8010 / What are the passive loss rules?

An individual can also deduct a limited amount of losses (and the deduction-equivalent of credits) arising from certain rental real estate activities against nonpassive income. See Q . A closely held C corporation (other than a personal service corporation) can deduct its passive activity losses against its net active income (other than its investment, or “portfolio,” income) and its passive credits can be applied against its tax liability attributable to its net active income.² Generally, a corporation is “closely” held if five or fewer individuals own more than 50 percent of the value of the stock.³ (For these purposes, certain organizations—including a qualified retirement plan under IRC Section 401(a) and a trust providing for the payment of supplemental unemployment compensation benefits under IRC Section 501(c)(17)—are considered an “individual.”)⁴ A personal service corporation is a corporation the principal activity of which is the performance of personal services and the services of which are substantially performed by employee-owners.⁵

An exception to the passive loss restrictions is applied to certain casualty losses resulting from unusual events such as fire, storm, shipwreck, and earthquake. Losses from such casualties are generally not subject to the passive loss rules.⁶ Likewise, passive activity income does not include reimbursements for such losses if (1) the reimbursement is includable in gross income under Treasury Regulation Section 1.165-1(d)(2)(iii) as an amount the taxpayer had deducted in a prior taxable year, and (2) the deduction for the loss was not a passive activity deduction. In other words, both the losses and the reimbursement should be taken into account in the calculation of the partnership’s gross income, not its passive activity gross income.⁷ The exception does not apply to losses that occur regularly in the conduct of the activity, such as theft losses from shoplifting in a retail store, or accident losses sustained in the operation of a rental car business.⁸

Special restrictions apply to publicly traded partnerships under the passive loss rules. The rules are applied separately to items attributable to a publicly traded partnership; thus, income, losses, and credits attributable to the partnership may not be aggregated with other income, losses, and credits of the taxpayer/partner for purposes of the passive loss rules.⁹ Net passive loss from a publicly traded partnership will be treated as passive, while net passive income from a publicly traded partnership is to be treated as investment income. See Q .¹⁰ Generally, net passive loss from a publicly traded partnership is carried forward until the partner has additional passive income from the partnership or the partner disposes of the partnership interest. See Q . Also, the $25,000 rental real estate exemption (see Q ) is available with respect to a publicly traded partnership only in connection with the low-income housing credit (see Q ) and the rehabilitation investment credit. See Q .Furthermore, a taxpayer will not be treated as having disposed of the taxpayer’s entire interest in an activity of a publicly-traded partnership until disposition of the entire interest in the partnership. A publicly traded partnership is a partnership that is traded on an established securities market or is readily tradable on a secondary market (or the substantial equivalent thereof).¹¹ It would seem that if a publicly traded partnership is taxed as a closely held C corporation or any personal service corporation (see Q ), the partnership is not a taxpayer subject to the passive loss rules.¹²

Losses and credits disallowed under the passive loss rules may be carried over to offset passive income and the tax attributable to it in later years. See Q . Suspended losses and credits of an activity may also offset the income and tax of that activity when the activity ceases to be passive or there is a change in status of a closely held corporation or personal service corporation. See Q .As to losses allowed upon disposition of an interest in a passive activity, see Q .

The passive loss rules apply to passive losses incurred in tax years beginning after 1986. They do not apply to any loss or credit carried over from a year beginning before 1987.¹³ A taxpayer may elect to treat investment interest (see Q ) as a passive activity deduction if the interest was carried over from a year prior to 1987 and is attributable to property used in a passive activity after 1986.¹⁴ However, the interest deduction is not treated as being from a pre-enactment interest in a passive activity.¹⁵ This election had to be made by filing an amended return on or before the later of (1) the due date (taking into account any extensions of time to file obtained by the taxpayer) for filing the income tax return of the taxpayer for the taxpayer’s first taxable year beginning after December 31, 1987, or (2) August 15, 1989.¹⁶