$10,000 |
| Maximum special allowance |
$25,000 |
| Minus required reduction (see above) |
10,000 |
| Adjusted special allowance |
$15,000 |
| Passive loss from rental real estate |
$31,000 |
| Deduction allowable/ Adjusted
special allowance (see above) |
15,000 |
| Amount that must be carried forward |
$16,000 |
Phaseout rule for certain credits.
A higher phaseout range applies to low-income housing credits for
property placed in service before 1990 and rehabilitation investment
credits from rental real estate activities. For those credits, the
phaseout of the $25,000 special allowance starts when your modified
adjusted gross income exceeds $200,000 ($100,000 if you are a married
individual filing a separate return and living apart at all times
during the year).
There is no phaseout of the $25,000 special allowance for
low-income housing credits for property placed in service after 1989.
If you hold an indirect interest in the property through a
partnership, S corporation, or other pass-through entity, this special
exception will not apply unless you also acquired your interest in the
pass-through entity after 1989.
You apply the $25,000 special allowance first to passive activity
losses, then to credits other than the rehabilitation and low-income
housing credits, then to rehabilitation credits and low-income housing
credits for property placed in service before 1990. You apply any
remaining part of the special allowance to low-income housing credits
for property placed in service after 1989.
Activities That Are Not Passive Activities
The following are not passive activities.
- Trade or business activities in which you materially
participated for the tax year.
- A working interest in an oil or gas well which you hold
directly or through an entity that does not limit your liability (such
as a general partner interest in a partnership). It does not matter
whether you materially participated in the activity for the tax year.
However, if your liability was limited for part of the year (for
example, you converted your general partner interest to a limited
partner interest during the year) and you had a net loss from the well
for the year, some of your income and deductions from the working
interest may be treated as passive activity gross income and passive
activity deductions. See Temporary Regulations section
1.469-1T(e)(4)(ii).
- The rental of a dwelling unit that you also used for
personal purposes during the year for more than the greater of
14 days or 10% of the number of days during the year that the
home was rented at a fair rental.
- An activity of trading personal property for the account of
those who own interests in the activity. See Temporary Regulations
section 1.469-1T(e)(6).
- Rental real estate activities in which you materially
participated as a real estate professional. See Real Estate
Professional, later.
You should not enter income and losses from these activities on
Form 8582. Instead, enter them on the forms or schedules you would
normally use.
Material Participation
A trade or business activity is not a passive activity if you
materially participated in the activity. You materially participated
in a trade or business activity for a tax year if you satisfy
any of the following tests.
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation
in the activity of all individuals for the tax year, including the
participation of individuals who did not own any interest in the
activity.
- You participated in the activity for more than 100 hours
during the tax year, and you participated at least as much as any
other individual (including individuals who did not own any interest
in the activity) for the year.
- The activity is a significant participation activity, and
you participated in all significant participation activities for more
than 500 hours. A significant participation activity is any trade or
business activity in which you participated for more than 100 hours
during the year and in which you did not materially participate under
any of the material participation tests, other than this test. See
Significant Participation Passive Activities, later, under
Recharacterization of Passive Income.
- You materially participated in the activity for any 5
(whether or not consecutive) of the 10 immediately preceding tax
years.
- The activity is a personal service activity in which you
materially participated for any 3 (whether or not consecutive)
preceding tax years. An activity is a personal service activity if it
involves the performance of personal services in the fields of health
(including veterinary services), law, engineering, architecture,
accounting, actuarial science, performing arts, consulting, or any
other trade or business in which capital is not a material
income-producing factor.
- Based on all the facts and circumstances, you participated
in the activity on a regular, continuous, and substantial basis.
You did not materially participate in the activity under test (7)
if you participated in the activity for 100 hours or less during the
year. Your participation in managing the activity does not count in
determining whether you materially participated under this test if:
- Any person other than you received compensation for managing
the activity, or
- Any individual spent more hours during the tax year managing
the activity than you did (regardless of whether the individual was
compensated for the management services).
Participation.
In general, any work you do in connection with an activity in which
you own an interest is treated as participation in the activity.
Work not usually performed by owners.
You do not treat the work you do in connection with an activity as
participation in the activity if both of the following are true.
