| Pub. 925, Passive Activity and At-Risk Rules |
2005 Tax Year |
Publication 925 - Main Contents
In general, you can deduct passive activity losses only from passive activity income (a limit on loss deductions). You carry
any excess loss
forward to the following year or years until used, or until deducted in the year you dispose of your entire interest in the
activity in a fully
taxable transaction. See Dispositions, later.
Before applying this limit on passive activity losses, you must first determine the amount of your loss disallowed under the
at-risk rules
explained in the second part of this publication.
Passive activity credits.
You can subtract passive activity credits only from the tax on net passive income. Passive activity credits include
the general business credit and
other special business credits, such as the credit for fuel produced from a nonconventional source. Credits that are more
than the tax on income from
passive activities are carried forward.
Unallowed passive activity credits, unlike unallowed passive activity losses, cannot be claimed when you dispose of your entire
interest in an
activity. However, to determine your gain or loss from the disposition, you can elect to increase the basis of the credit
property by the amount of
the original basis reduction for the credit, to the extent that the credit was not allowed because of the passive activity
limits. You cannot elect to
adjust the basis for a partial disposition of your interest in a passive activity.
See the instructions for Form 8582-CR for more information.
Publicly traded partnership.
You must apply the rules in this part separately to your income or loss from a passive activity held through a publicly
traded partnership (PTP).
You also must apply the limit on passive activity credits separately to your credits from a passive activity held through
a PTP.
You can offset losses from passive activities of a PTP only against income or gain from passive activities of the
same PTP. Likewise, you can
offset credits from passive activities of a PTP only against the tax on the net passive income from the same PTP. This separate
treatment rule also
applies to a regulated investment company holding an interest in a PTP for the items attributable to that interest.
For more information on how to apply the passive activity loss rules to PTPs, and on how to apply the limit on passive
activity credits to PTPs,
see Publicly Traded Partnerships (PTPs) in the instructions for Forms 8582 and 8582-CR, respectively.
Who Must Use These Rules?
The passive activity rules apply to:
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Individuals,
-
Estates,
-
Trusts (other than grantor trusts),
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Personal service corporations, and
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Closely held corporations.
Even though the rules do not apply to grantor trusts, partnerships, and S corporations directly, they do apply to the owners
of these entities.
For information about personal service corporations and closely held corporations, including definitions and how the passive
activity rules apply
to these corporations, see Form 8810 and its instructions.
Closely held corporation.
A closely held corporation can offset net active income with its passive activity loss. It also can offset the tax
attributable to its net active
income with its passive activity credits. However, a closely held corporation cannot offset its portfolio income (defined
later, under Passive
Activity Income) with its passive activity loss.
Net active income is the corporation's taxable income figured without any income or loss from a passive activity or
any portfolio income or loss.
There are two kinds of passive activities.
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Trade or business activities in which you do not materially participate during the year.
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Rental activities, even if you do materially participate in them, unless you are a real estate professional.
Material participation in a trade or business is discussed later, under Activities That Are Not Passive Activities.
Treatment of former passive activities.
A former passive activity is an activity that was a passive activity in any earlier tax year, but is not a passive
activity in the current tax
year. You can deduct a prior year's unallowed loss from the activity up to the amount of your current year net income from
the activity. Treat any
remaining prior year unallowed loss like you treat any other passive loss.
In addition, any prior year unallowed passive activity credits from a former passive activity offset the allocable
part of your current year tax
liability. The allocable part of your current year tax liability is that part of this year's tax liability that is allocable
to the current year net
income from the former passive activity. You figure this after you reduce your net income from the activity by any prior year
unallowed loss from that
activity (but not below zero).
Trade or Business Activities
A trade or business activity is an activity that:
-
Involves the conduct of a trade or business (that is, deductions would be allowable under section 162 of the Internal Revenue
Code if other
limitations, such as the passive activity rules, did not apply),
-
Is conducted in anticipation of starting a trade or business, or
-
Involves research or experimental expenditures that are deductible under Internal Revenue Code section 174 (or that would
be deductible if
you chose to deduct rather than capitalize them).
A trade or business activity does not include a rental activity or the rental of property that is incidental to an activity
of holding the
property for investment.
