Limitation On Loss Deductions

July 25, 2024

8004 / To what types of investment activities do the “at risk” rules apply

<div class="Section1">The “at risk” rules apply to each of the following activities when engaged in by an individual (including partners and S corporation shareholders) as a trade or business or for the production of income:<div class="Section1"> …holding, producing, or distributing motion picture films or video tapes; …farming (including raising, shearing, feeding, caring for, training, or management of animals); …leasing of depreciable personal property (and certain other “IRC Section 1245” property, which includes both real and personal property and certain other tangible property that is being, or has been depreciated or amortized<a href="#_ftn1" name="_ftnref1">1</a>); …exploring for, or exploiting, oil and gas reserves (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>); …exploring, or exploiting, geothermal deposits; …holding real property (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for effective date and transitional relief rules); …all other activities engaged in by a taxpayer in carrying on a trade or business or for the production of income.<a href="#_ftn2" name="_ftnref2">2</a> Apparently, if a publicly traded partnership is taxed as a corporation (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>), the partnership is not subject to the at risk rules unless it is closely-held (generally, more than 50 percent control by five or fewer individuals).<a href="#_ftn3" name="_ftnref3">3</a> For these purposes, a qualified retirement plan described in IRC Section 401(a) as well as a plan providing for the payment of unemployment compensation benefits under IRC Section 501(c)(17) are considered individuals.<a href="#_ftn4" name="_ftnref4">4</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRS Publication 925, Passive Activity and At-Risk Rules. <a href="#_ftnref2" name="_ftn2">2</a>.  IRC §§ 465(c), 464(e). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 465(a). <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 542(a)(2). </div></div>

July 25, 2024

8010 / What are the passive loss rules?

<div class="Section1">Under the passive loss rules, aggregate losses from “passive” activities (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>) may generally be deducted in a year only to the extent they do not exceed aggregate income from passive activities in that year; credits from passive activities may be taken against tax liability allocated only to passive activities.<a href="#_ftn1" name="_ftnref1">1</a> (Aggregation is not permitted in the case of certain publicly traded partnerships. See below.) The rules generally apply to losses incurred in tax years beginning after 1986. The rules are intended to prevent losses from passive activities from offsetting salaries, interest, dividends, and income from “active” businesses. They apply to individuals, estates, trusts, closely held C corporations, and personal service corporations.<div class="Section1"> 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 href="javascript:void(0)" class="accordion-cross-reference" id=""></a>. 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.<a href="#_ftn2" name="_ftnref2">2</a> Generally, a corporation is “closely” held if five or fewer individuals own more than 50 percent of the value of the stock.<a href="#_ftn3" name="_ftnref3">3</a> (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.”)<a href="#_ftn4" name="_ftnref4">4</a> 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.<a href="#_ftn5" name="_ftnref5">5</a> 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.<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> 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.<a href="#_ftn8" name="_ftnref8">8</a> 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.<a href="#_ftn9" name="_ftnref9">9</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>.<a href="#_ftn10" name="_ftnref10">10</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>. Also, the $25,000 rental real estate exemption (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>) is available with respect to a publicly traded partnership only in connection with the low-income housing credit (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>) and the rehabilitation investment credit. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>.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).<a href="#_ftn11" name="_ftnref11">11</a> It would seem that if a publicly traded partnership is taxed as a closely held C corporation or any personal service corporation (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>), the partnership is not a taxpayer subject to the passive loss rules.<a href="#_ftn12" name="_ftnref12">12</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>. 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 <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>.As to losses allowed upon disposition of an interest in a passive activity, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>. 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.<a href="#_ftn13" name="_ftnref13">13</a> A taxpayer may elect to treat investment interest (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>) 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.<a href="#_ftn14" name="_ftnref14">14</a> However, the interest deduction is not treated as being from a pre-enactment interest in a passive activity.<a href="#_ftn15" name="_ftnref15">15</a> 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.<a href="#_ftn16" name="_ftnref16">16</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 469. <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 469(e)(2). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 469(j)(1). <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 542(a)(2). <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 469(j)(2). <a href="#_ftnref6" name="_ftn6">6</a>.  Temp. Treas. Reg. § 1.469-2T(d)(2), Treas. Reg. § 1.469-2(d)(2)(xi). <a href="#_ftnref7" name="_ftn7">7</a>.  Temp. Treas. Reg. § 1.469-2T(c)(7), Treas. Reg. § 1.469-2(c)(7)(vi). <a href="#_ftnref8" name="_ftn8">8</a>.  TD 8290, 1990-1 CB 109. <a href="#_ftnref9" name="_ftn9">9</a>.  IRC § 469(k)(1). <a href="#_ftnref10" name="_ftn10">10</a>.  Notice 88-75, 1988-2 CB 386. <a href="#_ftnref11" name="_ftn11">11</a>.  IRC § 469(k). <a href="#_ftnref12" name="_ftn12">12</a>.  IRC § 469(a). <a href="#_ftnref13" name="_ftn13">13</a>.  TRA ’86 § 501(c)(2). <a href="#_ftnref14" name="_ftn14">14</a>.  TAMRA ’88 § 1005(c)(11). <a href="#_ftnref15" name="_ftn15">15</a>.  Notice 89-36, 1989-1 CB 677. <a href="#_ftnref16" name="_ftn16">16</a>.  TAMRA ’88 § 1005(c)(11; Notice 89-36, 1989-1 CB 6771. </div></div>