- The work is not work that is customarily done by the owner
of that type of activity.
- One of your main reasons for doing the work is to avoid the
disallowance of any loss or credit from the activity under the passive
activity rules.
Participation as an investor.
You do not treat the work you do in your capacity as an investor in
an activity as participation unless you are directly involved in the
day-to-day management or operations of the activity. Work you do as an
investor includes:
- Studying and reviewing financial statements or reports on
operations of the activity,
- Preparing or compiling summaries or analyses of the finances
or operations of the activity for your own use, and
- Monitoring the finances or operations of the activity in a
nonmanagerial capacity.
Spouse's participation.
Your participation in an activity includes your spouse's
participation. This applies even if your spouse did not own any
interest in the activity and you and your spouse do not file a joint
return for the year.
Proof of participation. You can use any reasonable
method to prove your participation in an activity for the year. You do
not have to keep contemporaneous daily time reports, logs, or similar
documents if you can establish your participation in some other way.
For example, you can show the services you performed and the
approximate number of hours spent by using an appointment book,
calendar, or narrative summary.
Limited partners.
If you owned an activity as a limited partner, you generally are
not treated as materially participating in the activity. However, you
are treated as materially participating in the activity if you met
material participation test (1), (5), or (6) for the tax year.
You are not treated as a limited partner, however, if you also were
a general partner in the partnership at all times during the
partnership's tax year ending with or within your tax year (or,
if shorter, during that part of the partnership's tax year
in which you directly or indirectly owned your limited partner
interest).
Retired or disabled farmer and surviving spouse of a farmer.
If you are a retired or disabled farmer, you are treated as
materially participating in a farming activity if you materially
participated for 5 or more of the 8 years before your retirement or
disability. Similarly, if you are a surviving spouse of a farmer, you
are treated as materially participating in a farming activity if the
real property used in the activity meets the estate tax rules for
special valuation of farm property passed from a qualifying decedent,
and you actively manage the farm.
Corporations.
A closely held corporation or a personal service corporation is
treated as materially participating in an activity only if one or more
shareholders holding more than 50% by value of the outstanding stock
of the corporation materially participate in the activity.
A closely held corporation can also satisfy the material
participation standard by meeting the first two requirements for the
qualifying business exception from the at-risk limits. See
Special exception for qualified corporations under
Activities Covered by the At-Risk Rules, later.
Real Estate Professional
Generally, rental activities are passive activities even if you
materially participated in them. However, if you qualified as a real
estate professional, rental real estate activities in which you
materially participated are not passive activities. For this purpose,
each interest you have in a rental real estate activity is a separate
activity, unless you choose to treat all interests in rental real
estate activities as one activity. See the instructions for Schedule E
(Form 1040) for information about making this choice.
If you qualified as a real estate professional for 2000, report
income or losses from rental real estate activities in which you
materially participated as nonpassive income or losses, and complete
line 42 of Schedule E (Form 1040). If you also have an unallowed loss
from these activities from an earlier year when you did not qualify,
see Treatment of former passive activities under
Passive Activities, earlier.
Qualifications.
You qualified as a real estate professional for the year if you met
both of the following requirements.
- More than half of the personal services you performed in all
trades or businesses during the tax year were performed in real
property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax
year in real property trades or businesses in which you materially
participated.
Do not count personal services you performed as an employee in real
property trades or businesses unless you were a 5% owner of your
employer. You were a 5% owner if you owned (or are considered to have
owned) more than 5% of your employer's outstanding stock, outstanding
voting stock, or capital or profits interest.
If you file a joint return, do not count your spouse's personal
services to determine whether you met the preceding requirements.
However, you can count your spouse's participation in an activity in
determining if you materially participated.
Real property trades or businesses.
A real property trade or business is a trade or business that does
any of the following with real property.
- Develops or redevelops it.
- Constructs or reconstructs it.
- Acquires it.
- Converts it.
- Rents or leases it.
- Operates or manages it.
- Brokers it.
Closely held corporations.
A closely held corporation can qualify as a real estate
professional if more than 50% of the gross receipts for its tax year
came from real property trades or businesses in which it materially
participates.