You generally report trade or business activities on Schedule C, C-EZ, F, or in Part II or III of Schedule E.
A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated
as a real estate
professional. See Real Estate Professional under Activities That Are Not Passive Activities, later. An activity is a rental
activity if tangible property (real or personal) is used by customers or held for use by customers, and the gross income (or
expected gross income)
from the activity represents amounts paid (or to be paid) mainly for the use of the property. It does not matter whether the
use is under a lease, a
service contract, or some other arrangement.
Exceptions.
Your activity is not a rental activity if any of the following apply.
-
The average period of customer use of the property is 7 days or less. You figure the average period of customer use by dividing
the total
number of days in all rental periods by the number of rentals during the tax year. If the activity involves renting more than
one class of property,
multiply the average period of customer use of each class by a fraction. The numerator of the fraction is the gross rental
income from that class of
property and the denominator is the activity's total gross rental income. The activity's average period of customer use will
equal the sum of the
amounts for each class.
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The average period of customer use of the property, as figured in (1) above, is 30 days or less and you provide significant
personal
services with the rentals. Significant personal services include only services performed by individuals. To determine if personal
services are
significant, all relevant facts and circumstances are taken into consideration, including the frequency of the services, the
type and amount of labor
required to perform the services, and the value of the services relative to the amount charged for use of the property. Significant
personal services
do not include the following.
-
Services needed to permit the lawful use of the property,
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Services to repair or improve property that would extend its useful life for a period substantially longer than the average
rental,
and
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Services that are similar to those commonly provided with long-term rentals of real estate, such as cleaning and maintenance
of common areas
or routine repairs.
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You provide extraordinary personal services in making the rental property available for customer use. Services are extraordinary
personal
services if they are performed by individuals and the customers' use of the property is incidental to their receipt of the
services.
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The rental is incidental to a nonrental activity. The rental of property is incidental to an activity of holding property
for investment if
the main purpose of holding the property is to realize a gain from its appreciation and the gross rental income from the property
is less than 2% of
the smaller of the property's unadjusted basis or fair market value. The unadjusted basis of property is its cost not reduced
by depreciation or any
other basis adjustment. The rental of property is incidental to a trade or business activity if all of the following apply.
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You own an interest in the trade or business activity during the year.
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The rental property was used mainly in that trade or business activity during the current year, or during at least 2 of the
5 preceding tax
years.
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Your gross rental income from the property is less than 2% of the smaller of its unadjusted basis or fair market value. Lodging
provided to
an employee or the employee's spouse or dependents is incidental to the activity or activities in which the employee performs
services if the lodging
is furnished for the employer's convenience.
-
You customarily make the rental property available during defined business hours for nonexclusive use by various customers.
-
You provide the property for use in a nonrental activity in your capacity as an owner of an interest in the partnership, S
corporation, or
joint venture conducting that activity.
If you meet any of the exceptions listed above, see the instructions for Form 8582 for information about how to report any
income or loss from the
activity.
Special $25,000 allowance.
If you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000
of loss from the activity from
your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income
from passive activities.
Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into
account any losses allowed
under this exception.
If you are married, filing a separate return, and lived apart from your spouse for the entire tax year, your special
allowance cannot be more than
$12,500. If you lived with your spouse at any time during the year and are filing a separate return, you cannot use the special
allowance to reduce
your nonpassive income or tax on nonpassive income.
The maximum special allowance is reduced if your modified adjusted gross income exceeds certain amounts. See Phaseout rule, later.
Example.
Kate, a single taxpayer, has $70,000 in wages, $15,000 income from a limited partnership, a $26,000 loss from rental real
estate activities in
which she actively participated, and less than $100,000 of modified adjusted gross income. She can use $15,000 of her $26,000
loss to offset her
$15,000 passive income from the partnership. She actively participated in her rental real estate activities, so she can use
the remaining $11,000
rental real estate loss to offset $11,000 of her nonpassive income (wages).
Commercial revitalization deduction.
The special allowance must first be applied to losses from rental real estate activities figured without the commercial
revitalization deduction.
Any remaining part of the special allowance is available for the commercial revitalization deduction from the rental real
estate activities and is not
subject to the active participation rules or the phaseout based on modified adjusted gross income.
