When Are Losses Deductible for Income Tax Purposes?

When you have a loss from a trade or business, from the rental of property, or from some other income-producing activity, the loss may serve to reduce your taxable income and therefore reduce your income taxes. But there are special rules that may limit the amount of loss you can claim. These rules are generally intended to discourage taxpayers from engaging in activities that are primarily intended to generate losses for purposes of reducing or avoiding taxation. The rules do this by limiting losses on activities in which your personal efforts are not a significant factor in producing the income or loss. These are referred to as the passive activity limits. The other set of rules limits losses on activities in which you do not have a personal stake in the endeavor. These are called the at-risk rules. Either one or both of these sets of rules may apply in each particular case, depending on the circumstances.

At-Risk Rules

Activities that are subject to the passive activity limits may first be subjected to the at-risk rules. For most activities, these rules limit the amount of a deductible loss to the amount you have at-risk, or the amount of your personal stake in the activity. The same at-risk rules apply to various different types of taxpayers, including individuals, partners, shareholders in an S corporation, estates, trusts, and certain closely held corporations.

When Do the At-Risk Rules Apply?

One of the activities subject to the at-risk rules is the leasing of what is referred to in the income tax code as section 1245 property. Section 1245 property includes personal property and other tangible property that is subject to depreciation or amortization.

In addition to the leasing of section 1245 property, other activities that are subject to the at-risk rules are the holding, production, or distribution of motion picture films or video tapes; farming; and exploring for, or exploiting oil and gas, or geothermal deposits.

Finally, in addition to specifically mentioning the above-referenced types of activities, the at-risk provisions also include any other activity that is carried on as a trade or business or for the production of income. Therefore, a loss from any of the specific activities mentioned would have to be subjected to the at-risk rules, and in general, any loss from an income-producing activity could potentially be subject to the at-risk rules.

Exceptions

There are some exceptions to the at-risk rules and one of them is for real property placed in service before 1987. Losses from this property (except for mineral properties) are not subject to the at-risk rules. This exception applies to individuals as well as pass-through entities, such as partnerships.

Another exception is for equipment leasing activities carried on by a closely held corporation. For these purposes, a closely held corporation is one in which five persons or less own more than 50% of the outstanding stock. Equipment leasing is treated as a separate activity, not subject to the at-risk rules, if 50% or more of the corporation’s gross receipts for the tax year are from the equipment leasing activity.

Certain qualifying business activities carried on by closely held corporations other than personal holding companies or personal service corporations may also qualify as exceptions to the at-risk rules. The exception will apply if the corporation carries on an active business, had at least one full-time employee actively engaged in managing the business, and at least three employees who are not owners, whose services were directly related to the business. In order to qualify for the exception, the corporation must also have allowable business expenses and contributions to employee benefit plans for the year that exceed 15% of its gross income, and the business cannot be an excluded business, including equipment leasing and any business related to sound recordings, motion picture films, video tapes, or other literary, artistic, or musical properties.

Separate or Aggregate Activities

Generally, each activity that is subject to the at-risk rules is treated separately in determining whether a loss is deductible. This includes investments that are not part of a trade or business – each investment would be treated separately. But there are situations in which different activities can be aggregated, or grouped together for purposes of applying the at-risk rules.

For partnerships or S corporations, all activities that involve section 1245 property placed in service during the tax year are treated as one activity. Also, partners and shareholders in an S corporation can aggregate their activities into the following categories and treat each category as one activity for purposes of applying the at-risk rules:
�· Films and video tapes,
�· Farms,
�· Oil and gas properties, and
�· Geothermal properties.

Activities subject to the at-risk rules can also be aggregated and treated as one activity if the owner actively participates in managing the business, or if a partnership or S corporation carries on the trade or business, and 65% or more of the losses are allocable to persons who activity participate in managing the business.

By aggregating activities, a loss from one specific activity may be offset against income from another activity and the loss would therefore not be subject to being disallowed due to the at-risk rules.

What Amounts Are Considered To Be At Risk?

The amounts that are at risk in an activity are the money and the adjusted basis of property you have contributed to the activity. The adjusted basis of property is the original basis, which could be cost, fair market value, or some other basis, depending on how you acquired the property, plus certain amounts that increase the basis, such as additions or improvements, and minus amounts that decrease the basis, such as depreciation or casualty losses.