Passive Activity Income
In figuring your net income or loss from a passive activity, take
into account only passive activity income and passive activity
deductions (discussed later). Passive activity income includes all
income from passive activities and generally includes gain from
disposition of an interest in a passive activity or property used in a
passive activity.
Passive activity income does not include the following
items.
- Income from an activity that is not a passive activity.
These activities are discussed, earlier, under Activities That
Are Not Passive Activities.
- Portfolio income. This includes interest, dividends,
annuities, and royalties not derived in the ordinary course of a trade
or business. It includes gain or loss from the disposition of property
that produces these types of income or that is held for investment.
- Personal service income. This includes salaries, wages,
commissions, self-employment income from trade or business activities
in which you materially participated, deferred compensation, taxable
social security and other retirement benefits, and payments from
partnerships to partners for personal services.
- Income from positive section 481 adjustments allocated to
activities other than passive activities. (Section 481 adjustments are
adjustments that must be made due to changes in your accounting
method.)
- Income or gain from investments of working capital.
- Income from an oil or gas property if you treated any loss
from a working interest in the property for any tax year beginning
after 1986 as a nonpassive loss, as discussed, earlier, in item (2)
under Activities That Are Not Passive Activities. This also
applies to income from other oil and gas property the basis of which
is determined wholly or partly by the basis of the property in the
preceding sentence.
- Any income from intangible property, such as a patent,
copyright, or literary, musical, or artistic composition, if your
personal efforts significantly contributed to the creation of the
property.
- Any other income that must be treated as nonpassive income.
See Recharacterization of Passive Income, later.
- Overall gain from any interest in a publicly traded
partnership. See Publicly Traded Partnerships (PTPs) in the
instructions for Form 8582.
- State, local, and foreign income tax refunds.
- Income from a covenant not to compete.
- Reimbursement of a casualty or theft loss included in gross
income to recover all or part of a prior year loss deduction, if the
loss deduction was not a passive activity deduction.
- Alaska Permanent Fund dividends.
- Cancellation of debt income, if at the time the debt is
discharged the debt is not allocated to passive activities under the
interest expense allocation rules. See chapter 5 of Publication 535,
Business Expenses, for information about the rules for
allocating interest.
Disposition of property interests.
Gain on the disposition of an interest in property generally is
passive activity income if, at the time of the disposition, the
property was used in an activity that was a passive activity in the
year of disposition. The gain generally is not passive activity income
if, at the time of disposition, the property was used in an activity
that was not a passive activity in the year of disposition. An
exception to this general rule may apply if you previously used the
property in a different activity.
Exception for more than one use in the preceding 12 months.
If you used the property in more than one activity during the
12-month period before its disposition, you must allocate the gain
between the activities on a basis that reasonably reflects the
property's use during that period. Any gain allocated to a passive
activity is passive activity income.
For this purpose, an allocation of the gain solely to the activity
in which the property was mainly used during that period reasonably
reflects the property's use if the fair market value of your interest
in the property is not more than the smaller of:
- $10,000, or
- 10% of the total of the fair market value of your interest
in the property and the fair market value of all other property used
in that activity immediately before the disposition.
Exception for substantially appreciated property.
The gain is passive activity income if the fair market value of the
property at disposition was more than 120% of its adjusted basis and
either of the following conditions applies.
- You used the property in a passive activity for 20% of the
time you held your interest in the property.
- You used the property in a passive activity for the entire
24-month period before its disposition.
If neither condition applies, the gain is not passive activity
income. However, it is treated as portfolio income only if you held
the property for investment for more than half of the time you held it
in nonpassive activities.
For this purpose, treat property you held through a corporation
(other than an S corporation) or other entity whose owners receive
only portfolio income as property held in a nonpassive activity and as
property held for investment. Also, treat the date you agree to
transfer your interest for a fixed or determinable amount as the
disposition date.
If you used the property in more than one activity during the
12-month period before its disposition, this exception applies only to
the part of the gain allocated to a passive activity under the rules
described in the preceding discussion.
Disposition of property converted to inventory.