For more information about the commercial revitalization deduction, see Publication 954, Tax Incentives for Distressed
Communities.
Active participation.
Active participation is not the same as material participation (defined later). Active participation is a less stringent
standard than material
participation. For example, you may be treated as actively participating if you make management decisions in a significant
and bona fide sense.
Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving
expenditures, and similar
decisions.
Only individuals can actively participate in rental real estate activities. However, a decedent's estate is treated
as actively participating for
its tax years ending less than 2 years after the decedent's death, if the decedent would have satisfied the active participation
requirement for the
activity for the tax year the decedent died.
A decedent's qualified revocable trust can also be treated as actively participating if both the trustee and the executor
(if any) of the estate
choose to treat the trust as part of the estate. The choice applies to tax years ending after the decedent's death and before:
-
2 years after the decedent's death if no estate tax return is required, or
-
6 months after the estate tax liability is finally determined if an estate tax return is required.
The choice is irrevocable and cannot be made later than the due date for the estate's first income tax return (including
any extensions).
Limited partners are not treated as actively participating in a partnership's rental real estate activities.
You are not treated as actively participating in a rental real estate activity unless your interest in the activity
(including your spouse's
interest) was at least 10% (by value) of all interests in the activity throughout the year.
Active participation is not required to take the low-income housing credit, the rehabilitation investment credit,
or commercial revitalization
deduction from rental real estate activities.
Example.
Mike, a single taxpayer, had the following income and loss during the tax year:
The rental loss came from a house Mike owned. He advertised and rented the house to the current tenant himself. He also collected
the rents and
either did the repairs or hired someone to do them.
Even though the rental loss is a loss from a passive activity, Mike can use the entire $4,000 loss to offset his other income
because he actively
participated.
Phaseout rule.
The maximum special allowance of $25,000 ($12,500 for married individuals filing separate returns and living apart
at all times during the year) is
reduced by 50% of the amount of your modified adjusted gross income that is more than $100,000 ($50,000 if you are married
filing separately). If your
modified adjusted gross income is $150,000 or more ($75,000 or more if you are married filing separately), you generally cannot
use the special
allowance.
Modified adjusted gross income for this purpose is your adjusted gross income figured without the
following.
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Taxable social security and tier 1 railroad retirement benefits.
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Deductible contributions to individual retirement accounts (IRAs) and section 501(c)(18) pension plans.
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The exclusion from income of interest from qualified U.S. savings bonds used to pay qualified higher education expenses.
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The exclusion from income of amounts received from an employer's adoption assistance program.
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Passive activity income or loss included on Form 8582.
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Any rental real estate loss allowed because you materially participated in the rental activity as a real estate professional
(as discussed
later, under Activities That Are Not Passive Activities).
-
Any overall loss from a publicly traded partnership (see Publicly Traded Partnerships (PTPs) in the instructions for Form
8582).
-
The deduction for one-half of self-employment tax.
-
The deduction for domestic production activities.
-
The deduction allowed for interest on student loans.
-
The deduction for qualified tuition and related expenses.
Example.
During 2005, John was unmarried and was not a real estate professional. For 2005, he had $120,000 in salary and a $31,000
loss from his rental real
estate activities in which he actively participated. His modified adjusted gross income is $120,000. When he files his 2005
return, he may deduct only
$15,000 of his passive activity loss. He must carry over the remaining $16,000 passive activity loss to 2006. He figures his
deduction and carryover
as follows:
Exceptions to the phaseout rules.
A higher phaseout range applies to low-income housing credits for property placed in service before 1990 and rehabilitation
investment credits from
rental real estate activities. For those credits, the phaseout of the $25,000 special allowance starts when your modified
adjusted gross income
exceeds $200,000 ($100,000 if you are a married individual filing a separate return and living apart at all times during the
year).
There is no phaseout of the $25,000 special allowance for low-income housing credits for property placed in service
after 1989 or for the
commercial revitalization deduction. If you hold an indirect interest in the property through a partnership, S corporation,
or other pass-through
entity, the special exception for the low-income housing credit will not apply unless you also acquired your interest in the
pass-through entity after
1989.
Ordering rules.
