Passive Activity Loss Audit Technique Guide (ATG) - Table of Contents

Exhibit 1.3: PASSIVE ACTIVITIES COMMON ISSUES: Schedule A, C, E, F

Interest expense to buy rental real estate, an equipment leasing activity, or an investment in a partnership or S Corporation is not investment interest! If the borrowed funds were used to buy rental real estate or equipment leasing or a Form 1065/1120S in which the taxpayer does not materially participate, that interest expense is passive activity interest and belongs on Form 8582. In the absence of passive income, it is generally not deductible. Reg. § 1.469-2T(d)(3), § 1.163-8T(a)(4)(B) and Notice 89-35
Investment interest expense is deductible only to the extent of investment income (Form 4952, Investment Interest Expense Deduction line 4f). Investment income is generally only interest, dividends, royalties, annuities, and short-term capital gains. An investment in a partnership or S Corporation business or a rental activity is not investment income.

Equipment, vehicle and airplane leases are often passive activities. Thus losses are generally not deductible without passive income. See IRC § 469(c)(2)&(4).
Hotel, motel, vacation cottage or condo. If on-site employees do the day-to-day work, it may be difficult for the taxpayer to materially participate. See Reg. § 1.469-5T(a).
Charter boat located a long way from the taxpayer’s home may be passive, i.e. the taxpayer does not materially participate.

Net rental income from a business where the taxpayer works is generally not passive income. If that income is on Form 8582 line 1a, there is an adjustment. When a dollar in passive income is removed from Form 8582, a dollar in passive losses is generally disallowed. Passive losses are allowed only up to passive income. See Reg. § 1.469-2(f)(6).
Net rental income is from leased land is not passive income. If that income is on Form 8582 line 1a, there is an adjustment. See Reg. § 1.469-2T(f)(3).
Unless the taxpayer is a real estate professional (Schedule E line 43), rental losses are generally limited to $25,000 and completely phased out when MAGI is more than $150,000. Even if the taxpayer is a real estate professional, rental losses are still passive and belong on Form 8582 unless the taxpayer materially participates in the rental. Indicators taxpayer does not materially participate: rental is out-of-state, commissions, and/or management fees.
The taxpayer does not materially participate in an out-of-state partnership or S- Corporation business on the back of Schedule E. See IRC § 469(h) and Reg. § 1.469-5T(a).

The taxpayer does not materially participate in the farm. Indicators: it is out-of-state or there is on-site management. See IRC § 469(h), Reg. § 1.469-5T(a).