If you disposed of property that you had converted to inventory
from its use in another activity (for example, you sold condominium
units you previously held for use in a rental activity), a special
rule may apply. Under this rule, you disregard the property's use as
inventory and treat it as if it were still used in that other activity
at the time of disposition. This rule applies only if you meet all the
following conditions.
- At the time of disposition, you held your interest in the
property in a dealing activity (an activity that involves holding the
property or similar property mainly for sale to customers in the
ordinary course of a trade or business).
- Your other activities included a nondealing activity (an
activity that does not involve holding similar property for sale to
customers in the ordinary course of a trade or business) in which you
used the property for more than 80% of the period you held it.
- You did not acquire or hold your interest in the property
for the main purpose of selling it to customers in the ordinary course
of a trade or business.
Passive Activity Deductions
Passive activity deductions include all deductions from activities
that are passive activities for the current tax year and all
deductions from passive activities that were disallowed under the
passive loss rules in prior tax years and carried forward to the
current tax year. They also include losses from dispositions of
property used in a passive activity at the time of the disposition and
losses from a disposition of less than your entire interest in a
passive activity.
Passive activity deductions do not include the following
items.
- Deductions for expenses (other than interest) that are
clearly and directly allocable to portfolio income.
- Interest expense other than interest properly allocable to
passive activities (e.g., qualified home mortgage interest and
capitalized interest expense are not passive activity
deductions).
- Losses from dispositions of property that produce portfolio
income or property held for investment.
- State, local, and foreign income taxes.
- Miscellaneous itemized deductions that may be disallowed
because of the 2%-of-adjusted-gross-income limit.
- Charitable contribution deductions.
- Net operating loss deductions.
- Percentage depletion carryovers for oil and gas
wells.
- Capital loss carryovers.
- Deductions and losses that would have been allowed for tax
years beginning before 1987 but for basis or at-risk limits.
- Net negative section 481 adjustments allocated to activities
other than passive activities. (Section 481 adjustments are
adjustments required due to changes in accounting methods.)
- Casualty and theft losses, unless losses similar in cause
and severity recur regularly in the activity.
- The deduction for one-half of self-employment tax.
Grouping Your Activities
You can treat one or more trade or business activities, or rental
activities, as a single activity if those activities form an
appropriate economic unit for measuring gain or loss under
the passive activity rules.
Grouping is important for a number of reasons. If you group two
activities into one larger activity, you need only show material
participation in the activity as a whole. But if the two activities
are separate, you must show material participation in each one. On the
other hand, if you group two activities into one larger activity and
you dispose of one of the two, then you have disposed of only part of
your entire interest in the activity. But if the two activities are
separate and you dispose of one of them, then you have disposed of
your entire interest in that activity.
Grouping can also be important in determining whether you meet the
10% ownership requirement for actively participating in a rental real
estate activity.
Appropriate Economic Units
Generally, to determine if activities form an appropriate economic
unit, you must consider all the relevant facts and circumstances. You
can use any reasonable method of applying the relevant facts and
circumstances in grouping activities. The following factors have the
greatest weight in determining whether activities form an appropriate
economic unit. All of the factors do not have to apply to treat more
than one activity as a single activity. The factors that you should
consider are:
- The similarities and differences in the types of trades or
businesses,
- The extent of common control,
- The extent of common ownership,
- The geographical location, and
- The interdependencies between or among activities, which may
include the extent to which the activities:
- Buy or sell goods between or among themselves,
- Involve products or services that are generally provided
together,
- Have the same customers,
- Have the same employees, or
- Use a single set of books and records to account for the
activities.
Example 1.
John Jackson owns a bakery and a movie theater at a shopping mall
in Baltimore and a bakery and movie theater in Philadelphia. Depending
on all the relevant facts and circumstances, there may be more than
one reasonable method for grouping John's activities. For example,
John may be able to group the movie theaters and the bakeries into:
- One activity,
- A movie theater activity and a bakery activity,
- A Baltimore activity and a Philadelphia activity, or
- Four separate activities.
Example 2.
Betty is a partner in ABC partnership, which sells nonfood items to
grocery stores. Betty is also a partner in DEF (a trucking business).
ABC and DEF are under common control. The main part of DEF's business
is transporting goods for ABC. DEF is the only trucking business in
which Betty is involved. Following the rules of this section, Betty
treats ABC's wholesale activity and DEF's trucking activity as a
single activity.