If you have more than one of the exceptions to the phaseout rules in the same tax year, you must apply the $25,000
phaseout against your passive
activity losses and credits in the following order.
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The portion of passive activity losses not attributable to the commercial revitalization deduction.
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The portion of passive activity losses attributable to the commercial revitalization deduction.
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The portion of passive activity credits attributable to credits other than the rehabilitation and low-income housing credits.
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The portion of passive activity credits attributable to the rehabilitation credit and low-income housing credit for property
placed in
service before 1990.
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The portion of passive activity credits attributable to the low-income housing credit for property placed in service after
1989.
Activities That Are Not Passive Activities
The following are not passive activities.
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Trade or business activities in which you materially participated for the tax year.
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A working interest in an oil or gas well which you hold directly or through an entity that does not limit your liability (such
as a general
partner interest in a partnership). It does not matter whether you materially participated in the activity for the tax year.
However, if your
liability was limited for part of the year (for example, you converted your general partner interest to a limited partner
interest during the year)
and you had a net loss from the well for the year, some of your income and deductions from the working interest may be treated
as passive activity
gross income and passive activity deductions. See Temporary Regulations section 1.469-1T(e) (4)(ii).
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The rental of a dwelling unit that you also used for personal purposes during the year for more than the greater of 14 days
or 10% of the
number of days during the year that the home was rented at a fair rental.
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An activity of trading personal property for the account of those who own interests in the activity. See Temporary Regulations
section
1.469-1T(e)(6).
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Rental real estate activities in which you materially participated as a real estate professional. See Real Estate Professional,
later.
You should not enter income and losses from these activities on Form 8582. Instead, enter them on the forms or schedules you
would normally use.
A trade or business activity is not a passive activity if you materially participated in the activity.
Material participation tests.
You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.
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You participated in the activity for more than 500 hours.
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Your participation was substantially all the participation in the activity of all individuals for the tax year, including
the participation
of individuals who did not own any interest in the activity.
-
You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any
other individual
(including individuals who did not own any interest in the activity) for the year.
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The activity is a significant participation activity, and you participated in all significant participation activities for
more than 500
hours. A significant participation activity is any trade or business activity in which you participated for more than 100
hours during the year and in
which you did not materially participate under any of the material participation tests, other than this test. See Significant Participation
Passive Activities, under Recharacterization of Passive Income, later.
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You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
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The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding
tax years.
An activity is a personal service activity if it involves the performance of personal services in the fields of health (including
veterinary
services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade
or business in which capital
is not a material income-producing factor.
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Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis
during the year.
You did not materially participate in the activity under test (7) if you participated in the activity for 100 hours
or less during the year. Your
participation in managing the activity does not count in determining whether you materially participated under this test if:
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Any person other than you received compensation for managing the activity, or
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Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual
was compensated
for the management services).
Participation.
In general, any work you do in connection with an activity in which you own an interest is treated as participation
in the activity.
Work not usually performed by owners.
You do not treat the work you do in connection with an activity as participation in the activity if both of the following
are true.
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The work is not work that is customarily done by the owner of that type of activity.
-
One of your main reasons for doing the work is to avoid the disallowance of any loss or credit from the activity under the
passive activity
rules.
Participation as an investor.
You do not treat the work you do in your capacity as an investor in an activity as participation unless you are directly
involved in the day-to-day
management or operations of the activity. Work you do as an investor includes:
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Studying and reviewing financial statements or reports on operations of the activity,
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Preparing or compiling summaries or analyses of the finances or operations of the activity for your own use, and
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Monitoring the finances or operations of the activity in a nonmanagerial capacity.
Spouse's participation.
Your participation in an activity includes your spouse's participation. This applies even if your spouse did not own
any interest in the activity
and you and your spouse do not file a joint return for the year.
Proof of participation. You can use any reasonable method to prove your participation in an activity for the year. You do not have to
keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other
way. For example, you can
show the services you performed and the approximate number of hours spent by using an appointment book, calendar, or narrative
summary.
Limited partners.
If you owned an activity as a limited partner, you generally are not treated as materially participating in the activity.
However, you are treated
as materially participating in the activity if you met test (1), (5), or (6) under Material participation tests, discussed earlier, for the
tax year.
