Passive Activity Loss

Passive 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 market investments.

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 materially participates.

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 of $10,000.

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.