March 13, 2024

8020 / How are suspended passive losses treated when an activity ceases to be passive or if a closely held C corporation or personal service corporation changes status?

<div class="Section1">If an activity ceases to be passive (e.g., because the taxpayer begins to participate materially), its unused losses (or credits) from prior years continue to be passive, but may be used against the income (and tax liability) of that activity. If there is a change in the status of a closely held C corporation or personal service corporation, its suspended losses from prior years will continue to be treated as if the status of the corporation had not changed.<a href="#_ftn1" name="_ftnref1">1</a> <hr> Planning Point: As a general rule, an individual will be treated as materially participating in an activity for the taxable year if, and only if, he or she participates in the activity for more than 500 hours during the year, or if his or her participation satisfies one of six other requirements in Temporary Treasury Regulation Section 1.469-5T(a). For instance, the individual’s participation will be deemed material if, based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year.<a href="#_ftn2" name="_ftnref2">2</a> <hr> For an explanation of losses allowed upon disposition of an interest in a former passive activity, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8019">8019</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 469(f). <a href="#_ftnref2" name="_ftn2">2</a>.  Temp. Treas. Reg. § 1.469-5T(a)(7). </div></div>

March 13, 2024

8008 / May an individual’s amount at risk in an activity be less than zero (i.e., a negative amount)? If so, what are the tax effects of a negative amount at risk?

<div class="Section1">Although the amount of loss that is allowed as a deduction for the tax year cannot reduce a taxpayer’s amount at risk below zero, it is possible to have a negative amount at risk. For example, if a distribution exceeding the amount at risk by $100 is made to the taxpayer, the amount at risk is reduced to a negative $100. (A negative amount at risk may also result when a recourse obligation is changed to nonrecourse, or when a guarantee that relieves the taxpayer of personal liability for a debt goes into effect.)<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="Section1"> If a taxpayer’s amount at risk falls below zero, he or she must recognize income to the extent the amount at risk is reduced below zero. An amount equal to the amount included in income is then carried over as a deduction with respect to the activity in the following tax year. In effect, the reduction (by distribution or other event) is treated as preceding the loss deductions previously taken that offset the original amount at risk, and the loss deduction in effect is treated as disallowed and carried over to a subsequent year. However, the amount required to be included in income when the at risk amount falls below zero cannot exceed the aggregate amount of reductions in the amount at risk that have taken place because of losses in prior years, reduced by any amounts included in income in prior years because the amount at risk had fallen below zero.<a href="#_ftn2" name="_ftnref2">2</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Prop. Treas. Reg. § 1.465-3. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 465(e). </div>

March 13, 2024

8009 / Do the at risk rules affect an individual’s tax basis in a tax shelter limited partnership?

<div class="Section1">No. The at risk rules and the limitations they impose on the deduction of losses do not affect the tax basis of property involved in the covered activity (including the tax basis of a limited interest in a partnership engaged in the covered activity) for purposes of determining gain or loss on disposition, calculating depreciation or depletion, or any other purpose.<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Prop. Treas. Reg. § 1.465-1(e). </div>

March 13, 2024

8011 / Under the passive loss rules, what is a passive activity?