You are not treated as a limited partner, however, if you also were a general partner in the partnership at all times
during the partnership's tax
year ending with or within your tax year (or, if shorter, during that part of the partnership's tax year in which you directly
or indirectly owned
your limited partner interest).
Retired or disabled farmer and surviving spouse of a farmer.
If you are a retired or disabled farmer, you are treated as materially participating in a farming activity if you
materially participated for 5 or
more of the 8 years before your retirement or disability. Similarly, if you are a surviving spouse of a farmer, you are treated
as materially
participating in a farming activity if the real property used in the activity meets the estate tax rules for special valuation
of farm property passed
from a qualifying decedent, and you actively manage the farm.
Corporations.
A closely held corporation or a personal service corporation is treated as materially participating in an activity
only if one or more shareholders
holding more than 50% by value of the outstanding stock of the corporation materially participate in the activity.
A closely held corporation can also satisfy the material participation standard by meeting the first two requirements
for the qualifying business
exception from the at-risk limits. See Special exception for qualified corporations under Activities Covered by the At-Risk Rules,
later.
Generally, rental activities are passive activities even if you materially participated in them. However, if you qualified
as a real estate
professional, rental real estate activities in which you materially participated are not passive activities. For this purpose,
each interest you have
in a rental real estate activity is a separate activity, unless you choose to treat all interests in rental real estate activities
as one activity.
See the instructions for Schedule E (Form 1040) for information about making this choice.
If you qualified as a real estate professional for 2005, report income or losses from rental real estate activities in which
you materially
participated as nonpassive income or losses, and complete line 43 of Schedule E (Form 1040). If you also have an unallowed
loss from these activities
from an earlier year when you did not qualify, see Treatment of former passive activities under Passive Activities, earlier.
Qualifications.
You qualified as a real estate professional for the year if you met both of the following requirements.
-
More than half of the personal services you performed in all trades or businesses during the tax year were performed in real
property trades
or businesses in which you materially participated.
-
You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially
participated.
Do not count personal services you performed as an employee in real property trades or businesses unless you were
a 5% owner of your employer. You
were a 5% owner if you owned (or are considered to have owned) more than 5% of your employer's outstanding stock, outstanding
voting stock, or capital
or profits interest.
If you file a joint return, do not count your spouse's personal services to determine whether you met the preceding
requirements. However, you can
count your spouse's participation in an activity in determining if you materially participated.
Real property trades or businesses.
A real property trade or business is a trade or business that does any of the following with real property.
Closely held corporations.
A closely held corporation can qualify as a real estate professional if more than 50% of the gross receipts for its
tax year came from real
property trades or businesses in which it materially participated.
Passive Activity Income and Deductions
In figuring your net income or loss from a passive activity, take into account only passive activity income and passive activity
deductions.
Self-charged interest.
Certain self-charged interest income or deductions may be treated as passive activity gross income or passive activity
deductions if the loan
proceeds are used in a passive activity.
Generally, self-charged interest income and deductions result from loans between you and a partnership or S corporation
in which you had a direct
or indirect ownership interest. This includes both loans you made to the partnership or S corporation and loans the partnership
or S corporation made
to you.
It also includes loans from one partnership or S corporation to another partnership or S corporation if each owner
in the borrowing entity has the
same proportional ownership interest in the lending entity.
Exception. The self-charged interest rules do not apply to your interest in a partnership or S corporation if the entity made an
election under Regulations section 1.469-7(g) to avoid the application of these rules. For more details on the self-charged
interest rules, see
Regulations section 1.469-7.
Passive activity income includes all income from passive activities and generally includes gain from disposition of an interest
in a passive
activity or property used in a passive activity.
Passive activity income does not include the following items.
-
Income from an activity that is not a passive activity. These activities are discussed under Activities That Are Not Passive
Activities, earlier.
-
Portfolio income. This includes interest, dividends, annuities, and royalties not derived in the ordinary course of a trade
or business. It
includes gain or loss from the disposition of property that produces these types of income or that is held for investment.
The exclusion for portfolio income does not apply to self-charged interest treated as passive activity income. For more information
on self-charged
interest, see Self-charged interest, earlier.
