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.
The Tax Code recognizes two types 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.
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. There are several exceptions to this rule, which is what greatly contributes to confusion regarding this particular rule’s interpretation and deducting passive activity losses (PALs). Clarifying the exceptions requires the expertise of a tax professional.
Rental investment property is reported by taxpayers on Schedule E, Page 1 of Form 1040. The property’s total income and expenses must be computed to determine a loss that may be limited. Expenses also include depreciation, even if it increases existing losses. In 1984, President Reagan changed the tax law so taxpayers with passive losses may not take them against non-passive income.
Rental property that has generated losses in past tax years may have suspended passive activity losses, which may only be deducted against other passive income, which is income from other passive business activities and rentals. Suspended PALs may be deducted when the property is sold that generated such losses. If a rental property is sold with suspended PALs, it may be deductible on top of deducting any § 1231 loss from the sale. Like § 1231 losses, deductible PALs may also create or increase a net operating loss that can be carried backward or forward. Sometimes it is an advantage for income to be passive as this may permit passive losses to be taken. Most taxpayers can hardly define and understand all of these terms, let alone make the necessary calculations using the correct formulas.
Deductions or losses from passive activities are limited. You generally cannot offset income, other than passive income, with losses from passive activities. Nor can you offset taxes on income, other than passive income, with credits resulting from passive activities.
An experienced and knowledgeable tax professional may help any individual or business assess their current tax situation as it stands in the present looking ahead to the future. A tax professional may evaluate anyone’s situation to help determine the wisdom of any year-end tax savings moves. If you have questions about passive activity losses, call THE TAX EXPERTS AT THE Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation, call 212-490-0704.