Consistency and disclosure requirement.
Generally, when you group activities into appropriate economic
units, you may not regroup those activities in a later tax year. You
must meet any disclosure requirements that the Internal Revenue
Service (IRS) may have when you first group your activities and when
you add or dispose of any activities in your groupings.
However, if the original grouping is clearly inappropriate or there
is a material change in the facts and circumstances that makes the
original grouping clearly inappropriate, you must regroup the
activities and comply with any disclosure requirements that the IRS
may have.
Regrouping by IRS.
If any of the activities resulting from your grouping is not an
appropriate economic unit and one of the primary purposes of your
grouping (or failure to regroup) is to avoid the passive activity
rules, the IRS may regroup your activities.
Rental activities.
In general, you cannot group a rental activity with a trade or
business activity. However, you can group them together if the
activities form an appropriate economic unit and:
- The rental activity is insubstantial in relation to the
trade or business activity,
- The trade or business activity is insubstantial in relation
to the rental activity, or
- Each owner of the trade or business activity has the same
ownership interest in the rental activity, in which case the part of
the rental activity that involves the rental of items of property for
use in the trade or business activity may be grouped with the trade or
business activity.
Example.
Herbert and Wilma are married and file a joint return. Healthy
Food, an S corporation, is a grocery store business. Herbert is
Healthy Food's only shareholder. Plum Tower, an S corporation, owns
and rents out the building. Wilma is Plum Tower's only shareholder.
Plum Tower rents part of its building to Healthy Food. Plum Tower's
grocery store rental business and Healthy Food's grocery business are
not insubstantial in relation to each other.
Because Herbert and Wilma file a joint return, they are treated as
one taxpayer for purposes of the passive activity rules. The same
owner (Herbert and Wilma) owns both Healthy Food and Plum Tower with
the same ownership interest (100% in each). If the grouping forms an
appropriate economic unit, as discussed earlier, Herbert and Wilma can
group Plum Tower's grocery store rental and Healthy Food's grocery
business into a single trade or business activity.
Grouping of real and personal property rentals.
In general, you cannot treat an activity involving the rental of
real property and an activity involving the rental of personal
property as a single activity. However, you can treat them as a single
activity if you provide the personal property in connection with the
real property or the real property in connection with the personal
property.
Certain activities may not be grouped.
In general, if you own an interest as a limited partner or a
limited entrepreneur in one of the following activities, you may not
group that activity with any other activity in another type of
business.
- Holding, producing, or distributing motion picture films or
video tapes.
- Farming.
- Leasing any section 1245 property (as defined in section
1245(a)(3) of the Internal Revenue Code). For a list of section 1245
property, see Section 1245 property under Activities
Covered by the At-Risk Rules, later.
- Exploring for, or exploiting, oil and gas resources.
- Exploring for, or exploiting, geothermal deposits.
If you own an interest as a limited partner or a limited
entrepreneur in an activity described in the list above, you may group
that activity with another activity in the same type of business if
the grouping forms an appropriate economic unit as discussed earlier.
Limited entrepreneur.
A limited entrepreneur is a person who:
- Has an interest in an enterprise other than as a limited
partner, and
- Does not actively participate in the management of the
enterprise.
Activities conducted through another entity.
A personal service corporation, closely held corporation,
partnership, or S corporation must group its activities using the
rules discussed in this section. Once the entity groups its
activities, you, as the partner or shareholder of the entity, may
group those activities (following the rules of this section):
- With each other,
- With activities conducted directly by you, or
- With activities conducted through other entities.
You may not treat activities grouped together by the entity as
separate activities.
Personal service and closely held corporations.
You may group an activity conducted through a personal service or
closely held corporation with your other activities only to determine
whether you materially or significantly participated in those other
activities. See Material Participation, earlier, and
Significant Participation Passive Activities, later.
Publicly traded partnership (PTP).
You may not group activities conducted through a PTP with any other
activity, including an activity conducted through another PTP.
Partial dispositions.
