Passive activity income includes all income from passive activities and generally includes gain from disposition of an interest in a passive activity. In figuring your net income or loss from a passive activity, take into account only passive activity income and passive activity deductions. Gains on the sale, exchange, or other disposition of property used in an activity is characterized in the same way as the activity itself. If the activity is passive, the gain is passive. This also applies to an interest held through a pass-through entity, (e.g., a partnership or S corporation).
Passive activity income does not include:
- Income from an activity that is not a passive activity.
- Gain from the disposition of substantially appreciated property that had been used in a nonpassive activity. Property is substantially appreciated if the fair market value exceeds 120% of the adjusted basis. However, the gain is passive income if the property was used in a passive activity for either:
- 20% of the time you held the property or
- the entire 24-month period ending on the disposition date. The disposition date is the date you agree to transfer your interest for a fixed or determinable amount.
- Portfolio income. This includes interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business. Also, gain or loss from the disposition of property that produces these types of income or that is held for investment is not passive income.
- Personal service income. This includes salaries, wages, commissions, self-employment income from trade or business activities in which you materially participated, deferred compensation, taxable social security and other retirement benefits, and payments from partnerships to partners for personal services
Passive Activity Losses
In general losses from passive activities can offset only passive income. They cannot offset active or portfolio income income, however, they can be carried forward to future years and applied against passive income. Likewise, tax credits, such as the reforestation tax credit can offset only tax payable on passive income. The first step in determining whether a passive loss in a given year is subject to these restrictions is to determine the amount of the loss not restricted by the at-risk limits.
At-Risk Limits - The deductions of losses from most activities is limited to the amount that the taxpayer has "at-risk" in the activity. Amounts at-risk are the amount of money and assets invested in the activity and loans for which the taxpayer is personally liable. The limits apply to property placed in service after December 31, 1986, and to losses attributable to an interest in a partnership or S corporation or other pass through entity that is acquired after December 31, 1986. For further details see IRS Publication 925 Passive Activity and At-Risk Rules.
Passive Activity Losses - A loss is the excess of allowable deductions from the activity for the year (including depreciation or amortization allowed or allowable disregarding the at-risk limits) over income received or accrued from that activity during the year. Income does not include income from the recapture of previous losses that is required to be recaptured because the amount at-risk was less than zero. The passive activity loss for the year is the amount by which passive activity deductions for the tax year exceeds passive activity gross income for the year.
Passive activity deductions include all deductions from activities that are passive activities for the tax year and all deductions from passive activities that were disallowed under the passive loss rules in prior tax years and carried forward to the tax year. They include losses from dispositions of property used in a passive activity at the time of the disposition and losses from a disposition of less than your entire interest in a passive activity.
Passive activity deductions do not include:
- Expenses (other than interest) that are clearly and directly allocable to portfolio income.
- Interest expenses other than interest properly allocable to passive activities (e. g., qualified home mortgage interest and capitalized interest expenses are not passive activity deductions).
- Losses from dispositions of property that produce portfolio income or property held for investment.
- Miscellaneous itemized deductions that may be disallowed because of the 2%-of-adjusted-gross-income limit.
Any passive activity losses (but not credits) that have not been allowed (including current year losses) generally are allowed in full in the tax year you dispose of your entire interest in the passive (or former passive) activity. However, for the losses to be allowed, you must dispose of your entire interest in the activity in a transaction in which all realized gain or loss is recognized. The person acquiring the interest from you can not be related to you. This doesn't apply to suspended credits. They can only be carried forward to offset tax on income from other passive activities.
Related Party - If disposed of to a related party, suspended losses remain with you and can continue to be offset against income from other passive activities. If the related party disposes of their interest to a party not related to you, your suspended losses from the activity become fully deductible.
Installment Sales - If you dispose of a passive activity in an installment sale, the suspended passive losses from the activity become available as the buyer makes payments. Losses become available in the same ratio that gain recognized each year bears to the total gain on the sale.
Dispositions by Gift - If you give away any interest in a passive activity, the accumulated unused passive activity losses allocable to the interest cannot be deducted in any tax year. Instead, the basis of the transferred interest must be increased by the amount of any such losses allocable to the interest for which a deduction has not been allowed. The donee's basis is increased by any suspended losses.
Transfers at Death - Any suspended losses remaining at a taxpayer's death can be deducted on their final return, but only to the extent that the basis of the property in the hands of the heir exceeds the property's adjusted basis immediately prior to the decedent's death. The basis of property in the hands of the heir will usually be the fair market value of the property on the date of death, or alternative valuation date.
Partial Dispositions - If you dispose of a substantial part of an activity during your tax year, you may treat that part of an activity as a separate activity. However, to treat the disposition of a substantial part of an activity, you must show with reasonable certainty:
- The amount of prior year deductions and credits disallowed under the passive activity rules that is allocable to the substantial part of the activity.
- The amount of gross income and any other deductions and credits that is allocable to the substantial part of the activity for the current tax year.
Reporting your Passive Activity Losses - Reporting your passive activities may require more than one form or schedule. The actual number of forms depends on the number and types of activities you must report. Some forms and schedules that may be required are:
- Schedule C (Form 1040), Profit and Loss From Business
- Schedule D (Form 1040), Capital Gains and Losses
- Schedule F (Form 1040), Profit or Loss From Farming
- Form 4797, Sales of Business Property
- Form 6252, Installment Sale Income
- Form 8582, Passive Activity Loss Limitations
- Form 8582-CR, Passive Activity Credit Limitations
Form 8582 - This form is used to allocate the total loss among the passive activities generating these losses. The amount of the allocated loss, if any, which can be deducted on the schedule on which these activities are reported is also determined on this form. This form must be filed by individual taxpayers, estates, trusts, personal service corporations, and closely held C corporations which have passive activities with net losses. You do not have to file it if you have an "overall gain" when you combine all of your net income and net losses (including prior year unallowed losses) from passive activities.
Form 8582-CR - This form must be filed by individuals, estates, trusts, personal service corporations, and closely held C corporations having certain credits from passive activities. Theses credits include the regular investment credit, such as the reforestation investment credit.