<div class="Section1">A passive activity is any activity (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8016">8016</a> for rules defining an activity) that involves the conduct of a trade or business in which the taxpayer does not “materially participate.”<a href="#_ftn1" name="_ftnref1">1</a> The IRC indicates that regulations may define the term “trade or business” to include activities in connection with a trade or business or activities that are engaged in for the production of income under IRC Section 212. The Service has studied this matter.<a href="#_ftn2" name="_ftnref2">2</a> Regulations provide that the Service will treat real property held for the production of income under IRC Section 212 as a trade or business for purposes of the rental real estate with material participation exception (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>).<div class="Section1"> The term “passive activity” does not include a working interest in an oil or gas property that the taxpayer holds directly or through an entity that does not limit the liability of the taxpayer with respect to the interest (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7862">7862</a>).<a href="#_ftn3" name="_ftnref3">3</a> It also does not include the activity of trading personal property (e.g., stocks or bonds) on behalf of the owners of interests in the activity.<a href="#_ftn4" name="_ftnref4">4</a> <blockquote>Example: ABC partnership is a trader of stocks, bonds, and other securities (within the meaning of IRC Section 1236(c)). The capital employed by the partnership in the trading activity consists of amounts contributed by the partners in exchange for their partnership interests, and funds borrowed by the partnership. The partnership derives gross income from the activity in the form of interest, dividends, and capital gains. Under these facts, the partnership is treated as conducting an activity of trading personal property for the account of its partners. Accordingly, the activity is not a passive activity.<a href="#_ftn5" name="_ftnref5">5</a></blockquote> Whether an activity is passive or not with regard to a partner or an S corporation shareholder is determined at the level of the partner or shareholder, not at the level of the entity. Such determination is made with regard to the entity’s taxable year (not the partner’s or shareholder’s taxable year).<a href="#_ftn6" name="_ftnref6">6</a> However, if a publicly traded partnership is taxed as a corporation (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7728">7728</a>), the partnership is the taxpayer, and apparently the partnership is not subject to the passive loss rule.<a href="#_ftn7" name="_ftnref7">7</a> In the case of a limited partnership interest in an electing large partnership (note that the rules governing electing large partnerships have been repealed), all passive loss limitation activities of the partnership are treated as a single passive activity (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7733">7733</a>). </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 469(c). <a href="#_ftnref2" name="_ftn2">2</a>.  TD 8175(II)(A), 1988-1 CB 191. <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 469(c)(3). <a href="#_ftnref4" name="_ftn4">4</a>.  Temp. Treas. Reg. § 1.469-1T(e)(6). <a href="#_ftnref5" name="_ftn5">5</a>.  Temp. Reg. § 1.469-1T(e)(6)(iii). <a href="#_ftnref6" name="_ftn6">6</a>.  Temp. Treas. Reg. §§ 1.469-2T(e)(1), 1.469-3T(b)(3). <a href="#_ftnref7" name="_ftn7">7</a>.  IRC § 469(a). </div></div>

March 13, 2024

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

<div class="Section1">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.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> Interest deductions attributable to passive activities are subject to limitation under the passive loss rule, not under the investment interest limitation.<a href="#_ftn2" name="_ftnref2">2</a> 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.<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> 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.<a href="#_ftn5" name="_ftnref5">5</a> 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.<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8027">8027</a>.) 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.<a href="#_ftn8" name="_ftnref8">8</a> <hr> 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.<a href="#_ftn9" name="_ftnref9">9</a> <hr> 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.<a href="#_ftn10" name="_ftnref10">10</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 469(e). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 163(d)(4)(D). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 469(l). <a href="#_ftnref4" name="_ftn4">4</a>.  Temp. Treas. Reg. § 1.469-2T(f), Treas. Reg. § 1.469-2(f). <a href="#_ftnref5" name="_ftn5">5</a>.  Temp. Treas. Reg. § 1.469-5T. <a href="#_ftnref6" name="_ftn6">6</a>.  TRA ’86 § 501(c)(4) as amended by TAMRA ’88, § 1005(a)(10). <a href="#_ftnref7" name="_ftn7">7</a>.  Temp. Treas. Reg. § 1.163-8T. <a href="#_ftnref8" name="_ftn8">8</a>.  Ann. 87-4, 1987-3 IRB 17. <a href="#_ftnref9" name="_ftn9">9</a>.  Temp. Treas. Reg. § 1.163-8T. <a href="#_ftnref10" name="_ftn10">10</a>.  Rev. Rul. 92-92, 1992-2 CB 103. </div></div>

March 13, 2024

8016 / How is an activity defined for purposes of the passive loss rules?