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Personal service income. This includes salaries, wages, commissions, self-employment income from trade or business activities
in which you
materially participated, deferred compensation, taxable social security and other retirement benefits, and payments from partnerships
to partners for
personal services.
-
Income from positive section 481 adjustments allocated to activities other than passive activities. (Section 481 adjustments
are adjustments
that must be made due to changes in your accounting method.)
-
Income or gain from investments of working capital.
-
Income from an oil or gas property if you treated any loss from a working interest in the property for any tax year beginning
after 1986 as
a nonpassive loss, as discussed in item (2) under Activities That Are Not Passive Activities, earlier. This also applies to income from
other oil and gas property the basis of which is determined wholly or partly by the basis of the property in the preceding
sentence.
-
Any income from intangible property, such as a patent, copyright, or literary, musical, or artistic composition, if your personal
efforts
significantly contributed to the creation of the property.
-
Any other income that must be treated as nonpassive income. See Recharacterization of Passive Income, later.
-
Overall gain from any interest in a publicly traded partnership. See Publicly Traded Partnerships (PTPs) in the instructions for
Form 8582.
-
State, local, and foreign income tax refunds.
-
Income from a covenant not to compete.
-
Reimbursement of a casualty or theft loss included in gross income to recover all or part of a prior year loss deduction,
if the loss
deduction was not a passive activity deduction.
-
Alaska Permanent Fund dividends.
-
Cancellation of debt income, if at the time the debt is discharged the debt is not allocated to passive activities under the
interest
expense allocation rules. See chapter 5 of Publication 535, Business Expenses, for information about the rules for allocating
interest.
Disposition of property interests.
Gain on the disposition of an interest in property generally is passive activity income if, at the time of the disposition,
the property was used
in an activity that was a passive activity in the year of disposition. The gain generally is not passive activity income if,
at the time of
disposition, the property was used in an activity that was not a passive activity in the year of disposition. An exception
to this general rule may
apply if you previously used the property in a different activity.
Exception for more than one use in the preceding 12 months.
If you used the property in more than one activity during the 12-month period before its disposition, you must allocate
the gain between the
activities on a basis that reasonably reflects the property's use during that period. Any gain allocated to a passive activity
is passive activity
income.
For this purpose, an allocation of the gain solely to the activity in which the property was mainly used during that
period reasonably reflects the
property's use if the fair market value of your interest in the property is not more than the lesser of:
Exception for substantially appreciated property.
The gain is passive activity income if the fair market value of the property at disposition was more than 120% of
its adjusted basis and either of
the following conditions applies.
-
You used the property in a passive activity for 20% of the time you held your interest in the property.
-
You used the property in a passive activity for the entire 24-month period before its disposition.
If neither condition applies, the gain is not passive activity income. However, it is treated as portfolio income only if
you held the property
for investment for more than half of the time you held it in nonpassive activities.
For this purpose, treat property you held through a corporation (other than an S corporation) or other entity whose
owners receive only portfolio
income as property held in a nonpassive activity and as property held for investment. Also, treat the date you agree to transfer
your interest for a
fixed or determinable amount as the disposition date.
If you used the property in more than one activity during the 12-month period before its disposition, this exception
applies only to the part of
the gain allocated to a passive activity under the rules described in the preceding discussion.
Disposition of property converted to inventory.
If you disposed of property that you had converted to inventory from its use in another activity (for example, you
sold condominium units you
previously held for use in a rental activity), a special rule may apply. Under this rule, you disregard the property's use
as inventory and treat it
as if it were still used in that other activity at the time of disposition. This rule applies only if you meet all of the
following conditions.
-
At the time of disposition, you held your interest in the property in a dealing activity (an activity that involves holding
the property or
similar property mainly for sale to customers in the ordinary course of a trade or business).
-
Your other activities included a nondealing activity (an activity that does not involve holding similar property for sale
to customers in
the ordinary course of a trade or business) in which you used the property for more than 80% of the period you held it.
-
You did not acquire or hold your interest in the property for the main purpose of selling it to customers in the ordinary
course of a trade
or business.
