Limitation On Loss Deductions

<div class="Section1"><br /> <p>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:</p><br /> <p>…holding, producing, or distributing motion picture films or video tapes;</p><br /> <p>…farming (including raising, shearing, feeding, caring for, training, or management of animals);</p><br /> <p>…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>);</p><br /> <p>…exploring for, or exploiting, oil and gas reserves (see <a class="accordion-cross-reference" href="https://www.thinkadvisor.com/tax-facts/2024/03/13/7857-how-do-individuals-invest-in-oil-and-natural-gas/">Q 7857</a> to <a class="accordion-cross-reference" href="https://www.thinkadvisor.com/tax-facts/2024/03/13/7887-what-items-of-tax-preference-for-purposes-of-the-alternative-minimum-tax-are-unique-to-an-oil-and-gas-program/">Q 7887</a>);</p><br /> <p>…exploring, or exploiting, geothermal deposits;</p><br /> <p>…holding real property (see <a class="accordion-cross-reference" href="https://www.thinkadvisor.com/tax-facts/2024/03/13/7792-does-the-at-risk-limitation-on-losses-apply-to-an-investor-in-real-estate-if-so-what-effect-will-it-have/">Q 7792</a> for effective date and transitional relief rules);</p><br /> <p>…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></p><br /> <p>Apparently, if a publicly traded partnership is taxed as a corporation (see ), 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></p><br /> </div><br /> <div class="refs"><br /> <hr align="left" size="1" width="33%"><br /> <p><a href="#_ftnref1" name="_ftn1">1</a>. IRS Publication 925, Passive Activity and At-Risk Rules.</p><br /> <p><a href="#_ftnref2" name="_ftn2">2</a>. IRC §§ 465(c), 464(e).</p><br /> <p><a href="#_ftnref3" name="_ftn3">3</a>. See IRC § 465(a).</p><br /> <p><a href="#_ftnref4" name="_ftn4">4</a>. IRC § 542(a)(2).</p><br /> </div>

<div class="Section1"><br /> <p>Under the passive loss rules, aggregate losses from “passive” activities (see <a href="javascript:void(0)" class="accordion-cross-reference" id="8011">Q 8011</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.</p><br /> <p>An <em>individual</em> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">Q 8021</a>. A <em>closely held C corporation</em> (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></p><br /> <p>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></p><br /> <p>Special restrictions apply to <em>publicly traded partnerships</em> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8040">Q 8040</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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8019">Q 8019</a>.Also, the $25,000 rental real estate exemption (see <a href="https://prod-taxfacts-alm.content.pugpig.com/faqs_page/limitation-on-loss-deductions/pugpig_index.html#faq-8021">Q 8021</a>) is available with respect to a publicly traded partnership only in connection with the low-income housing credit (see <a href="javascript:void(0)" class="accordion-cross-reference" id="7808">Q 7808</a>) and the rehabilitation investment credit. See <a href="https://prod-taxfacts-alm.content.pugpig.com/faqs_page/real-estate/pugpig_index.html#faq-7808">Q 7808</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 ), the partnership is not a taxpayer subject to the passive loss rules.<a href="#_ftn12" name="_ftnref12">¹²</a></p><br /> <p>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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8019">Q 8019</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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8020">Q 8020</a>.As to losses allowed upon disposition of an interest in a passive activity, see <a href="https://prod-taxfacts-alm.content.pugpig.com/faqs_page/limitation-on-loss-deductions/pugpig_index.html#faq-8019">Q 8019</a>.</p><br /> <p>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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8040">Q 8040</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></p><br /> </div><br /> <div class="refs"><br /> <hr align="left" size="1" width="33%"><br /> <p><a href="#_ftnref1" name="_ftn1">1</a>. IRC § 469.</p><br /> <p><a href="#_ftnref2" name="_ftn2">2</a>. IRC § 469(e)(2).</p><br /> <p><a href="#_ftnref3" name="_ftn3">3</a>. IRC § 469(j)(1).</p><br /> <p><a href="#_ftnref4" name="_ftn4">4</a>. IRC § 542(a)(2).</p><br /> <p><a href="#_ftnref5" name="_ftn5">5</a>. IRC § 469(j)(2).</p><br /> <p><a href="#_ftnref6" name="_ftn6">6</a>. Temp. Treas. Reg. § 1.469-2T(d)(2), Treas. Reg. § 1.469-2(d)(2)(xi).</p><br /> <p><a href="#_ftnref7" name="_ftn7">7</a>. Temp. Treas. Reg. § 1.469-2T(c)(7), Treas. Reg. § 1.469-2(c)(7)(vi).</p><br /> <p><a href="#_ftnref8" name="_ftn8">8</a>. TD 8290, 1990-1 CB 109.</p><br /> <p><a href="#_ftnref9" name="_ftn9">9</a>. IRC § 469(k)(1).</p><br /> <p><a href="#_ftnref10" name="_ftn10">10</a>. Notice 88-75, 1988-2 CB 386.</p><br /> <p><a href="#_ftnref11" name="_ftn11">11</a>. IRC § 469(k).</p><br /> <p><a href="#_ftnref12" name="_ftn12">12</a>. See IRC § 469(a).</p><br /> <p><a href="#_ftnref13" name="_ftn13">13</a>. TRA ’86 § 501(c)(2).</p><br /> <p><a href="#_ftnref14" name="_ftn14">14</a>. TAMRA ’88 § 1005(c)(11).</p><br /> <p><a href="#_ftnref15" name="_ftn15">15</a>. Notice 89-36, 1989-1 CB 677.</p><br /> <p><a href="#_ftnref16" name="_ftn16">16</a>. TAMRA ’88 § 1005(c)(11; Notice 89-36, 1989-1 CB 6771.</p><br /> </div>

