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:: Passive Activity Loss ATG - Chapter 3, Passive Income
Chapter 3: Passive
Income
In a
Nutshell
Because passive
losses generally can offset only
income from passive activities,
some taxpayers have attempted to
“create” passive income in order
to trigger passive losses. In
other words, non-passive income
may have been improperly
classified as passive and
entered on Form 8582 in order to
trigger deductibility of
otherwise nondeductible passive
losses. Therefore, a common
issue is whether income on Form
8582 lines 1a or 3a is truly
passive. For every dollar of
passive income removed from Form
8582, there is frequently an
adjustment to allowable passive
losses of a dollar. Passive
losses are generally deductible
only to the extent of
passive income.
Regardless of
whether income is deemed to be
passive or non-passive, it must
always be reported somewhere on
the return, most typically on
Schedule E. The Form 8582 is
computational only, figuring the
amount of passive loss
deductible for the current
year. It not the form
used to report income.
See passive
income checksheet at end of
chapter.
Passive
Income
Passive income
can only be generated by a
passive activity. Just because
the taxpayer did not work for
the income does not mean it is
passive. There are only two
sources for passive income:
-
a rental
activity; or,
-
a business
in which the taxpayer does
not materially participate.
Gain on a
partial or entire disposition of
a passive activity generally is
passive income. See
Chapter 5 for a
detailed discussion of passive
income issues on disposition.
While the
following may seem
passive, generally none are
passive income:
-
Portfolio
income, including interest,
dividends, royalties,
annuities and gains on
stocks and bonds;
[1]
-
Lottery
winnings;[2]
-
Salaries,
wages, Form 1099-Misc.
commissions and retirement
income;[3]
-
Guaranteed
payments for services; and,[4]
-
Income from
any activity in which the
taxpayer materially
participates.[5]
Even if
generated by a passive activity,
portfolio income is
non-passive.
Issue
Identification:
-
Passive
income is most commonly
reflected on Schedule E as a
net rental income or
as income from a partnership
or S Corporation in which
the taxpayer does not
materially participate.
-
Passive
income may also be reflected
on Form 4797, Sale of
Business Property or
Schedule D, Capital Gain and
Losses due to the
disposition of a passive
activity or asset used in a
passive activity.
-
Passive
income may also be found on
Schedule C and F if these
are activities in which the
taxpayer does not materially
participate.
Examination
Techniques:
-
Review Form
8582 lines 1a and 3a.
Verify income is reported
somewhere on the return
(Schedule E, D, C, F,
etc.). The Form 8582 is
computational only, figuring
the allowable passive loss.
It does not report income.
If there is income on Form
8582, which is not reflected
elsewhere on the return, you
have unreported income!
-
Scan
Schedules B, Fiscal Year
Supplemental Schedule of
Income and Retirement Income
Credit, Schedule D, and
Schedule K-1 to verify that
passive income does not
include interest, dividends,
royalties or stock and bond
sales.
-
Verify the
income is not from a
partnership that is a trader
in stocks, bonds and other
securities. Traders fall
completely outside the
passive activity rules (Reg.
§ 1.469-1T(e)(6)). Schedule
K-1 line 1 income from a
trader in stocks and bonds
is non-passive, even if the
taxpayer is a limited
partner!
-
For
activities claimed as
passive on Form 8582, verify
that income is not from a
business in which the
taxpayer materially
participates. You may want
to use one of the search
engines on the internet to
see what is said about the
level of activity of the
taxpayer.
-
Verify that
income is not from a
business which is related to
another activity in which
the taxpayer materially
participates. If so,
possibly, the two businesses
should be grouped as a
single activity under Reg. §
1.469-4(f). See Chapter 9.
-
Verify that
passive income is not from
the rental of a building or
equipment to a business
where the taxpayer works.
Reg. § 1.469-2(f)(6)
recharacterizes so-called
“self-rental” income as
non-passive.
-
Verify that
passive income is not from
the rental or sale of land
or other nondepreciable
property. See Reg. §
1.469-2T(f)(3).
-
Verify that
compensation for the
performance of personal
services is not classified
as passive income. This
includes W-2 wages, Form
1099-Misc commissions,
retirement income and
guaranteed payments.
Documents to
Request:
-
The Form
8582 worksheets break down
the income items on Form
8582. Worksheet 1, 2 and 3
reveal which entities are
generating income.
Worksheet 5 (6 beginning in
2002) indicates which
schedule an allowed passive
loss is reflected on.
-
Schedule
K-1s and other documents
supporting amounts reflected
on Form 8582.
Supporting
Law:
-
IRC §
469(c) Passive income
can only be generated by a
rental activity or a
business in which the
taxpayer does not materially
participate.
-
Reg. §
1.469-2T(c) Income is
passive if and only if the
income is from a passive
activity.
-
Reg. §
1.469-2T(c)(2) Gain on
the sale of a passive
activity is passive income,
if it was a passive activity
in the year of disposition.
-
IRC §
469(e)(1)A) and Reg.
1.469-2T(c)(3)
Portfolio income is
non-passive.
-
IRC §
469(e)(1)(A)(ii) and Reg.
1.469-2T(c)(3)(C)&(D)
Gain on the sale of stocks
and bonds is non-passive.
-
Reg. §
1.469-2T(f)(3) Net
income from lease or sale of
land is non-passive.
-
Reg. §
1.469-2(f)(6) Income
from rental real estate,
equipment or other property
leased to a business where
the taxpayer works is
non-passive.
