The passive activity loss rules under IRC Section 469 were enacted in 1986 to prevent individuals from using tax shelters to reduce tax liability on their tax return by offsetting passive activity losses and passive activity tax credits against other taxable income. But the tax rules went beyond that and covered real estate investors and “non-active” owners in businesses.
In general, passive activity losses can only offset passive activity income on your tax return. Any disallowed passive activity losses are deferred until future years until passive activity income is generated or the passive activity is disposed of in a taxable transaction.
The first step in understanding how the rues impact you is to identify your passive activities (rental act ivies, limited partnership investments any other businesses in which you are not an active participant. The determination of who is an active participant in a business is a major issue in the understanding of the rules.
The next step is to calculate your passive activity income and your passive activity losses. In general the losses can only be deducted against passive activity income. Any excess losses are carried forward until you have passive activity income or the passive activity is disposed.
A common problem and one that neither the average tax pracitioner nor the average IRS agent understands well is when a person owns a business and the business rents real estate which is also owned by the individual. In that case the passive activity rules that apply to most rentals often do not apply. As an example, Joe Medical is family practice physician. His practice is an S-corporation “Family Medecine Corp.”. Family Medicine Corp. rents its office from “Office LLC” Both Family Medicine Corp and Office LLC are owned by Joe. In this situation tax law generally considers rental activity in Office LLC to be merely an extension of the active business conducted by Family Medicine. As a consequence, if office LLC has a profit, that profit is not passive income (and can’t offset other passive losses), but on the good side, if there is a loss it may be fully deductible.
Special rule for rental real estate
If your rental of real estate is a passive activity, you may generally offset a passive activity loss of up to $25,000 against your non passive income on your tax return if you actively participate in the passive activity. However, married persons filing separate tax returns who lived together at any time during the tax year may not claim this offset on their tax returns. Married persons filing separate tax returns who lived apart at all times during the tax year are each allowed a $12,500 maximum offset for passive activity real estate on their tax returns. The allowance is phased-out if your modified adjusted gross income is between $100,000 and $150,000.
The tax rules related to passive activities are not well understood by the tax preparation community or by the IRS. We know the rules and have a successful record in defending taxpayers. We know passive activity law. If you have been selected for IRS audit you owe it to yourself to get the best defense.