8014 / How are income and expenses characterized for purposes of the passive loss rules?

Interest deductions attributable to passive activities are subject to limitation under the passive loss rule, not under the investment interest limitation.²

In order to prevent taxpayers from defeating the purpose of the passive loss rules by structuring transactions to produce passive income from what are essentially active businesses or portfolio investments, Treasury was given very broad regulatory authority for carrying out the provisions of IRC Section 469. The IRC specifies that regulations may: provide that certain items of gross income will not be taken into account in determining income and loss from an activity, require that net income or gain from a limited partnership or other passive activity not be treated as passive income or loss, and allocate interest expense among activities.³ In the following instances, part or all of the income from a passive activity may be treated as income that is not from a passive activity: (1) the individual participates in such passive activity for more than 100 hours during the year, (2) less than 30 percent of the property used in a rental activity is depreciable property, (3) there is net interest income from a passive equity-financed lending activity, (4) rental of property developed by the taxpayer commenced within 12 months of disposition of such property, (5) the taxpayer rents property to a trade or business in which the taxpayer materially participates, and (6) the taxpayer acquires certain royalty interests in intangible property previously developed by a passthrough entity.⁴

Special rule for significant participation. An amount of the taxpayer’s gross income from each significant participation passive activity for the taxable year equal to a ratable portion of the taxpayer’s net passive income from the activity for the year is treated as not from a passive activity if the taxpayer’s passive activity gross income from all significant participation passive activities for the year exceeds the taxpayer’s passive activity deductions from all such activities for the year. For purposes of this paragraph, the term “significant participation passive activity” means any trade or business activity in which the taxpayer significantly participates for the taxable year but in which he does not materially participate for the year. The terms “significant participation” and “material participation” are defined in the temporary income tax regulations.⁵

If gain is recognized in a taxable year beginning after 1986 with respect to an activity sold or exchanged before 1987, the gain is treated as passive if the activity would have been passive had the passive loss rule been in effect in the year the activity was sold or exchanged and in all succeeding years.⁶

The Service has issued temporary and proposed regulations that provide complex tracing rules allocating interest expense (other than qualified residence interest) on the basis of the use of the proceeds of the underlying debt.⁷ (See Q 8027.) Once allocated, interest on proceeds used to purchase a passive activity is taken into account in determining income or loss from the activity. Characterization of interest on proceeds used to purchase a partnership or S corporation interest depends on whether the activity is passive to the partner or shareholder.⁸

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Planning Point: Rules for allocating interest expense for purposes of applying the passive loss limitation of Section 469 of the Internal Revenue Code provide that interest expense is generally allocated in the same manner as the debt to which the interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. These interest tracing rules provide that the allocation is not affected by the use of an interest in any property to secure the repayment of the debt or interest.⁹

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Income from discharge of indebtedness is generally characterized as income from a passive activity to the extent that the debt is allocated to passive activity expenditures and as income from a nonpassive activity to the extent that, at the time indebtedness is discharged, the debt is not allocated to passive activity expenditures.¹⁰