Passive Loss Limitations
Losses (and credits) from passive activities are limited. The concept of passive income was introduced in Chapter 3, Income: Personal Wages and Investments of this text. Essentially, passive income or loss arises from a passive activity, which is an activity in which the taxpayer does not have a substantial participation.
Passive losses may not be used to offset active income, such as wages and income from a trade or business, or portfolio income, such as dividends and interest. Frequently passive losses flow through to taxpayers from investments in partnerships, which carry on businesses with no involvement by the taxpayer. In general, passive losses may only be used to offset income from other passive activities. Unused passive losses may be carried forward to offset passive income in future years or they can be deducted when the investment is sold. Taxpayers calculate their allowable passive losses using Form 8582.
Passive loss rules specifically state real estate rental activities are passive, even if the taxpayer actively manages the property and even if the activity is not conducted as a partnership. Individual taxpayers may, however, deduct up to $25,000 of rental property losses against other income, if they are actively involved in the management of the property and their income does not exceed certain limits. The $25,000 loss deduction is phased out with higher adjusted gross incomes. The $25,000 is reduced by 50 cents for each $1.00 the taxpayer’s modified AGI (AGI before passive losses and IRA deductions) exceeds $100,000. Therefore, no deduction is allowed when the taxpayer’s modified AGI reaches $150,000. The loss deduction is also limited to $12,500 for married individuals filing separate returns.
Example
Oksana’s modified AGI before passive losses is $130,000. She has a rental house, which shows a loss of $12,000 for the year. She may deduct only $10,000 ($25,000 − 50% of $30,000) of the loss because of the phaseout of the $25,000 allowance for passive rental losses where modified AGI is over $100,000.
Taxpayers who are heavily involved in real estate rental activities may qualify as having a trade or business rather than a passive activity. If so, the income and losses from qualified rental activities will no longer be subject to passive loss limitations. For real estate rental to be considered a trade or business, the taxpayer must materially participate in the activity. To qualify a taxpayer must:
Perform more than 50% of his/her personal service time during the tax year in real property trades or businesses, and
Perform more than 750 hours of service in the real property trade or business in which he or she claims material participation.
Example
In the current tax year, Pam owns six rental properties and spends 90% of her personal service time (1,800 hours) managing them. Since both the above tests are met, Pam’s real estate rental activity is not a passive activity.
Income from passive investments can be used by taxpayers to absorb passive losses that would otherwise be disallowed. The passive loss limitations are very complex. Certain oil and gas investments are not subject to the passive loss limitations, and special rules apply to investments in qualified low-income housing.
Go to Publication 17, Chapter 9 and read the sections: Limits on Rental Losses and Passive Activity Limits. Go to Publication 1, Chapter 16 and under the section Reporting Capital Gains and Losses, read the subsection: Passive activity gains and losses.
Problems
Tony is single and purchased a limited partnership interest in a tax shelter in 1985. He also acquired a rental house in the current tax year, which he actively manages. During the tax year, Tony’s share of the partnership’s losses was $21,000, and his rental house generated $20,000 in losses. Tony’s modified AGI before passive losses is $130,000.
Calculate the amount of Tony’s, allowable deduction for rental house activities. $__________
Calculate the amount of Tony’s allowable deduction for the partnership losses. $__________
Wilma has a limited partnership investment and a rental condominium. She actively manages the rental condominium. During this tax year, her share of the loss from the limited partnership was $9,000, and her loss from the rental condo was $14,000. Assuming Wilma’s modified AGI is $110,000, complete Form 8582 for Wilma. The total amount of passive activity losses allowed from line 16 of Form 8582 is: $__________