<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><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> 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&rsquo;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><br /> <br /> <hr><br /> <br /> 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>.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 469(f).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Temp. Treas. Reg. &sect; 1.469-5T(a)(7).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> 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><br /> <br /> 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><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. See Prop. Treas. Reg. § 1.465-3.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 465(e).<br /> <br /> </div>

<div class="Section1">No. The at risk rules and the limitations they impose on the deduction of losses do <em>not</em> 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><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Prop. Treas. Reg. § 1.465-1(e).<br /> <br /> </div>

<div class="Section1"><br /> <br /> 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 &ldquo;materially participate.&rdquo;<a href="#_ftn1" name="_ftnref1">¹</a> The IRC indicates that regulations may define the term &ldquo;trade or business&rdquo; 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>).<br /> <br /> The term &ldquo;passive activity&rdquo; 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><br /> <br /> <em>Example:</em> 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><br /> <br /> 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&rsquo;s taxable year (not the partner&rsquo;s or shareholder&rsquo;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>).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 469(c).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. TD 8175(II)(A), 1988-1 CB 191.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. IRC &sect; 469(c)(3).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>. Temp. Treas. Reg. &sect; 1.469-1T(e)(6).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>. Temp. Reg. &sect; 1.469-1T(e)(6)(iii).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>. Temp. Treas. Reg. &sect;&sect;1.469-2T(e)(1), 1.469-3T(b)(3).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>. See IRC &sect; 469(a).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> 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><br /> <br /> 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><br /> <br /> 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><br /> <br /> <strong>Special rule for significant participation</strong>. An amount of the taxpayer&rsquo;s gross income from each significant participation passive activity for the taxable year equal to a ratable portion of the taxpayer&rsquo;s net passive income from the activity for the year is treated as not from a passive activity if the taxpayer&rsquo;s passive activity gross income from all significant participation passive activities for the year exceeds the taxpayer&rsquo;s passive activity deductions from all such activities for the year. For purposes of this paragraph, the term &ldquo;significant participation passive activity&rdquo; 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 &ldquo;significant participation&rdquo; and &ldquo;material participation&rdquo; are defined in the temporary income tax regulations.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> 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><br /> <br /> 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><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> 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><br /> <br /> <hr><br /> <br /> 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><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 469(e).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC &sect; 163(d)(4)(D).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. IRC &sect; 469(l).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>. Temp. Treas. Reg. &sect; 1.469-2T(f), Treas. Reg. &sect; 1.469-2(f).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>. Temp. Treas. Reg. &sect; 1.469-5T.