<div class="Section1"> Regulations allow taxpayers to use a facts-and-circumstances approach to define one or more trade or business activities as a single activity if the activities constitute an appropriate economic unit for purposes of IRC Section 469. (In the case of a limited partnership interest in an electing large partnership, all passive loss limitation activities of the partnership are treated as a single passive activity. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7733">7733</a>.) Relevant factors to consider include: (1) similarities and differences in types of businesses; (2) the extent of common control; (3) the extent of common ownership; (4) geographical location; and (5) interdependencies between the activities. There may be more than one reasonable method for grouping activities.<a href="#_ftn1" name="_ftnref1">1</a> Rental activities may not be grouped with trade or business activities unless either the rental activity is insubstantial in relation to the trade or business activity or vice versa, or ownership interests in the trade and business activity are held in the same proportion as ownership interests in the rental activity.<a href="#_ftn2" name="_ftnref2">2</a> An activity involving the rental of real property and an activity involving the rental of personal property may not be treated as a single activity (unless the personal property is provided in connection with the real property or vice versa).<a href="#_ftn3" name="_ftnref3">3</a> For activities conducted through partnerships, S corporations, or C corporations subject to the passive loss rules, the entity must first group its activities under the above rules. Individual partners and shareholders may then group those activities with others conducted directly by the individual taxpayer or with activities conducted through other partnerships, S corporations, or C corporations subject to the passive loss rules, under the same rules. However, a shareholder or partner may not treat activities grouped by an entity as separate activities.<a href="#_ftn4" name="_ftnref4">4</a> Example: Taxpayer B, an individual, is a partner in a business that sells non-food items to grocery stores (partnership L). B also is a partner in a partnership that owns and operates a trucking business (partnership Q). The two partnerships are under common control. The predominant portion of Q’s business is transporting goods for L, and Q is the only trucking business in which B is involved. Under this section, B appropriately treats L’s wholesale activity and Q’s trucking activity as a single activity. A taxpayer involved as a limited partner or limited entrepreneur in certain activities (generally, holding, producing, or distributing motion picture films or videotapes; farming; equipment leasing; or exploring for, or exploiting oil and gas resources or geothermal resources) may group that activity with another activity only if the two activities are in the same type of business and the grouping is appropriate under the facts-and-circumstances test above.<a href="#_ftn5" name="_ftnref5">5</a> Once a taxpayer has grouped individual activities under the rules above, he or she may not regroup them in subsequent taxable years unless the original grouping was clearly inappropriate or there is a material change in facts and circumstances making the original grouping clearly inappropriate.<a href="#_ftn6" name="_ftnref6">6</a> The IRS may regroup a taxpayer’s activities if any of the activities resulting from the taxpayer’s grouping is not an appropriate economic unit and a principal purpose of the taxpayer’s grouping (or failure to regroup) is to circumvent the underlying purpose of IRC Section 469.<a href="#_ftn7" name="_ftnref7">7</a> Example: Taxpayers D, E, F, G, and H are doctors who operate separate medical practices. D invested in a tax shelter several years ago that generates passive losses and the other doctors intend to invest in real estate that will generate passive losses. The taxpayers form a partnership to engage in the trade or business of acquiring and operating X-ray equipment. In exchange for equipment contributed to the partnership, the taxpayers receive limited partnership interests. The partnership is managed by a general partner selected by the taxpayers; the taxpayers do not materially participate in its operations. Substantially all of the partnership’s services are provided to the taxpayers or their patients, roughly in proportion to the doctors’ interests in the partnership. Fees for the partnership’s services are set at a level equal to the amounts that would be charged if the partnership were dealing with the taxpayers at arm’s length and are expected to assure the partnership a profit. The taxpayers treat the partnership’s services as a separate activity from their medical practices and offset the income generated by the partnership against their passive losses. For each of the taxpayers, the taxpayer’s own medical practice and the services provided by the partnership constitute an appropriate economic unit, but the services provided by the partnership do not separately constitute an appropriate economic unit. Moreover, a principal purpose of treating the medical practices and the partnership’s services as separate activities is to circumvent the underlying purposes of Section 469. Accordingly, the IRS may require the taxpayers to treat their medical practices and their interests in the partnership as a single activity, regardless of whether the separate medical practices are conducted through C corporations subject to Section 469, S corporations, partnerships, or sole proprietorships. Additionally, the IRS may assert penalties under IRC section 6662 against the taxpayers in appropriate circumstances.<a href="#_ftn8" name="_ftnref8">8</a> A taxpayer who disposes of substantially all of an activity may treat the disposed interest as a separate activity, but only if the taxpayer can establish with reasonable certainty both (1) the amount of deductions and credits allocable to that part of the activity for that taxable year under IRC Section 469 and (2) the amount of gross income and any other deductions and credits allocable to that part of the activity for the taxable year.<a href="#_ftn9" name="_ftnref9">9</a> In general, for the first taxable year ending after May 10, 1992, taxpayers that are not in compliance with the activity grouping rules of Treasury Regulation Section 1.469-4 must regroup their activities under those rules without regard to how the activities were previously grouped. Further, regrouping is permissible for the first taxable year ending after May 10, 1992, even if the taxpayer is already in compliance with the activity grouping rules of Treasury Regulation Section 1.469-4.<a href="#_ftn10" name="_ftnref10">10</a> For special rules relating to rental real estate in which a taxpayer materially participates, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. § 1.469-4(c). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.469-4(d)(1). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.469-4(d)(2). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.469-4(d)(5). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.469-4(d)(3). <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. § 1.469-4(e). <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. § 1.469-4(f). <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 1.469-4(f)(2). <a href="#_ftnref9" name="_ftn9">9</a>. Treas. Reg. § 1.469-4(g). <a href="#_ftnref10" name="_ftn10">10</a>. Treas. Reg. § 1.469-11(a)(1), Treas. Reg. § 1.469-11(b)(3)(ii). </div></div>