If you dispose of substantially all of an activity during your tax
year, you may treat the part disposed of as a separate activity. But,
you can only do this if you can show with reasonable certainty:
- The amount of deductions and credits disallowed in prior
years under the passive activity rules that is allocable to the part
of the activity disposed of, and
- The amount of gross income and any other deductions and
credits for the current tax year that is allocable to the part of the
activity disposed of.
Recharacterization
of Passive Income
Net income from the following passive activities may have to be
recharacterized and excluded from passive activity income:
- Significant participation passive activities,
- Rental of nondepreciable property,
- Equity-financed lending activities,
- Rental of property incidental to development
activities,
- Rental of property to nonpassive activities, and
- Licensing of intangible property by
pass-through entities.
If you are engaged in or have an interest in one of these
activities during the tax year (either directly or through a
partnership or an S corporation), combine the income and losses from
the activity to determine if you have a net loss or net income from
that activity.
If the result is a net loss, treat the income and losses
the same as any other income or losses from that type of passive
activity (trade or business activity or rental activity).
If the result is net income, do not enter any of the
income or losses from the activity or property on Form 8582 or its
worksheets. Instead, enter income or losses on the form and schedules
you normally use. But see Significant Participation Passive
Activities, later, if the activity is a significant
participation passive activity and you also have a net loss from a
different significant participation passive activity.
Limit on recharacterized passive income.
The total amount that you treat as nonpassive income under the
rules described later in this discussion for significant participation
passive activities, rental of nondepreciable property, and
equity-financed lending activities, cannot exceed the greatest amount
that you treat as nonpassive income under any one of these rules.
Investment income and investment expense.
To figure your investment interest expense limitation on Form 4952,
treat as investment income any net passive income recharacterized as
nonpassive income from rental of nondepreciable property, an
equity-financed lending activity, or the licensing of intangible
property by a pass-through entity.
Significant Participation
Passive Activities
A significant participation passive activity is any trade or
business activity in which you participated for more than 100 hours
during the tax year but did not materially participate.
If your gross income from all significant participation passive
activities is more than your deductions from those activities, a part
of your net income from each significant participation passive
activity is treated as nonpassive income.
Corporations.
An activity of a personal service corporation or closely held
corporation is a significant participation passive activity if both of
the following statements are true.
- The corporation is not treated as materially participating
in the activity for the year.
- One or more individuals, each of whom is treated as
significantly participating in the activity, directly or indirectly
hold (in total) more than 50% (by value) of the corporation's
outstanding stock. Generally, an individual is treated as
significantly participating in an activity if the individual
participates in it for more than 100 hours during the year.
Worksheet A.
Complete Worksheet A, Significant Participation Passive
Activities (shown on the next page), if you have income or
losses from any significant participation activity. Enter the names of
the activities in the left column.
Worksheet A.
Worksheet B.
Column (a).
Enter the number of hours you participated in each activity and
total the column.
If the total is more than 500, do not complete Worksheet A or B.
None of the activities are passive activities because you satisfy test
4 for material participation. (See Material Participation
under Activities That Are Not Passive Activities,
earlier.) Report all the income and losses from these activities
on the forms and schedules you normally use. Do not include the income
and losses on Form 8582.
Column (b).
Enter the net loss, if any, from the activity. Net loss from an
activity means either:
- The activity's current year net loss (if any) plus prior
year unallowed losses (if any), or
- The excess of prior year unallowed losses over the current
year net income (if any). Enter -0- here if the prior year unallowed
loss is the same as the current year net income.
Column (c).
Enter net income, if any, from the activity. Net income means the
excess of the current year's net income from the activity over any
prior year unallowed losses from the activity.
Column (d).
Combine amounts in the Totals row for columns (b) and
(c) and enter the total net income or net loss in the Totals
row of column (d). If column (d) is a net loss, skip Worksheet B,
Significant Participation Activities With Net Income.
Include the income and losses in Worksheet 2 of Form 8582 (or
Worksheet 2 of Form 8810).
If column (d) shows net income and you must complete Form 8582
because you have other passive activities to report, complete
Worksheet B on page 9. However, you do not have to complete Form 8582
if column (d) shows net income and you have only significant
participation activities. If you do not have to complete Form 8582,
skip Worksheet B and report the net income and net losses from columns
(b) and (c) on the forms and schedules you normally use.
