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

Certain income and expenses of a passive activity are not considered passive activity income or expenses in determining passive activity income and loss: income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business; expenses allocable to such income; and gain or loss not derived in the ordinary course of a trade or business that is attributable to the disposition of property either producing such income or held for investment. An interest in a passive activity is not treated as property held for investment. Income from the investment of working capital is not derived in the ordinary course of a trade or business.¹

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