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:: Passive Activity Loss ATG - Exhibit 5.3: Income Issues On Disposition Of A Passive Activity
Exhibit 5.3:
Income Issues On
Disposition Of A
Passive Activity
ISSUE: On the
sale (or other
disposition) of a
passive activity, is
gain or other income
on Form 8582 truly
passive
income? Should gain
on sale be removed
from Form 8582,
thereby limiting
deductibility of
passive losses?
_____ Verify that
income on Form 8582
line 1a,
and 3a
resulting from a
disposition is
also reflected on
Form 4797 and
Schedule D or
elsewhere.
Form 8582 is merely
a computational form
for allowable
passive activity
losses. Income on
Form 8582 must
also be reflected on
the appropriate
schedule.
Generally, income on
Form 8582 from the
sale of a building
used in a rental
activity is carried
from Form 4797 to
Schedule D (capital
gain portion) and
Line 15 of the front
Form 1040 (ordinary
income).
NOTES: (1) If
no Form 4797 is
filed with the
return, it is
indicative that
there was not a
fully taxable
disposition which
would trigger
suspended losses.
(2) Gain on sale,
however, generally
is passive income.
See Reg. §
1.469-2T(c)(2).
_____ Ensure that
only net gain has
been entered on
Form 8582 line 1a
or 3a, not the
entire sales price.
_____ Verify that
net gain from Form
4797 has been
entered on Form 8582
line 1a or 3a and
the current net loss
on line 1b, 2b or 3b
and carryover
losses on line 1c or
2c. The result
is that only
excess gain
after current and
carryforward losses
have been absorbed
can be used of
offset other passive
losses. If there
was a gain on
disposition, but
current and
carryforward losses
exceed the gain,
nothing should be
entered on Form
8582. In both
instances, the full
taxable gain should
be on Schedule D and
current and
suspended losses on
Schedule E. See Form
8582 Instructions,
page 8.
NOTE: Some
taxpayers enter
only the Form
4797 gain on Form
8582 without
considering the
impact of current
and suspended
losses, thereby
erroneously allowing
other passive
losses. If net gain
is more than current
and suspended
losses, both the net
gain and
all losses must be
reflected on Form
8582.
_____ Verify that
activity was a
passive activity
(rental or
business without
material
participation) in
the year of
disposition
in which
gain is
recognized.
Reg. §
1.469-2T(c)(2)(i)(A)(3)
If activity is not
passive for taxable
year of disposition,
gain is
non-passive.
Example: building
rented in prior
years, but not
rented in the year
of sale. Check
Schedule E (or Form
8825, Rental Real
Estate Income and
Expense of a
Partnership or an S
Corporation, if from
a partnership or S
Corporation) for
rental income and
advertising. If
none, indicates not
rented.
_____ Verify that
income is not from
the sale of land.
Passive income is
only generated by
rentals or passive
businesses. Whether
held for investment
or leased, gain on
the sale of land is
not passive and
should not be on
Form 8582. See IRC
§
469(e)(1)(A)(ii)(II),
Reg. § 1.469-2T(c),
Reg. §
1.469-2T(f)(3).
_____ If
there is
a Form
6252 for
an
installment
sale, verify
that:
-
Income entered
on Form 6252
line 24 ties to
Form 8582 line
1a, AND
-
Current and
carryforward
losses are
deducted in same
ratio as
gain.
NOTE: When gain
recognized from an
installment sale
exceeds all the
current and
suspended losses,
taxpayer need not
compute any ratios.
Losses are fully
deductible.
_____ If the
property is
substantially
appreciated, verify
that the
property was used in
a passive activity
for either 20
percent of
taxpayer's holding
period OR property
used in a passive
activity for the
entire two-year
period prior to
disposition.
Property is
substantially
appreciated if FMV
exceeds 120 percent
of adjusted basis.
See Reg. §
1.469-2(c)(2)(iii).
If 20 percent and
2-year rule
requirements are not
met, income is
non-passive.
_____ If gain is
from the sale of a
building, verify
that
building was
used in
a
passive
activity
in the year of sale.