March 13, 2024

8018 / How is a passive loss treated if the taxpayer is subject to other limitations on loss deductions?

<div class="Section1">The determination of whether a loss is disallowed under the passive loss rules is made after the application of (1) the limitations on the deductibility of losses in excess of basis with respect to investment in a partnership (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7750">7750</a>) or S corporation (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="805">805</a>), and (2) the “at risk” rule (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8003">8003</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8009">8009</a>). A passive loss that would not be allowed because of the basis limitations or the at risk rules is suspended and carried forward under the basis and/or at risk provisions, not the passive loss rules. The amount becomes subject to the passive loss rules in subsequent years when it would be otherwise allowable under both the basis and at risk limitations.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> According to the Senate Finance Committee Report, TRA ’86, amounts at risk are reduced even if deductions that would be allowed under the at risk rules are suspended under the passive loss rules. Similarly, basis is reduced if the deduction would be allowed under the at risk rules but is suspended under the passive loss rules. When a taxpayer’s amount at risk or basis has been reduced by a deduction not allowed under the passive loss rules, the amount at risk or basis is not reduced again when the deduction becomes allowable under the passive loss rules.<a href="#_ftn2" name="_ftnref2">2</a> Under the regulations, passive activity deductions do not include: (1) a deduction for an item of expense (other than interest) that is clearly and directly allocable to portfolio income; (2) a deduction allowed under IRC Sections 243, 244, or 245 with respect to any dividend that is not included in passive activity gross income; (3) interest expense (other than expense allocated to a passive activity expenditure and which is neither qualified residence interest nor capitalized); (4) a deduction for a loss from the disposition of property of a type that produces portfolio income; (5) a deduction that is treated as a deduction that is not a passive activity deduction; (6) a deduction for any state, local, or foreign income, war profits, or excess profits tax; (7) a miscellaneous itemized deduction that is subject to partial or total disallowance; or (8) a deduction allowed for a charitable contribution.<a href="#_ftn3" name="_ftnref3">3</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  Temp. Treas. Reg. § 1.469-2T(d). <a href="#_ftnref2" name="_ftn2">2</a>.  Sen. Rep. 99-313, 1986-3 CB (vol. 3) 713, 723. <a href="#_ftnref3" name="_ftn3">3</a>.  Temp. Treas. Reg. § 1.469-2T(d)(2). </div></div>

March 13, 2024

8022 / What is material participation in rental real estate?