-
Carlstedt TC Memo
1997-331 The taxpayers
failed to sustain their
burden of proving they did
not materially participate
in an S Corporation.
-
Seits
TC Memo 1994-522 Gain
from the sale of an
apartment was investment
income, not passive income.
-
Refer to
Chapter 1 Case Summaries
for more cases related to
income.
Self-Rental
Income
Certain types
of income are treated
(“recharacterized”) as
non-passive. If a taxpayer
rents a property to a business
in which he materially
participates, net rental income
is non-passive and should not be
on Form 8582 line 1a as passive
income. See Reg. §
1.469-2(f)(6) and self-rented
property checksheet at the end
of the chapter. Net rental
losses, however, generally
remain passive.
Even though
income is treated as
non-passive, it may offset
suspended prior year passive
losses from the same activity.[6]
-
Peruse
Schedule E for any property
with net income and few
expenses, indicating that
the property might be under
a net lease. Income from
property leased to an entity
where the taxpayer works is
often structured as a net
lease.
-
Check Form
8582 line 1a to see if what
appears to be self-rental
income from Schedule E is
improperly reflected there.
Self-rented
property is a frequent
adjustment, as it is common
practice for many professionals
to own the property personally
and lease it to a corporation or
partnership where they conduct
business.
Exception:
Pre-88 Lease
Self-rental
income is passive if there is a
written currently binding lease
signed before 2/19/88.[7]
However, as a practical matter,
pre-1988 leases that bind years
under examination are rarely
seen, as the lease period would
have to be 15 years or more.
Renewable options generally do
not constitute a written binding
lease, as the option is not
legally binding until exercised.[8]
Examination
Techniques:
Ask to see the
lease for the year under
examination. If the lease was
signed after 1988, income is
non-passive
Leased Land
Income from
leased land (ground rents) is
non-passive and should not be on
Form 8582 line 1a. Reg. §
1.469-2T(f)(3) recharacterizes
income from leased property
where less than 30 percent of
the unadjusted basis is
depreciable as non-passive.
Examples:
fields leased to a farmer,
mobile home parks, land leased
for billboards, lots leased to
sell Christmas tree, land leased
for cell towers and campgrounds.
The character
of an activity is not changed.
Even though income is
recharacterized as non-passive,
the activity remains a passive
activity and, in fact, if it
produced losses, they would
generally be passive. See Reg.
§ 1.469-2T(f)(1).
Land held
for Investment
Property (land,
for example) held for investment
is non-passive under IRC §
469(e)(1)(A)(ii)(II).
Issue
identification:
-
If the land
is entered on Schedule D and
gains are limited to 20
percent versus being taxed
at ordinary rates
potentially as high as 39.6
percent, it is an indicator
that the land was held for
investment. See IRC § 1(h).
Examination
Techniques:
-
Peruse
Schedule E. If there is
little or no depreciation,
it is an indicator that the
activity may be leased land.
-
If the
taxpayer claims to be in the
business of land sales, i.e.
the activity is on Schedule
C or in partnership,
sporadic sales is an
indicator that land is being
held for investment versus
being treated as a
business. Reminder:
if the taxpayer performs
most of the work in a
business, income is
non-passive. See Reg. §
1.469-5T(a)(2).
Supporting
Law
-
IRC §
469(c): Passive income
can only be generated by a
rental activity or a
business in which the
taxpayer does not materially
participate.
-
Reg. §
1.469-2T(c): Income is
passive if and only if the
income is from a passive
activity.
-
Reg. §
1.469-2T(c)(2): Gain on
the sale of a passive asset
or activity is passive
income if it was a passive
activity in the year of
disposition.
-
IRC §
469(e)(1) and Reg. §
1.469-2T(c)(3):
Portfolio income is
non-passive.
-
IRC §
469(e)(1)(A)(ii) and Reg. §
1.469-2T(c)(3)(C)&(D):
Gain on the sale of stocks
and bonds is non-passive.
-
Reg. §
1.469-1T(e)(6): Traders
in stocks, bonds and other
securities are not passive
activities.
-
Reg. §
1.469-2T(f)(3): Net
income from lease or sale of
land is non-passive.
-
Reg. §
1.469-2(f)(6): Income
from property leased to a
business where the taxpayer
works is non-passive.
-
Carlstedt T.C. Memo
1997-331: The taxpayers
failed to sustain their
burden of proving they did
not materially participate
in an S- Corporation.
-
Seits
T.C. Memo 1994-522:
Gain from the sale of an
apartment was investment
income, not passive income.
Summary
-
Passive
income has only two
sources: net rental income
and income from a business
in which the taxpayer does
not materially participate.
-
Interest,
dividends, royalties,
annuities and gains on
stocks and bonds are not
passive income.
-
Net rental
income from property leased
to a business where the
taxpayer materially
participates is non-passive
and should not be reflect on
Form 8582.
-
Income from
land, whether leased land or
property held for
investment, is non-passive.
Stated differently, net
income (but not net loss)
from the leasing of
nondepreciable property
(such as land) is treated as
non-passive.
[1] IRC §
469(e)(1)
[2] PLR 8943055
[3] IRC §
469(e)(3)
[4] Reg. §
1.469-2(e)(2)(ii)
[5] IRC §
469(c)(1)
[6] IRC §
469(f)(1)
[7] Reg. §
1.469-11(c)(2)
[8] Thomas P.
Krukowski, 114 T.C. No. 25
US Tax Court
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