Passive activity is
either a rental
activity (check
Schedule E for
rental income and
advertising) or a
business in which
the taxpayer does
not materially
participate. If
there are no gross
receipts/rents and
no advertising, it
is an indicator that
there may be no
rental or business
activity in the year
of disposition.
Also verify that
building was not
simply held for
investment, and thus
income is
non-passive. See
IRC § 469(c), Reg. §
1.469-2T(c), Seits
T.C. Memo 1994-52 If
income is
non-passive, it
should be removed
from Form 8582,
thereby reducing
allowable passive
losses. Investment
income is not
passive income (IRC
§ 469(e)(1)(A)).
_____ If a
business interest is
sold, verify the
taxpayer did not
materially
participate in any 5
of the prior 10
years. If
losses/income are
non-passive in
any 5 of 10 years,
current year gain
will be non-passive
even if the taxpayer
did not work in the
activity in the
current year. See
Reg. §
1.469-5T(a)(5).
_____ For 1994
and later years,
consider whether the
taxpayer might be a
real estate
professional.
If he did most of
the work or
otherwise materially
participated in the
rental sold OR if he
elected to group
rental properties,
gain on disposition
is non-passive. A
real estate
professional is an
individual who spent
more than half his
time on real
property businesses
and rentals AND
more than 750 hours
during the year.
See IRC § 469(c)(7),
Reg. § 1.469-9.
_____ Consider
whether
property was
held for
investment
and thus falls
outside the rental
definition (i.e.
that the rental
activity is
incidental to an
investment motive).
Did the taxpayer
seriously intend to
generate rental
income or was his
motive ultimate gain
via capital
appreciation? Reg. §
1.469-1T(e)(3)(vi)
provides that
property will not be
treated as a rental
if the principal
purpose was gain
from appreciation
AND gross rental
income is less than
2 percent of
unadjusted basis or
FMV OR
propertywas leased
to a business in
which the taxpayer
has an ownership
interest AND gross
rental income is
less than 2 percent
of unadjusted basis
or FMV.
_____ Verify that
income on FORM 8582
line 3a (2a for 2001
and prior years) is
not from an activity
in which the
taxpayer
materially
participates.
See Reg. §
1.469-5T(a). If
the taxpayer and/or
the spouse meets any
of the following, he
materially
participates and
income is
non-passive and
should not be on
Form 8582,
triggering passive
losses:
-
Did taxpayer
work more than
500 hours a year
in business?
-
Did taxpayer do
most of the
work?
-
Did taxpayer
work 100 hours
and no one
worked more?
-
Did taxpayer
work 100-500
hours in several
passive
activities, the
sum of which
exceed 500
hours?
-
Did taxpayer
materially
participate in
the activity any
5 of the prior
10 years?
-
If the business
is a personal
service
activity, did he
materially
participate in
any 3 prior
years?
_____ If the
taxpayer is involved
in multiple related
business entities,
consider whether
they form an
"economic unit" (in
other words, one
single activity)
under the activity
rules in Reg. §
1.469-4(c).
Consequently, the
taxpayer materially
participates, and
income is
non-passive. See
anti-abuse provision
in Reg. §
1.469-4(f).
_____ Consider
whether taxpayer is
subject to AMT.
Depreciation and
other AMT preference
and adjustment items
relating to a
passive activity are
suspended until the
year of a qualifying
disposition (or
there is passive
income to trigger
losses).
Consequently, in the
year of sale, there
may be AMT.
LAW: Gain from
disposition
(including
recapture) of assets
used in a rental
activity or business
in which taxpayer
did not materially
participate is
generally passive
income (Reg. §
1.469-2T(c)(2)(A)(2)).
However, there are
several exceptions,
including gain on
the sale of land.
Gain on disposition
may be used to
trigger other PALs
only if it exceeds
current and
suspended losses
from the
entity/property
sold.
ADJUSTMENT:
Income reclassified
as non-passive
should be removed
from Form 8582. Of
course, it should
still be reported on
Schedule D or
another appropriate
schedule. Form 8582
should then be
recomputed without
the income which was
recharacterized.
Passive losses
generally will be
disallowed up to the
amount of passive
income treated as
non-passive.
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