<div class="Section1"> A rental real estate activity of a taxpayer is not automatically considered a rental activity (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8011">8011</a>) subject to the passive loss rules for a year, but only if during the year (1) more than one-half of the personal services performed by the taxpayer in trades or businesses during the year is in real property trades or businesses (see below) in which the taxpayer materially participates (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8011">8011</a>), and (2) the taxpayer performs more than 750 hours of service during the year in such real property trades or businesses (making the taxpayer a qualifying taxpayer). For purposes of (2), personal services performed as an employee are not treated as performed in a real property trade or business unless the employee is a 5 percent owner. In the case of a closely held C corporation, the requirements are considered met if more than 50 percent of the gross receipts of the corporation are derived from real property trades or businesses in which the corporation materially participates. With respect to a joint return, these requirements are met only if either spouse separately satisfies the requirements.<a href="#_ftn1" name="_ftnref1">1</a> Work performed by the taxpayer’s spouse in a trade or business is treated as work performed by the taxpayer regardless of whether the spouses file a joint return.<a href="#_ftn2" name="_ftnref2">2</a> Personal services do not include work performed in the individual’s capacity as an investor.<a href="#_ftn3" name="_ftnref3">3</a> Any interest in rental real estate, including real property held for the production of income under IRC Section 212, is considered a trade or business for purposes of the rental real estate with material participation exception.<a href="#_ftn4" name="_ftnref4">4</a> However, any rental real estate that the taxpayer grouped with a trade or business activity because the rental real estate was insubstantial in relation to the trade or business activity, or because the ownership interests in each activity were held in the same proportion (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8016">8016</a>), is not an interest in rental real estate for purposes of the rental real estate with material participation exception.<a href="#_ftn5" name="_ftnref5">5</a> A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.<a href="#_ftn6" name="_ftnref6">6</a> A facts and circumstances approach is used in determining the taxpayer’s real property trade or business and, once determined, may not be changed unless the original determination was clearly inappropriate or a material change in circumstances has occurred that makes the earlier determination clearly inappropriate.<a href="#_ftn7" name="_ftnref7">7</a> Each interest of a qualifying taxpayer in rental real estate will be treated as a separate rental real estate activity, unless an election is made to treat all rental real estate as a single activity (see below). A qualifying taxpayer may not group a rental real estate activity with any other activity.<a href="#_ftn8" name="_ftnref8">8</a> A qualifying taxpayer may elect to treat all interests in rental real estate as a single rental real estate activity and that election is binding for the taxable year in which it is made and for all future years in which the taxpayer is a qualifying taxpayer unless the taxpayer revokes the election because of a material change in circumstances. If a taxpayer makes this election and at least one rental real estate interest is held by the taxpayer as a limited partnership interest, the combined rental real estate activity will be treated as a limited partnership interest for the purpose of determining material participation (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8011">8011</a>) unless the taxpayer’s share of gross rental income from all limited partnership interests in rental real estate is less than 10 percent of his or her share of gross rental income from all interests in rental real estate for the year.<a href="#_ftn9" name="_ftnref9">9</a> <hr> Planning Point: The election may be made in any year in which the taxpayer is a qualifying taxpayer, and the failure to make the election in one year does not preclude the taxpayer from making the election in a subsequent year. <a href="#_ftn10" name="_ftnref10">10</a> <hr> The fact that an election is less advantageous to the taxpayer in a particular taxable year is not, of itself, a material change in the taxpayer’s facts and circumstances. Similarly, a break in the taxpayer’s status as a qualifying taxpayer is not, of itself, a material change in the taxpayer’s facts and circumstances.