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>. TRA &rsquo;86 &sect; 501(c)(4) as amended by TAMRA &rsquo;88, &sect; 1005(a)(10).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>. Temp. Treas. Reg. &sect; 1.163-8T.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>. Ann. 87-4, 1987-3 IRB 17.<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>. Temp. Treas. Reg. &sect; 1.163-8T.<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>. Rev. Rul. 92-92, 1992-2 CB 103.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The determination of whether a loss is disallowed under the passive loss rules is made <em>after</em> 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 &ldquo;at risk&rdquo; 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><br /> <br /> According to the Senate Finance Committee Report, TRA &rsquo;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&rsquo;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><br /> <br /> 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><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Temp. Treas. Reg. &sect; 1.469-2T(d).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Sen. Rep. 99-313, 1986-3 CB (vol. 3) 713, 723.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. Temp. Treas. Reg. &sect; 1.469-2T(d)(2).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> 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&rsquo;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&rsquo;s capacity as an investor.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> 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&rsquo;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><br /> <br /> 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&rsquo;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><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> 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><br /> <br /> <hr><br /> <br /> 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&rsquo;s facts and circumstances. Similarly, a break in the taxpayer&rsquo;s status as a qualifying taxpayer is not, of itself, a material change in the taxpayer&rsquo;s facts and circumstances.<a href="#_ftn11" name="_ftnref11">¹¹</a><br /> <br /> 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><br /> <br /> 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><br /> <p style="padding-left: 40px"><em>Example:</em> 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.</p><br /> <p style="padding-left: 40px">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 &ndash; $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.</p><br /> <p style="padding-left: 40px">Because Al has $60,000 ($100,000 &ndash; $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 &ndash; $25,000) of non-passive income remaining and disallowed passive losses from X of $35,000 ($60,000 &ndash; $25,000) in 2024.<a href="#_ftn14" name="_ftnref14">¹⁴</a></p><br /> 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>.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 469(c)(7).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. &sect; 1.469-9(c)(4).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. &sect; 1.469-9(b)(4).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. &sect; 1.469-9(b)(1).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. &sect; 1.469-9(b)(3).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>. IRC &sect; 469(c)(7)(C).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. &sect; 1.469-9(d).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. &sect; 1.469-9(e)(3).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>. Treas. Reg. &sect; 1.469-9(f).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>. Treas. Reg. &sect; 1.469-9(g)(1)<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>. Treas. Reg. &sect; 1.469-9(g)(2).<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>. Treas. Reg. &sect; 1.469-9(h).<br /> <br /> <a href="#_ftnref13" name="_ftn13">13</a>. Treas. Reg. &sect; 1.469-9(j).<br /> <br /> <a href="#_ftnref14" name="_ftn14">14</a>. Treas. Reg. &sect; 1.469-9(j)(2).<br /> <br /> <a href="#_ftnref15" name="_ftn15">15</a>. Treas. Reg. &sect; 1.469-11(b)(3)(iii).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> &ldquo;Loss&rdquo; is given a special meaning for purposes of applying the at risk limitations. &ldquo;At risk loss,&rdquo; otherwise known as an IRC Section 465(d) loss, is the excess of the income tax deductions (including deductions normally accorded special treatment, such as tax preferences, short-term loss, long-term loss) attributable to the covered activity <em>over</em> the income received or accrued during the year from the activity. (Both deductions and income are determined without regard to the at risk provisions at this point.) Thus, otherwise allowable deductions may be taken freely against income generated by the activity regardless of the taxpayer&rsquo;s amount at risk in the activity. The at risk provisions act only to deny a deduction when the taxpayer attempts to use a loss incurred in the covered activity to offset income received by the taxpayer from a separate source.