Passive Activity Deductions
Passive activity deductions include all deductions from activities that are passive activities for the current tax year and
all deductions from
passive activities that were disallowed under the passive loss rules in prior tax years and carried forward to the current
tax year. They also include
losses from dispositions of property used in a passive activity at the time of the disposition and losses from a disposition
of less than your entire
interest in a passive activity.
Passive activity deductions do not include the following items.
-
Deductions for expenses (other than interest expense) that are clearly and directly allocable to portfolio income.
-
Qualified home mortgage interest, capitalized interest expenses, and other interest expenses (other than self-charged interest)
properly
allocable to passive activities. For more information on self-charged interest, see Self-charged interest under Passive Activity
Income and Deductions, earlier.
-
Losses from dispositions of property that produce portfolio income or property held for investment.
-
State, local, and foreign income taxes.
-
Miscellaneous itemized deductions that may be disallowed because of the 2%-of-adjusted-gross-income limit.
-
Charitable contribution deductions.
-
Net operating loss deductions.
-
Percentage depletion carryovers for oil and gas wells.
-
Capital loss carrybacks and carryovers.
-
Deductions and losses that would have been allowed for tax years beginning before 1987 but for basis or at-risk limits.
-
Net negative section 481 adjustments allocated to activities other than passive activities. (Section 481 adjustments are adjustments
required due to changes in accounting methods.)
-
Casualty and theft losses, unless losses similar in cause and severity recur regularly in the activity.
-
The deduction for one-half of self-employment tax.
You can treat one or more trade or business activities, or rental activities, as a single activity if those activities form
an appropriate economic
unit for measuring gain or loss under the passive activity rules.
Grouping is important for a number of reasons. If you group two activities into one larger activity, you need only show material
participation in
the activity as a whole. But if the two activities are separate, you must show material participation in each one. On the
other hand, if you group two
activities into one larger activity and you dispose of one of the two, then you have disposed of only part of your entire
interest in the activity.
But if the two activities are separate and you dispose of one of them, then you have disposed of your entire interest in that
activity.
Grouping can also be important in determining whether you meet the 10% ownership requirement for actively participating in
a rental real estate
activity.
Appropriate Economic Units
Generally, to determine if activities form an appropriate economic unit, you must consider all the relevant facts and circumstances.
You can use
any reasonable method of applying the relevant facts and circumstances in grouping activities. The following factors have
the greatest weight in
determining whether activities form an appropriate economic unit. All of the factors do not have to apply to treat more than
one activity as a single
activity. The factors that you should consider are:
-
The similarities and differences in the types of trades or businesses,
-
The extent of common control,
-
The extent of common ownership,
-
The geographical location, and
-
The interdependencies between or among activities, which may include the extent to which the activities:
-
Buy or sell goods between or among themselves,
-
Involve products or services that are generally provided together,
-
Have the same customers,
-
Have the same employees, or
-
Use a single set of books and records to account for the activities.
Example 1.
John Jackson owns a bakery and a movie theater at a shopping mall in Baltimore and a bakery and movie theater in Philadelphia.
Based on all the
relevant facts and circumstances, there may be more than one reasonable method for grouping John's activities. For example,
John may be able to group
the movie theaters and the bakeries into:
-
One activity,
-
A movie theater activity and a bakery activity,
-
A Baltimore activity and a Philadelphia activity, or
-
Four separate activities.
Example 2.
Betty is a partner in ABC partnership, which sells nonfood items to grocery stores. Betty is also a partner in DEF (a trucking
business). ABC and
DEF are under common control. The main part of DEF's business is transporting goods for ABC. DEF is the only trucking business
in which Betty is
involved. Based on the rules of this section, Betty treats ABC's wholesale activity and DEF's trucking activity as a single
activity.
Consistency and disclosure requirement.
Generally, when you group activities into appropriate economic units, you may not regroup those activities in a later
tax year. You must meet any
disclosure requirements of the Internal Revenue Service (IRS) when you first group your activities and when you add or dispose
of any activities in
your groupings.
However, if the original grouping is clearly inappropriate or there is a material change in the facts and circumstances
that makes the original
grouping clearly inappropriate, you must regroup the activities and comply with any disclosure requirements of the IRS.
Regrouping by the IRS.