<a href="#_ftn11" name="_ftnref11">11</a> In the absence of an election by a qualifying taxpayer, interests in rental real estate held by a partnership or S corporation pass-through entity are treated as one or more activities as grouped by the pass-through entity. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8016">8016</a>.However, if the election is not made and the qualifying taxpayer holds at least a 50 percent interest in the capital, profits, or losses, of a pass-through entity, each interest in rental real estate held by the pass-through entity is treated as a separate activity of the qualifying taxpayer, regardless of the way the pass-through entity groups activities. If one pass-through entity owns at least a 50 percent interest in the capital, profits, or losses of another pass-through entity, each interest in rental real estate held by the lower-tier entity will be a separate interest in rental real estate of the upper-tier entity regardless of the way the lower-tier entity groups activities.<a href="#_ftn12" name="_ftnref12">12</a> The $25,000 rental real estate exemption of IRC Section 469(i) (discussed above) also applies to the passive losses and credits from rental real estate activities (including prior-year disallowed passive activity losses and credits from rental real estate activities in which the taxpayer materially participates) of a qualifying taxpayer. The $25,000 rental real estate exemption is determined after application of the rental real estate with material participation rules. However, losses allowable under the rental real estate with material participation rules are not considered in determining adjusted gross income for purposes of phase-out of the $25,000 rental real estate exemption.<a href="#_ftn13" name="_ftnref13">13</a> Example: Al owns building X and building Y, both interests in rental real estate. In 2024, Al is a qualifying taxpayer under the rental real estate with material participation rules. Al does not elect to treat X and Y as one activity under the rental real estate with material participation rules. As a result, X and Y are treated as separate activities. Al materially participates in X, which has $100,000 of passive losses disallowed from prior years and produces $20,000 of losses in 2024. Al does not materially participate in Y, which produces $40,000 of income in 2024. Al also has $50,000 of income from other non-passive sources in 2024. Al otherwise meets the requirements of the $25,000 rental real estate exemption. Because X is not a passive activity in 2024, the $20,000 of losses produced by X in 2024 are non-passive losses that may be used by Al to offset part of the $50,000 of non-passive income. Accordingly, Al is left with $30,000 ($50,000 – $20,000) of non-passive income. In addition, Al may use the prior year disallowed passive losses of X to offset any income from X and passive income from other sources. Therefore, Al may offset the $40,000 of passive income from Y with $40,000 of passive losses from X. Because Al has $60,000 ($100,000 – $40,000) of passive losses remaining from X and meets all of the requirements of the $25,000 rental real estate exemption, Al may offset up to $25,000 of non-passive income with passive losses from X under the exemption. As a result, Al has $5,000 ($30,000 – $25,000) of non-passive income remaining and disallowed passive losses from X of $35,000 ($60,000 – $25,000) in 2024.<a href="#_ftn14" name="_ftnref14">14</a> A taxpayer may have regrouped his activities without regard to the manner in which they were grouped in the preceding taxable years for the first taxable year beginning after December 31, 1993, to the extent necessary or appropriate to take advantage of the rental real estate with material participation exception.<a href="#_ftn15" name="_ftnref15">15</a> See also Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8016">8016</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 469(c)(7). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.469-9(c)(4). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.469-9(b)(4). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.469-9(b)(1). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.469-9(b)(3). <a href="#_ftnref6" name="_ftn6">6</a>. IRC § 469(c)(7)(C). <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. § 1.469-9(d). <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 1.469-9(e)(3). <a href="#_ftnref9" name="_ftn9">9</a>. Treas. Reg. § 1.469-9(f). <a href="#_ftnref10" name="_ftn10">10</a>. Treas. Reg. § 1.469-9(g)(1) <a href="#_ftnref11" name="_ftn11">11</a>. Treas. Reg. § 1.469-9(g)(2). <a href="#_ftnref12" name="_ftn12">12</a>. Treas. Reg. § 1.469-9(h). <a href="#_ftnref13" name="_ftn13">13</a>. Treas. Reg. § 1.469-9(j). <a href="#_ftnref14" name="_ftn14">14</a>. Treas. Reg. § 1.469-9(j)(2). <a href="#_ftnref15" name="_ftn15">15</a>. Treas. Reg. § 1.469-11(b)(3)(iii). </div></div>