Our next article addresses passive activity. You might wonder why we are addressing this issue some thirty years after its implementation. Well folks, we have found that the level of understanding of passive activity is woefully lacking.
One CPA told me that he lets the computer do the work. Another seemed resigned that his clients will die with the suspended losses. This is not an indictment of all CPAs, especially those who aren’t old enough to recall pre-1986. Until last July I felt that passive activity was just an archaic part of the tax code. How wrong I was!
There is hope – do you and your clients like tax free income? I thought that might get your attention. We will discuss passive activity, the definition, how it works, and finally, how you and your clients can benefit from the passive activity rules.
Tax Reform Act of 1986
Remember the 10 for 1 write-offs of the early 1980’s – Wow! Tremendous economic substance? Not! Oops, that should be “I think not!”, but “Not” just comes out as a 66-year-old with 6 children, including a teenager, five grands and….
In 1986 Congress passed the Tax Reform Act of 1986 (the Act) that ended such abuses. I.R.C. Section 469 created special categories of income and loss called passive income and passive loss. The Act limited the use and value of passive losses to shelter income from taxation. Passive losses could only be used to shelter passive income, not earned income or portfolio income.
Next we will discuss what creates passive income and passive losses and how they work.
The IRS identifies two types of passive activity:
- Trade or business activities in which you do not materially participate during the year.
- Rental activities, even if you do materially participate in them, unless you are a real estate professional.
You materially participate in an activity if you are involved in the operation of the activity on a regular, continuous, and substantial basis. Now, what does regular, continuous, and substantial mean? Pretty subjective…again, Not!
The IRS has tests to determine material participation:
- You participated in the activity for more than 500 hours during the year
- You participated in the activity substantially more than anyone else
- You participated at least 100 hours and at least as much as others
- You materially participated for at least 5 of the last 10 years
- Your activity is a personal service activity in which you participated (e.g., legal, accounting)
- Or, based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis
Next, the following types of activity create passive results:
- Equipment leasing
- Rental real estate – with some exceptions
- Limited partnership
- Sole proprietorship or farm in which you don’t materially participate
- Partnerships, S Corporations and LLCs in which you do not materially participate
- Any business enterprise in which you do not materially participate
Income from an investment in a limited partnership is generally passive due to more restrictive tests for material participation. Generally, limited partners will have passive income or loss from the partnership.
As with any good law, there are exceptions. The most prevalent exceptions deal with real estate. First, if you qualify as a real estate professional, your real estate activities will be nonpassive, and you are allowed to deduct unlimited rental losses against any income you earn. You have to document that you spent at least 750 hours of activity in real estate activities during the year.
The second exception is if you have active participation in real estate. Active participation is a less stringent standard than material participation. You may be treated as actively participating if you make management decisions. Such management decisions include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.
Thus, if you actively participated in a passive rental real estate activity, the amount of the passive activity loss that is disallowed is decreased and you therefore can deduct from your nonpassive income up to $25,000 of loss from the activity. This is referred to as the special $25,000 allowance.
Now that we are perfectly clear on real estate activities (tongue firmly in cheek), let’s discuss what will not be passive activity.
Nonpassive activities are businesses in which the taxpayer materially participates on a regular, continuous, and substantial basis, and includes income from salaries, portfolio and investment income.
Nonpassive income includes:
- Salary, wages, 1099 commissions
- Guaranteed payments
- 1099 commission income
- Interest income
- Portfolio income
- Rental income in ordinary course of business
- Royalties in ordinary course of business
- Gains and losses on stocks and bonds
- Lottery winnings
- Sale of other property held for investment
- Sole proprietorship or farm in which you materially participate
- Partnership, S Corporation, LLC which you materially participate
- Trusts in which fiduciary materially participate
Now that we have discussed what creates passive activity and what does not create passive activity, the question is what happens next? All passive activity is separated into a separate tax basket.
Within each basket, losses and gains for different passive activities are netted against each other. If the total of losses and gains, including suspended passive losses that were carried forward from prior years, is positive, income is included in taxable income. If the net total of losses and gains is negative, the loss is suspended and carried forward indefinitely, until passive income is recognized in a future year or years, or the activities are sold and go out of existence.
An investor’s passive income can be offset by passive losses on a dollar for dollar basis. There is no limit on the amount of passive losses and passive income that can be offset annually.
IRS Form 8582, Passive Activity Loss Limitations, reflects the passive activity for a year, including any passive losses carried forward. Generally, losses from passive activities that exceed the income from passive activities are disallowed for the current year. You can carry forward disallowed passive losses to the next taxable year. A similar rule applies to credits from passive activities.
If an activity is sold or goes out of business, the taxpayer may deduct in full any previously disallowed passive activity loss in the year you dispose of your entire interest in an entity. The taxpayer may not claim unused passive activity credits upon disposition of entire interest. However, the taxpayer may elect to increase the basis of credit property an amount equal to the portion of unused credit that previously reduced the basis of the credit property.
Investment Opportunities – Both Sides of the Coin
We have now described passive activity and provided a brief overview of how it works. I highly recommend that you review your own and your client’s passive activity.
If there are suspended loss carry forwards on form 8582, and there are available resources, there is an opportunity to receive tax free passive income to the extent of the loss carry forwards. And, rather than navigating how to generate passive income, which can be a wee bit tricky, there are investments that generate passive income.
On the other side of the coin, there are investors who have a large percentage of their income classified as passive income. If you or your clients have passive income, there are investments that create passive losses.
Either way, this is your opportunity to make the tax code work for you and your clients. And, even though we are all stretched thin, tax preparation time is the right time for getting busy with passive activity.