6.2 Passive Activity Losses

Passive Activity Losses are a crucial concept in tax planning, affecting how investors can offset income with losses from certain activities. These rules aim to prevent taxpayers from using passive losses to reduce taxes on active income, like wages or business profits.

Understanding Passive Activity Losses is key to grasping the broader topic of Losses and Loss Limitations. It's essential to know how these rules work, as they can significantly impact your tax situation, especially if you're involved in rental properties or other passive investments.

Passive activities and their tax implications

Defining passive activities and material participation

• Passive activities consist of business activities where taxpayer does not materially participate or rental activities (regardless of participation level)
• Material participation determined by meeting specific IRS criteria (working more than 500 hours in activity during tax year)
• Passive activity rules apply to individuals, estates, trusts, closely held C corporations, and personal service corporations
• Rules implemented to prevent taxpayers from using losses from passive investments to offset income from other sources (wages, active business income)

Tax treatment of passive activity income and losses

• Passive activity income and losses subject to special tax treatment under Internal Revenue Code Section 469
• Passive activity losses can only offset passive activity income, with limited exceptions
• Unused passive losses carried forward to future tax years until utilized or activity disposed of in taxable transaction
• Passive losses from publicly traded partnerships subject to additional limitations (can only offset income from same partnership)

Limitations on passive activity losses

General limitations and special allowances

• Passive activity losses (PALs) generally limited to amount of passive activity income for tax year
• Excess passive losses not deducted in current year are suspended and carried forward
• Special allowance for rental real estate activities with active participation allows up to $25,000 in losses to be deducted against non-passive income
• $25,000 special allowance phased out for taxpayers with modified adjusted gross income (MAGI) between$100,000 and $150,000
  • Phase-out calculation: Allowance = $25,000 - (MAGI - $100,000) * 50%

Additional limitations and disposition rules

• At-risk rules may further limit deductibility of passive losses to amount taxpayer has at risk in activity
  • At-risk amount typically includes cash contributions, loan proceeds taxpayer is personally liable for, and certain property contributions
• Upon complete disposition of passive activity, any suspended losses become fully deductible against both passive and non-passive income
• Disposition must be taxable transaction to trigger release of suspended losses (sale, exchange, abandonment)

Calculating passive activity loss deductions

Step-by-step calculation process

• Determine total passive income from all passive activities for tax year
• Calculate total passive losses from all passive activities for tax year
• Offset passive losses against passive income on activity-by-activity basis
• Apply any remaining losses against aggregate passive income from other activities
• Determine if taxpayer qualifies for $25,000 special allowance for rental real estate activities and calculate applicable phase-out
• Calculate allowable losses under special allowance for rental real estate activities with active participation
• Carry forward any remaining passive losses that cannot be deducted in current year to future tax years

Examples of passive activity loss calculations

• Example 1: Taxpayer has $10,000 passive income from Activity A and$15,000 passive loss from Activity B
  • Allowable loss deduction: $10,000 (limited to passive income)
  • Suspended loss carried forward: $5,000
• Example 2: Taxpayer has $30,000 MAGI,$5,000 passive income, and $20,000 rental real estate loss with active participation
  • Allowable loss deduction: $25,000 ($5,000 passive income + $20,000 special allowance)

Special rules for real estate professionals vs active participation

Real estate professional rules

• Real estate professionals exempt from passive activity loss limitations for their real estate activities if meeting specific criteria
• Qualifications for real estate professional status:
  • Spend more than 750 hours and more than 50% of working time in real property trades or businesses
  • Materially participate in each rental real estate activity to treat it as non-passive
• Taxpayers can elect to group rental real estate activities to meet material participation requirements more easily as real estate professional
  • Grouping election made by filing statement with tax return

Active participation in rental real estate

• Active participation less stringent standard than material participation (applies specifically to rental real estate activities)
• Active participation requires making management decisions or arranging for others to provide services in significant and bona fide sense
  • Examples: approving new tenants, deciding on rental terms, approving capital expenditures
• $25,000 special allowance for rental real estate activities requires active participation but not material participation
• Active participation can be met even if taxpayer uses property management company, as long as taxpayer retains decision-making authority