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> A Section 465(d) loss is determined without regard to the amount at risk.<a href="#_ftn2" name="_ftnref2">²</a> Thus, even if the taxpayer has no amount at risk in the activity, deductions are allowable under Section 465 for a taxable year to the extent there is income from the activity in that taxable year.<br /> <br /> <hr><br /> <p style="padding-left: 40px"><em>Example:</em> Before taking into account any gain or loss during the year, the amount that C, a calendar year taxpayer, is at risk in an activity described in IRC Section 465(c)(1) is equal to minus $20,000. During the year, C has deductions of $10,000 allocable to the activity and income of $15,000 from the activity. Because the income from the activity exceeds the amount of allocable deductions from the activity, there is no Section 465(d) loss in the year to be disallowed under Section 465(a). Thus, although C has a negative amount at risk, C is permitted to take deductions in the amount of $10,000 for the year.<a href="#_ftn3" name="_ftnref3">³</a></p><br /> Losses disallowed because of the at risk rules may be carried forward indefinitely and deducted in future years to the extent that the activity produces net income for that year, or to the extent the taxpayer&rsquo;s amount at risk has been increased by additional contributions, etc. to the activity.<a href="#_ftn4" name="_ftnref4">⁴</a> However, because &ldquo;at risk loss&rdquo; is made up of various deductions (including some normally accorded special tax treatment), the proposed regulations provide ordering rules that allocate the items of deductions between the current and carryover years. Items disallowed in the current tax year will retain their character when treated as deductions in succeeding years.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> The proposed regulations provide that when only a portion of &ldquo;at risk loss&rdquo; is allowed as a deduction for the tax year, the individual items of deduction making up the &ldquo;at risk loss&rdquo; will be allowed in the following order: (1) capital losses are allowed first; (2) all items entering into computation of &ldquo;IRC Section 1231&rdquo; property (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7834">7834</a>) come next; (3) deductible items to the extent they are not tax preference items and are not described in (1) or (2) above follow; (4) all items of deduction that are tax preference items not allowed under (1) or (2) above come last. Furthermore, items of deduction described in (4), that are disallowed by reason of the at risk rules must be further subdivided according to the tax year in which they were originally paid or accrued; when such deductions are eventually allowed, those deductions paid or accrued earliest will be allowed first.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <p style="padding-left: 40px"><em>Example:</em> A, an individual calendar year taxpayer, is engaged in an activity described in IRC Section 465(a) (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8004">8004</a>). At the close of 2023, A is at risk $1,000 in the activity. During 2024, A had $3,000 of income from the activity and $7,500 of deductions allocated to the activity. Of the $7,500 of the deductions, $2,500 are of the type described (3) and $5,000 are of the type described (4). Assuming nothing else has occurred during 2024 to affect A&rsquo;s amount at risk, A will be allowed $4,000 of deductions and $3,500 of deductions will be disallowed. Since A has no deductions described in (1) or (2), the $4,000 of allowed deductions will consist of the entire $2,500 described in (3) and $1,500 of the $5,000 deductions described in (4). The $3,500 deductions disallowed will consist of deductions in (4).<a href="#_ftn7" name="_ftnref7">⁷</a></p><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 465; Prop. Treas. Reg. &sect; 1.465-2(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Prop. Treas. Reg. &sect; 1.465-11(c)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. Prop. Treas. Reg. &sect; 1.465-11(c)(2).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>. IRC &sect; 465(a)(2); Prop. Treas. Reg. &sect; 1.465-2(b).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>. Prop. Treas. Reg. &sect; 1.465-38(b).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>. Prop. Treas. Reg. &sect;&sect; 1.465-38(a), 1.465-38(c).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>. Prop. Treas. Reg. &sect; 1.465-38(d), Example (1).<br /> <br /> </div></div><br />