If any of the activities resulting from your grouping is not an appropriate economic unit and one of the primary purposes
of your grouping (or
failure to regroup) is to avoid the passive activity rules, the IRS may regroup your activities.
Rental activities.
In general, you cannot group a rental activity with a trade or business activity. However, you can group them together
if the activities form an
appropriate economic unit and:
-
The rental activity is insubstantial in relation to the trade or business activity,
-
The trade or business activity is insubstantial in relation to the rental activity, or
-
Each owner of the trade or business activity has the same ownership interest in the rental activity, in which case the part
of the rental
activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade
or business
activity.
Example.
Herbert and Wilma are married and file a joint return. Healthy Food, an S corporation, is a grocery store business. Herbert
is Healthy Food's only
shareholder. Plum Tower, an S corporation, owns and rents out the building. Wilma is Plum Tower's only shareholder. Plum Tower
rents part of its
building to Healthy Food. Plum Tower's grocery store rental business and Healthy Food's grocery business are not insubstantial
in relation to each
other.
Herbert and Wilma file a joint return, so they are treated as one taxpayer for purposes of the passive activity rules. The
same owner (Herbert and
Wilma) owns both Healthy Food and Plum Tower with the same ownership interest (100% in each). If the grouping forms an appropriate
economic unit, as
discussed earlier, Herbert and Wilma can group Plum Tower's grocery store rental and Healthy Food's grocery business into
a single trade or business
activity.
Grouping of real and personal property rentals.
In general, you cannot treat an activity involving the rental of real property and an activity involving the rental
of personal property as a
single activity. However, you can treat them as a single activity if you provide the personal property in connection with
the real property or the
real property in connection with the personal property.
Certain activities may not be grouped.
In general, if you own an interest as a limited partner or a limited entrepreneur in one of the following activities,
you may not group that
activity with any other activity in another type of business.
-
Holding, producing, or distributing motion picture films or video tapes.
-
Farming.
-
Leasing any section 1245 property (as defined in section 1245(a)(3) of the Internal Revenue Code). For a list of section 1245
property, see
Section 1245 property under Activities Covered by the At-Risk Rules, later.
-
Exploring for, or exploiting, oil and gas resources.
-
Exploring for, or exploiting, geothermal deposits.
If you own an interest as a limited partner or a limited entrepreneur in an activity described in the list above,
you may group that activity with
another activity in the same type of business if the grouping forms an appropriate economic unit as discussed earlier.
Limited entrepreneur.
A limited entrepreneur is a person who:
-
Has an interest in an enterprise other than as a limited partner, and
-
Does not actively participate in the management of the enterprise.
Activities conducted through another entity.
A personal service corporation, closely held corporation, partnership, or S corporation must group its activities
using the rules discussed in this
section. Once the entity groups its activities, you, as the partner or shareholder of the entity, may group those activities
(following the rules of
this section):
You may not treat activities grouped together by the entity as separate activities.
Personal service and closely held corporations.
You may group an activity conducted through a personal service or closely held corporation with your other activities
only to determine whether you
materially or significantly participated in those other activities. See Material Participation, earlier, and Significant Participation
Passive Activities, later.
Publicly traded partnership (PTP).
You may not group activities conducted through a PTP with any other activity, including an activity conducted through
another PTP.
Partial dispositions.
If you dispose of substantially all of an activity during your tax year, you may treat the part disposed of as a separate
activity. However, you
can do this only if you can show with reasonable certainty:
-
The amount of deductions and credits disallowed in prior years under the passive activity rules that is allocable to the part
of the
activity disposed of, and
-
The amount of gross income and any other deductions and credits for the current tax year that is allocable to the part of
the activity
disposed of.
Recharacterization of Passive Income
Net income from the following passive activities may have to be recharacterized and excluded from passive activity income.
-
Significant participation passive activities,
-
Rental of property when less than 30% of the unadjusted basis of the property is subject to depreciation,
-
Equity-financed lending activities,
-
Rental of property incidental to development activities,
-
Rental of property to nonpassive activities, and
-
Licensing of intangible property by
pass-through entities.
If you are engaged in or have an interest in one of these activities during the tax year (either directly or through a partnership
or an S
corporation), combine the income and losses from the activity to determine if you have a net loss or net income from that
activity.
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