Worksheet B.
List only the significant participation passive activities that
have net income as shown in column (c) of Worksheet A.
Column (a).
Enter the net income of each activity from column (c) of Worksheet
A.
Column (b).
Divide each of the individual net income amounts in column (a) by
the total of column (a). The result is a ratio. In column (b), enter
the ratio for each activity as a decimal (rounded to at least three
places). The total of these ratios must equal 1.000.
Column (c).
Multiply the amount in the Totals row of column (d) of
Worksheet A by each of the ratios in column (b). Enter the results in
column (c).
Column (d).
Subtract column (c) from column (a). To this figure, add the amount
of prior year unallowed losses, if any, that reduced the current year
net income. Enter the result in column (d). Enter these amounts on
Worksheet 2 of Form 8582 or Form 8810. (But see Limit on
recharacterized passive income under Recharacterization of
Passive Income, earlier.)
Rental of Nondepreciable Property
If you have net passive income (including prior year unallowed
losses) from renting property in a rental activity, and less than 30%
of the unadjusted basis of the property is subject to depreciation,
you treat the net passive income as nonpassive income.
Example.
Calvin acquires vacant land for $300,000, constructs improvements
at a cost of $100,000, and leases the land and improvements to a
tenant. He then sells the land and improvements for $600,000,
realizing a gain of $200,000 on the disposition.
The unadjusted basis of the improvements ($100,000) equals 25% of
the unadjusted basis of all property ($400,000) used in the rental
activity. Calvin's net passive income from the activity (which is
figured with the gain from the disposition, including gain from the
improvements) is treated as nonpassive income.
Equity-Financed
Lending Activities
If you have gross income from an equity-financed lending activity,
the lesser of the net passive income or the equity-financed interest
income is nonpassive income.
For more information, see Temporary Regulations section
1.469-2T(f)(4).
Rental of Property Incidental
to a Development Activity
Net passive income from this type of activity will be treated as
nonpassive income if all of the following apply.
- You recognize gain from the sale, exchange, or other
disposition of the rental property during the tax year.
- You started to rent the property less than 12 months before
the date of disposition.
- You materially participated or significantly participated
for any tax year in an activity that involved the performance of
services for the purpose of enhancing the value of the property (or
any other item of property if the basis of the property disposed of is
determined in whole or in part by reference to the basis of that item
of property).
For more information, see Regulations section 1.469-2(f)(5).
Rental of Property to a Nonpassive Activity
If you rent property to a trade or business activity in which you
materially participated, net rental income from the property is
treated as nonpassive income. This rule does not apply to net income
from renting property under a written binding contract entered into
before February 19, 1988. It also does not apply to property just
described under Rental of Property Incidental to a Development
Activity.
Licensing of Intangible Property
by Pass-Through Entities
Net royalty income from intangible property held by a pass-through
entity in which you own an interest may be treated as nonpassive
royalty income. This applies if you acquired your interest in the
pass-through entity after the partnership, S corporation, estate, or
trust created the intangible property or performed substantial
services or incurred substantial costs for developing or marketing the
intangible property.
This recharacterization rule does not apply if:
- The expenses the entity reasonably incurred in developing or
marketing the property exceed 50% of the gross royalties from
licensing the property that are includible in your gross income for
the tax year, or
- Your share of the expenses the entity reasonably incurred in
developing or marketing the property for all tax years exceeded 25% of
the fair market value of your interest in the intangible property at
the time you acquired your interest in the entity.
For purposes of (2) above, capital expenditures are taken into
account for the entity's tax year in which the expenditure is
chargeable to a capital account, and your share of the expenditure is
figured as if it were allowed as a deduction for the tax year.
Dispositions
Any passive activity losses (but not credits) that have not been
allowed (including current year losses) generally are allowed in full
in the tax year you dispose of your entire interest in the passive (or
former passive) activity. However, for the losses to be allowed, you
must dispose of your entire interest in the activity in a transaction
in which all realized gain or loss is recognized. Also, the person
acquiring the interest from you must not be related to you.
If you have a capital loss on the disposition of an interest in a
passive activity, the loss may be limited by the capital loss rules.
