Activity Loss Rules
In 1986, the administration and Congress were concerned that
investors could use real estate and other tax-shelter losses to
offset wages, interest and dividend income, and gains from stock
Accordingly, the Tax Reform Act of 1986 provided that losses
from passive investments could only be offset against passive
income (limited exceptions are discussed below). Passive
investments are defined as activities that are deemed not to be
a trade or business (such as real estate) and trade or business
activities in which the investor has less than material
participation. Most investments in partnerships by limited
partners are deemed passive. By definition, all rental
activities are considered to be passive.
How the Passive Activity Loss Rules Work
The passive activity loss rules create a separate "tax
basket" for passive activities. Within this basket, losses
and gains from different passive activities are
"netted" against each other. If the losses and gains
(including carryforward suspended losses) net to overall income,
the income is included with wage and portfolio income in total
taxable income. If the losses and gains net to an overall loss,
the loss is suspended and carried forward until passive income
is recognized in future years or the activities are sold or go
out of existence.
There are exceptions to these rules. First, active participants
in a rental real estate activity may deduct up to $25,000 of
these losses against other income, including wages and portfolio
income. You may meet the active participation requirement if you
participate in the making of management decisions (for example,
deciding on rental terms) or arrange for others to provide
services (such as repairs) in a significant and bona fide sense.
However, you are not considered an active participant if you own
the property as a limited partner or if you own less than 10% of
the rental real estate.
The full $25,000 ($12,500 for married taxpayers who file
separate returns and live apart) allowance is available only if
your adjusted gross income does not exceed $100,000. The
allowance is reduced fifty cents for each dollar of adjusted
gross income over $100,000 and is completely phased out if your
adjusted gross income exceeds $150,000 (the phaseout range for
married taxpayers filing separately who live apart is between
$50,000 and $75,000). This allowance is not available to married
taxpayers who live together and file separate returns.
A second exception is that, in the year in which the taxpayer
disposes of an interest in an activity in a taxable transaction
to an unrelated party or the activity terminates, the passive
activity loss rules do not limit losses from the activity. In
the year of disposition, the current year's loss and all losses
previously suspended with respect to the disposed activity
become deductible against other types of income.
Finally, there is an exception for real estate professionals.
Specifically, the law permits the net losses from rental real
estate activities in which an eligible taxpayer materially
participates to offset any other income. The provision applies
to all individuals and closely held C corporations. To qualify
for this relief, individual taxpayers must meet all of the
following three conditions for the taxable year of their rental
real estate loss:
1. More than half of the personal services performed in trades
or businesses by the taxpayer during the taxable year are
performed in real property trades or businesses in which the
taxpayer materially participates. Real property trade or
business activities are any real property development,
redevelopment, construction, reconstruction, acquisition,
conversion, rental, operation, management, leasing, or brokerage
trade or business.
2. The taxpayer must perform more than 750 hours of services in
real property trades or businesses in which the taxpayer
3. The taxpayer must materially participate in the rental real
estate activity generating the loss that the taxpayer wants to
deduct. Taxpayers can elect to treat all of their interests in
rental real estate as one activity.
Planning Point for Taxpayers Facing
Passive Activity Gains from Tax Shelters
One common situation involving real estate is the sale of the
property and the recognition of capital gains, which may or may
not be accompanied by the receipt of cash. These capital gains
can be offset by both capital losses and passive losses
(including losses from other passive activities). In effect, one
gain allows two losses.
For example, assume that you sell real estate, that the sale
generates a capital gain of $10,000, and that you have carried
forward passive losses from earlier years totaling $10,000. If
you do nothing, your capital gain will be sheltered by the
passive loss carryforward, and the transaction will have no net
effect on your taxable income. If, however, your stock portfolio
also has a $10,000 capital loss in it, the capital gain related
to the disposition of the real estate presents an opportunity.
You can dispose of the appropriate stock and realize the capital
loss, which will offset the real estate capital gain, and then
use the passive loss carryforward to shelter other ordinary
income. The net result is a reduction in current taxable income
When planning for passive income, you cannot assume that all
income from a disposition of real estate is capital gain income.
Depreciation recapture rules for real estate and associated
personal property may convert some of the gain from the sale
into ordinary income. If the debt in a troubled real estate
partnership is restructured, the cancellation or reduction of
the mortgage will be ordinary income and not capital gain. Thus,
you need to plan carefully, as this technique for avoiding tax
on capital gains will not work if the income is ordinary income.