Amounts that you borrow for use in the activity are also considered to be at risk, provided that you are personally liable for repaying the debt, or you pledge property (other than the property used in the activity) as security for repayment of the debt. In the case of pledged property, the amount at risk is considered to be the fair market value of the property on the date it is pledged, less any prior or superior claims on the property.

Borrowed Amounts That Are Not At Risk

Amounts borrowed from persons who have an interest in the activity are not considered to be at risk. Neither is an amount borrowed from someone related to a person who has an interest in the activity. Persons, in this case, include individuals as well as other taxpayer entities, and there are various different relationships that qualify as related persons for this purpose. These include members of an individual’s family, a partnership and an individual who owns more than a 10% interest in capital or profits, a corporation and an individual who owns more than 10% of the outstanding stock, and two partnerships or two S corporations if the same persons have more than a 10% interest in each. Other related persons include grantors and fiduciaries or beneficiaries of the same trust, related corporations, and other types of similar relationships.

Amounts that are protected against loss through non-recourse financing, guarantees, or similar arrangements are not considered at risk. When money is borrowed to be invested in an activity and the lender’s only recourse is your interest in the activity or the property used in the activity, the loan is a non-recourse loan and is not considered to be at risk.

Where to Report At-Risk Limitations

If the at-risk rules apply, their effect in terms of a limitation on an allowable loss is determined on Form 6198 – At-Risk Limitations. This form must be completed and filed with the corresponding tax return, depending on whether the affected taxpayer is an individual, partnership, S-corporation, trust, or estate.

Once the at-risk rules have been applied, and their effect determined, the passive activity limits may also apply.

Passive Activity Limits

According to the passive activity limits, you can generally deduct passive activity losses only against passive activity income. You cannot use losses from passive activities to reduce taxable income from other types of activities. If you have a loss that you cannot deduct in one year, because of these rules, you can carry over the loss and deduct it against income from the same activity the following year. And on the contrary, if your losses are allowed in one year, you may have to recapture them, or include them in income, if your amount at risk is reduced below zero in a subsequent year.

The passive activity limits, like the at-risk rules, apply to different types of taxpayers, including individuals, personal service corporations, closely held corporations, trusts, and estates. While these limits do not apply directly to partnerships and S corporations, they do apply to their owners.

What Are Passive Activities?

Passive activities are divided into two general categories:
1. Trade or business activities in which you do not “materially participate”, and
2. Rental activities, whether or not you materially participate. But there is an exception for real estate professionals.

Trade or business activities include the normal conduct of the trade or business, activities during the organization or start-up period, and research and development activities. They are normally reported on Schedule C or C-EZ, Schedule F for a farming business, or Part II or III of Schedule E.

Rental Activity

A rental activity is considered a passive activity even if you materially participated, unless you are a real estate professional. Rental activities include both real and personal tangible property, where gross income represents amounts paid for the use of the property, whether through a lease, service contract, or other arrangement.

There are some exceptions, and if the activity involves any of the following, it is not considered a rental activity for purposes of applying the passive activity limits:
1. The average period the customer uses the property is 7 days or less.
2. The average rental period is 30 days or less, and you provide significant personal services, other than repairs or normal and routine maintenance.
3. The rental activity is incidental to an investment, in which property is held in order to realize a gain from the appreciation in its value. In this case, the gross rental income from the property must be less than 2% of the smaller of the property’s basis, without reduction for depreciation or other basis adjustments, or its fair market value.
4. The rental is incidental to a trade or business, and the rental property was used mainly in the trade or business during the current year or during 2 of the 5 preceding years, and the same 2% limit on gross income, as indicated above, applies.
5. You own an interest in a partnership, S corporation, or joint venture, and you provide the property for a non-rental use by one of these entities.

Special $25,000 Allowance

There is an important exception to the general rule on the limitation of loss from passive rental activities. If you or your spouse “actively participated” in the activity, you can offset a rental loss of up to $25,000 against non-passive income. If you are married filing separately and lived apart from your spouse the entire year, the special allowance is $12,500. But if you are married filing separately and lived with your spouse at any time during the year, you cannot use the special allowance.