The limit is generally $3,000 for individuals. See Publication 544,
Sales and Other Dispositions of Assets, for more
information.
Example.
Ray earned a $60,000 salary and owned one passive activity through
a 5% interest in the B Limited Partnership. He sold his entire
interest in the current tax year to an unrelated person for $30,000.
His adjusted basis in the partnership interest was $42,000, and he had
carried over $2,000 of passive activity losses from the activity.
Ray's deductible loss is $5,000, figured as follows:
| Sales price |
$30,000 |
| Minus: adjusted basis |
42,000 |
| Capital loss |
$12,000 |
| Minus: capital loss limit |
3,000 |
| Capital loss carryover |
$9,000 |
| Allowable capital loss on sale |
$3,000 |
| Carryover losses allowable |
2,000 |
| Total current deductible loss |
$5,000 |
Ray deducts the $5,000 total current deductible loss in the current
tax year. He must carry over the remaining $9,000 capital loss, which
is not subject to the passive activity loss limit. He will treat it
like any other capital loss carryover.
Installment sale of an entire interest.
If you sell your entire interest in a passive activity through an
installment sale, to figure the loss for the current year that is not
limited by the passive activity rules, multiply your overall loss (not
including losses allowed in prior years) by a fraction. The numerator
(top part) of the fraction is the gain recognized in the current year,
and the denominator (bottom part) is the total gain from the sale
minus all gains recognized in prior years.
Example.
John Ash has a total gain of $10,000 from the sale of an entire
interest in a passive activity. Under the installment method he
reports $2,000 of gain each year, including the year of sale. For the
first year, 20% (2,000/10,000) of the losses are allowed. For the
second year, 25% (2,000/8,000) of the remaining losses are allowed.
Partners and S corporation shareholders.
Generally, any gain or loss on the disposition of a partnership
interest must be allocated to each trade or business, rental, or
investment activity in which the partnership owns an interest. If you
dispose of your entire interest in a partnership, the passive activity
losses from the partnership that have not been allowed generally are
allowed in full. They also will be allowed if the partnership (other
than a PTP) disposes of all the property used in that passive
activity.
If you do not dispose of your entire interest, the gain or loss
allocated to a passive activity is treated as passive activity income
or deduction in the year of disposition. This includes any gain
recognized on a distribution of money from the partnership that you
receive in excess of the adjusted basis of your partnership interest.
These rules also apply to the disposition of stock in an S
corporation.
Dispositions by gift.
If you give away your interest in a passive activity, the unused
passive activity losses allocable to the interest cannot be deducted
in any tax year. Instead, the basis of the transferred interest must
be increased by the amount of these losses.
Dispositions by death.
If a passive activity interest is transferred because the owner
dies, unused passive activity losses are allowed (to a certain extent)
as a deduction against the decedent's income in the year of
disposition. The decedent's losses are allowed only to the extent they
exceed the amount by which the transferee's basis in the passive
activity has been increased under the rules for determining the basis
of property acquired from a decedent. For example, if the basis of an
interest in a passive activity in the hands of a transferee is
increased by $6,000 and unused passive activity losses of $8,000 were
allocable to the interest at the date of death, then the decedent's
deduction for the tax year would be limited to $2,000 ($8,000 -
$6,000).
Partial dispositions.
If you dispose of substantially all of an activity during your tax
year, you may treat the part of the activity disposed of as a separate
activity. See Partial dispositions under Grouping Your
Activities, earlier.
How To Report Your Passive Activity Loss
Reporting your passive activities may require more than one form or
schedule. The actual number of forms depends on the number and types
of activities you must report. Some forms and schedules that may be
required are:
- Schedule C (Form 1040), Profit or Loss From Business,
- Schedule D (Form 1040), Capital Gains and Losses,
- Schedule E (Form 1040), Supplemental Income and Loss,
- Schedule F (Form 1040), Profit or Loss From Farming,
- Form 4797, Sales of Business Property,
- Form 6252, Installment Sale Income,
- Form 8582, Passive Activity Loss Limitations, and
- Form 8582-CR, Passive Activity Credit
Limitations.
Regardless of the number or complexity of passive activities you
have, you should use only one Form 8582.
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