The passive activity loss (PAL) rules were introduced by the Tax Reform Act of 1986
and were designed to curb perceived tax shelter abuses. However, the PAL rules are
far-reaching and affect activities other than tax shelters. Additionally, these rules
limit the deductibility of losses for federal income tax purposes.
The PAL rules provide that passive losses can only be used to offset passive income,
not active income the owners may earn from business activities in which they
materially participate or portfolio income they receive from investments, such as
dividend and interest income. So, while taxpayers may not benefit currently from
losses sustained from passive activities, they may be able to use those losses to
offset gains in future years.
A passive activity is a trade or business in which the taxpayer does not materially
participate or, with certain exceptions, any rental activity. Rental activities
generally are passive regardless of whether the taxpayer materially participates.
However, the rental real estate activities of certain qualifying taxpayers in real
estate businesses are subject to the same general rule that applies to nonrental
activities. In other words, if the taxpayer satisfies certain participation
requirements, the rental activity is nonpassive and any losses or credits it
generates can be used to offset the taxpayer'cs other nonpassive income. Additionally,
federal regulations provide several exceptions to the general rule allowing a rental
activity to be treated as either a trade or business or an investment activity.
A special rule allows taxpayers who actively participate in a rental activity to
deduct up to $25,000 of loss from the activity each year regardless of the PAL rules.
Examples of what would constitute active participation include approving new tenants,
deciding on rental terms, and approving capital or repair expenditures. The $25,000
special allowance is, however, subject to a limitation. The $25,000 amount is reduced
if the taxpayer has an adjusted gross income (AGI) (before passive losses) in excess
of $100,000. The allowance is reduced by 50% of the amount by which AGI exceeds the
$100,000 level. Consequently, the allowance is completely phased out when AGI exceeds
$150,000. If taxpayers have rehabilitation or low-income housing credits, a special
rule allows the credits to offset tax on nonpassive income of up to $25,000,
regardless of the limitation based on AGI.
Another special rule is the exception for real estate professionals. This provision
allows qualifying real estate professionals to deduct losses from rental real estate
activities as nonpassive losses if they materially participate in the activity. To
qualify as a real estate professional, a taxpayer must demonstrate that he or she
spends more than 750 hours during the tax year in real property businesses in which
they are a material participant. In addition, they must demonstrate that more than
50% of the services they perform in all of their businesses during the tax year are
performed in real property businesses in which they materially participate.
Please contact us to discuss the passive activity provisions or any other tax planning
or compliance issue.
This publication is distributed with the understanding that the author, publisher and
distributor are not rendering legal, accounting or other professional advice or
opinions on specific facts or matters, and, accordingly, assume no liability
whatsoever in connection with its use. The information contained in this newsletter
was not intended or written to be used and cannot be used for the purpose of (1)
avoiding tax-related penalties prescribed by the Internal Revenue Code or (2)
promoting or marketing any tax-related matter addressed herein. © 2014