The tax code differentiates between “active participation” and “material participation”. Active participation is less stringent. If you make management decisions in a significant and bona fide sense you may be considered to have actively participated in the activity. This could include approving new tenants, deciding on rental terms, and approving expenditures. You also must have held at least a 10% interest in the rental activity throughout the year in order to qualify as an active participant.

This special allowance is phased out if your modified adjusted gross income is over $100,000 ($50,000 if married filing separately). The amount of your allowance is reduced by 50% of the amount by which your modified adjusted gross income exceeds the limit, up to $150,000 ($75,000), at which point the allowance is completely phased out.

Renting Out Your Home

Another exception to the passive activity limit applies to the rental of your home. If you rent out your home during part of the year and you also used it for personal purposes for more than the greater of 14 days or 10% of the number of days the home was rented out during the year, the passive activity limit does not apply to any loss on the rental.

Material Participation

Material participation is one of the key factors in determining whether an activity is passive or non-passive, and therefore whether you can fully claim any loss from the activity. Material participation is not the same as active participation. Active participation refers to the type of work you are performing, while material participation refers more to the amount of time you spend working in the activity, and the relative importance of your work.

For income tax purposes, if you satisfy any of the following tests, you are considered to have materially participated in the activity:
�· You participated in the activity for more than 500 hours during the year.
�· Your participation was substantially all the participation in the activity.
�· You participated for more than 100 hours and this was at least as much as the participation of anyone else involved in the activity, including persons who did not have an interest in the activity.
�· You materially participated in the activity for any 5 of the 10 preceding years. These 5 years do not have to be consecutive.
�· The activity involves personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor, and you materially participated for any 3 preceding years, whether or not they are consecutive.
�· Based on the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis, for at least 100 hours during the year.

There are other factors to be taken into consideration, which could disqualify your material participation, even if you meet one of the above tests. For example, if someone else is paid to manage the business, or if someone else spent more time managing the activity than you did, you are not considered to have materially participated.

Participation is defined as any work you do in connection with an activity in which you have an interest. But your work is not treated as participation if it is work that is normally done by owners of that type of activity, and one of your main reasons for doing the work is to avoid the disallowance of any loss due to the passive activity limits. If you are an investor, the work you do in connection with the activity is not treated as participation unless you are directly involved in the day-to-day operations or management.

Keeping Records of Your Participation

You can prove your participation in an activity using any reasonable method. You do not necessarily have to maintain a log or keep time reports. Noting the approximate number of hours you worked and the activities you performed in an agenda, on a calendar, or in an appointment book can provide sufficient evidence.

Real Estate Professional

Rental activities are normally considered passive activities, even if you materially participated. But rental activities are not passive activities if you are a real estate professional, and therefore, rental losses incurred by real estate professionals are not subject to the passive loss limitation.

There are two tests to qualify as a real estate professional:
1. More than half your personal services during the year were performed in connection with real property trades or businesses, and you materially participated in these activities, and
2. You performed more than 750 hours of service in these real property activities.

If you qualify, you would report the results from your rental activities as non-passive income or losses on Schedule E.

Passive Activity Income and Deductions

When you figure your income or loss from a passive activity, you take into account only the income and deductions related to the passive activity. Passive income includes all income derived from passive activities and any gain from the disposition of an interest in a passive activity.

Certain types of income are specifically excluded from passive income. These include:
�· Portfolio income, which includes interest, dividends, royalties and annuities that are not derived from a trade or business. This includes any gain on the sale or disposition of property held for investment that produces these types of income.
�· Personal service income, including salaries, wages, commissions, income from self-employment, social security and other retirement benefits, and payments from a partnership to partners for personal services.
�· Income or gains from working capital investments.
�· Income from an intangible asset such as a patent, copyright, or literary, artistic or musical composition, if your personal efforts significantly contributed to its creation.

Passive deductions include all deductions from passive activities, deductions that are carried over from prior years because they were disallowed according to the passive loss limits, and any loss on the disposition of an interest in a passive activity. Passive activity deductions do not include the following:
�· Deductions allocable to portfolio income.
�· Qualified home mortgage interest, capitalized interest, and other interest expenses.
�· Losses from dispositions of property held for investment that produce portfolio income.
�· State, local, and foreign income taxes.
�· Miscellaneous itemized deductions that are disallowed because of the 2% of adjusted-gross-income limit.
�· Charitable contributions.
�· Net operating loss deductions.
�· Casualty and theft losses.
�· The deduction for one-half of the self-employment tax.

