A passive activity is....
In general, a taxpayer can only deduct passive activity losses against passive activity income. Any excess loss is carried forward until used, or until the activity is disposed of in a fully taxable disposition.
There are two kinds of passive activities.
1. Trade or business activities in which the taxpayer did not materially participate during the year.
2. Rental activities, even if the taxpayer did materially participate during the year, unless he/she is real estate professional.
Rental activities are usually assumed to be passive. There is an exception to this rule if the average customer usage of 7 days or less or if extraordinary personal services provided in the rental of the property. See IRS Publication 925 for more information about these and other exceptions.
Passive Activity Income and Deduction
In figuring net income from a passive activity, only passive activity income and deductions are taken into account.
Passive income generally includes all income from passive activities and usually includes gain on disposition of a property interest, if at the time of disposition the activity the asset was used in was passive.
Passive income does not include portfolio income. This includes interest, dividends, annuities, royalties not derived in the ordinary course of business. Portfolio income includes gains from the sale of assets that produces these types of income or is held for investment. Certain types of interest, called self-charged interest, are passive.
The following income is not considered passive income:
- Personal service income
- Overall gain from an interest in a publicly traded partnership
- State, Local, and foreign income tax refunds
- Reimbursement from a casualty or theft loss included in gross income, if the loss deduction was not a passive activity deduction
- Positive Section 481 accounting adjustments
- Income from an oil and gas working interest if any losses incurred after 1986 treated as nonpassive
- Income from intangible property, if personal efforts significantly contributed to the creation of the property
Passive deductions include all deductions from passive activities except those listed below. Losses from disposition of property used in a passive activity is considered if it is a disposition of less than your interest interest in the activity.
The following income is not considered passive deductions:
- Deductions for expenses (other than interest expene) that are clearly and directly allocable to portfolio income.
- Qualified home mortgage interest expense, capitalized interest expenses, and other interest expenses (Other than self-charged interest)
- Losses from the sale of proprerty that produces portfolio income or is held for investment.
- State, local, or foreign income taxes
- Misc. itemized deductions that may be subject to the 2% AGI limit
- charitable contribution deductions
- NOL deductions
- Percentage depletion carryovers for oil and gas wells
- capital loss carrybacks and carryforwards
- At-risk and basis carryovers from years prior to 1987
- Negative section 481 accounting adjustments
- Casualty and theft losses, unless losses similar in cause and severity recur regularly in the activity
- The deduction for 1/2 of the Self-employment tax
You can only deduct passive activity credits to the extent of tax on net passive income. Passive activity credits include the general business credit, and other special business credits, such as the credit for fuel from nonconventional sources. Credits in excess of the tax on net passive income are carried forward. When the activity is disposed of in a fully taxable disposition, unlike passive loss carryovers, passive credit carryovers are not allowed in full. However, in the determination of the gain or loss from the disposal of the passive activity, you are allowed to increase the basis of the credit property by the original basis reduction of the credit, to the extent the credit was disallowed by the passive activity limits. You cannot elect to adjust the basis for a partial disposition of your interest in the passive activity.
If the taxpayer or spouse actively participated in rental real estate activity, they can deduct up to $25,000 of loss from the activity against nonpassive income. This special allowance is an exception to the general rule that losses in excess of income from passive activities cannot be deducted. This special allowance can also allows passive credit on the tax on up to $25,000 of nonpassive income. If the taxpayer filing status is married filing separate, the special allowance is $12,500 if the taxpayer and spouse lived apart the entire year, if they lived together for any portion of the year; the special allowance is $0. The special allowance is reduced as modified adjusted gross income exceeds certain amounts. For filing statuses other than Married filing separate, the special allowance is reduced by 50% of the amount of your modified adjusted gross income in excess of $100,000. For married filing separate, the phase-out begins at $75,000.
Certain credits have a higher phase-out range. Low income housing credit for houses placed in service before 1990 and rehabilitation investment credit for rental real estate activities start to get phased out when modified adjusted gross income exceeds $200,000. ($100,000 for MFS when spouses lived apart the entire year). There is no phase-out for low income housing credits on houses placed in service after 1989 or for the commercial revitalization credit. See Publication 925 if you have more than one exception to the phase-out rule in the same year.
Modified adjusted gross income is adjusted gross income shown on Form 1040, computed without the following:
- Taxable Social Security Benefits
- Contributions to IRA’s and certain other retirement plans
- Exclusion from income of interest on qualified US savings bonds
- Exclusion from income of amounts received from an employers adoption assistance program
- Passive income or loss included on Form 8582
- Any rental real estate loss allowed because the taxpayer was a real estate professional
- Any overall loss from a publicly traded partnership
- The deduction for ½ of SE tax
- Deduction for interest on student loans
- Deduction for qualified tuition and related expenses
Former passive activities
Former passive activities are activities which were passive in a prior year but not passive in the current year. You can deduct any prior year unallowed passive loss from the activity up to the amount of current year net income from the activity. Any prior year loss remaining after combining prior loss with current year net income is treated as any other passive loss. After combining prior year loss with current year net income from the former passive activity, any prior year unallowed passive credits are allowed. Prior credits are allowed to the extent of the current year tax liability allocable the income from the former passive activity.