passive activity losses (PALs)

Most Confusing Parts Of The Income Tax Code, Part 1: Passive Activity Loss Rules

Many provisions of the Internal Revenue Code are complicated. Proper interpretation of the rules and regulations contained in these provisions requires the assistance of an experienced and knowledgeable tax professional. The first part of the series about the most confusing provisions of the Internal Revenue Code addresses passive activity loss rules.

Why Is It Confusing?

  • Many exceptions
  • Understanding defined terms
  • Calculating losses over time is complicated and cumbersome

A passive activity is any rental activity or any business in which a taxpayer does not materially participate. Nonpassive activities include businesses in which the taxpayer works on a regular, continuous, and substantial basis. Passive income does not include wages, salaries, portfolio, or investment income.

Passive Activities – What is A Rental Activity?

There are two kinds of passive activities: trade or business activities in which the taxpayer does not materially participate during the year; and rental activities, even if the taxpayer does not materially participate in them, unless the taxpayer is a real estate professional. Many taxpayers have heard the term “passive activity” in relation to a rental activity and wondered exactly what it means.

An activity is a rental activity if real or personal tangible property is used or held for use by a taxpayer and gross income or expected gross income from the activity represents amounts paid or to be paid primarily for the property’s use, whether pursuant to a lease, service contract, or other agreement.

Real Estate Loss Deduction for Individuals

In the last ten years, too many taxpayers have sold real estate at a loss. How does this type of loss ultimately affect the amount of taxes owed to the IRS? First, to accurately determine the amount of a loss from disposition, compare the property’s sale price to its tax basis. The tax basis is generally the original purchase price, plus the cost of improvements (but not expenses deducted as repairs and maintenance) less depreciation.