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1992-04-30
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@079 CHAP ZZ
┌───────────────────────────────────┐
│ PASSIVE ACTIVITY LOSS LIMITATIONS │
└───────────────────────────────────┘
As anyone who reads the newspapers knows by now, "passive activity"
losses (i.e., tax shelters) have become an endangered species since the
passage of the Tax Reform Act of 1986. In general terms, a so-called
"passive activity" is one that involves the conduct of a trade or a
business, or an investment activity, in which the taxpayer does not
materially participate. But rental activities of any type are con-
sidered to be passive regardless of the taxpayer's material partici-
pation in the business (but certain short-term rental activities, such
as hotel rooms, tuxedos, etc. where the average customer uses the pro-
perty for 7 days or less aren't considered to be "rental" activities).
Under the tax law as it now stands, all of a taxpayer's income and
losses go into 3 separate categories:
. Active source income (such as salary, wages or income or loss
from an "actively conducted" business);
. Passive activity income or loss (as from a tax shelter, or from
a rental property); and
. Portfolio income and related expenses (interest, dividends,
capital gains).
In general, net losses from passive activities for a taxable year
cannot be offset against other income, but must be carried over to
future years to be offset against passive income (if any). Similarly,
net portfolio losses resulting from investment interest expense can't
be offset against either of the other 2 categories. Only losses from
active sources can be used to currently offset income from the other
2 categories, generally.
Thus, if you are a passive investor in a partnership or an S corpora-
tion business that has net losses that are considered passive activity
losses, you must carry those losses forward to future tax years for an
indefinite period, and cannot use the losses until you generate net
passive income against which they can be offset, or else you sell or
otherwise dispose of the investment in a way that permits you to recog-
nize the deferred losses.
For small businesses, perhaps the most important exception to these
passive loss restrictions is the exception for up to $25,000 a year of
losses from rental real estate, where the taxpayer is considered to
"actively participate" in the rental activity. This allowable de-
duction phases out at the rate of $1 for every $2 that the taxpayer's
adjusted gross income exceeds $100,000. Thus, no such deduction is
allowed for rental losses if adjusted gross income is $150,000 or more.
(Note that adjusted gross income for this purpose is recomputed without
taking into account any passive losses, IRA deductions, or taxable
Social Security benefits.)
Only a natural person (not a corporation, trust, etc.) can qualify for
the special $25,000 rental loss exception. Also, to qualify for such a
current deduction of rental losses, the taxpayer must own at least a
10% interest (by value) in the property, such as a 10% interest in a
real estate partnership. Thus, you can't obtain this loss by buying
0.000001% of a large public real estate partnership. In addition, you
must "actively participate" in the activity. This means only that you
must make major management decisions about the property, such as
hiring a management company to manage it, or by approving new tenants,
setting rental terms, approving major expenditures, or the like.
The passive loss restrictions apply not only to individual taxpayers,
but also to "personal service corporations," in full. They also apply,
but only to a limited extent, to certain other closely-held C corpora-
tions, which are allowed to offset passive losses against "net active
income," but not against portfolio income. C corporations that are not
"personal service corporations" or "closely-held C corporations" are
not subject to the passive loss restrictions.
Finally, neither partnerships nor S corporations are subject to the
passive loss rules, but any passive losses they pass through to their
partners or shareholders will be subject to the passive loss rules at
the partner or shareholder level.