Grouping Activities

You can group together different trade, business, or rental activities if they form an appropriate economic unit for purposes of determining the gain or allowable loss from passive activities. When you group activities, there are consequences for the passive loss limitation rules. By grouping activities, you only have to prove that you materially participated in the overall activity rather than in each individual activity. Grouping activities may also affect the determination of whether you meet the 10% ownership test to qualify as an active participant in a rental activity. And, if you have grouped together different activities and you dispose of your interest in one of the activities, you have only disposed of part of your interest in the overall activity, rather than having disposed of all your interest in one activity.

Determining which activities form an economic unit and can therefore be grouped together depends on the facts and circumstances. Some of the factors to be taken into consideration include similarities and differences between the activities, the extent of common control and ownership, geographical location, and the interdependence between the activities. Interdependence could include factors such as purchases and sales between the activities, common customers or employees, products and services that are generally provided together, and whether separate sets of accounting books are maintained for the activities.

Generally, once you group activities together you cannot regroup them in a different way in a subsequent tax year. You must also meet any disclosure requirements the Internal Revenue Service (IRS) makes at the time you first group activities together and later, if you add or subtract any activity from the group. If the IRS finds that your principal reason for grouping the activities was to avoid the passive loss limitation, it may regroup the activities.

Generally, activities from the different categories that are subject to the passive loss limitation cannot cross over and be grouped together. This means that if you have an interest in an activity from one of the following categories, you cannot group that activity with an activity from a different category:
�· Holding, producing, or distributing motion picture films or video tapes.
�· Farming.
�· Leasing section 1245 property.
�· Exploring for, or exploiting oil and gas resources, or geothermal deposits.

But you could potentially group together different activities within the same category.

Grouping Activities Conducted Through Another Entity

If you have an interest in a partnership, S corporation, closely held corporation, or personal service corporation, that entity must first group together its activities subject to the passive loss limitation. Then, you can take your interest in the activities of that entity and group it together with your own personal activities, or with activities conducted through another entity in which you hold an interest. But once an entity has grouped its activities, you as a partner or shareholder, cannot separate those activities or group them in a different way.

Dispositions

When you dispose of your entire interest in a passive activity, you can fully deduct passive activity losses that have not been allowed in prior years. You must have disposed of your entire interest, and all realized gain or loss on the transaction must be recognized for tax purposes. If there is a capital loss on the disposition, the loss may be subject to the limit on capital losses. This limit is generally $3,000, or $1,500 for married individuals filing separate returns. The disallowed passive activity loss carryovers from prior years would be deductible in addition to the capital loss realized on the disposition.

If you dispose of your interest in a partnership or S corporation, the gain or loss on the disposition must be allocated to each trade or business, rental, or investment activity in which the partnership or S corporation holds an interest. If you dispose of your entire interest, the passive activity losses that were not allowed in prior years are generally fully deductible in the year of the disposition. If you disposed of a portion of your interest, rather than your entire interest, the portion of the gain or loss on the disposition that is allocable to a passive activity is treated as passive income or deduction in the year of the disposition, and a loss would therefore be subject to the passive activity limitation.

How To Report Passive Activities

The results of activities that are subject to the passive activity limits must be reported on Form 8582, Passive Activity Loss Limitations. All passive activities are reported on just one Form 8582, showing each activity on a separate line. Depending on the type of activity for which you are subject to the passive loss limitations, you may need to file Schedule C, Profit or Loss From Business, for a trade or business; Schedule E, Supplemental Income and Loss, for rental properties; or Schedule F, Profit or Loss From Farming. You may also need to file Schedule D, Capital Gains and Losses; Form 4797, Sales of Business Property; or Form 6252, Installment Sale Income, if you dispose of interests in passive activities.

For More Information

For more information on the at-risk rules and the passive activity limits, you can refer to IRS Publication 925, Passive Activity and At-Risk Rules. For information on how to complete the required tax forms, you can refer to the instructions for Form 6198, At-Risk Limitations, and Form 8582, Passive Activity Loss Limitations. Publication 925 is available for downloading from the Internal Revenue Service website at www.irs.gov. The related forms and instructions can also be viewed and downloaded from this website.

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