Recharacterization
of Passive Income
Net income from the following passive activities may have to be recharacterized and excluded from passive activity income.
- Significant participation passive activities,
- Rental of property when less than 30% of the unadjusted basis of the property is subject to depreciation,
- Equity-financed lending activities,
- Rental of property incidental to development activities,
- Rental of property to nonpassive activities, and
- Licensing of intangible property by
pass-through entities.
If you are engaged in or have an interest in one of these activities during the tax year (either directly or through a partnership or an S corporation), combine the income and losses from the activity to determine if you have a net loss or net income from that activity.
If the result is a
net loss, treat the income and losses the same as any other income or losses from that type of passive activity (trade or business activity or rental activity).
If the result is
net income, do not enter any of the income or losses from the activity or property on Form 8582 or its worksheets. Instead, enter income or losses on the form and schedules you normally use. However, see
Significant Participation Passive Activities, later, if the activity is a significant participation passive activity and you also have a net loss from a different significant participation passive activity.
Limit on recharacterized passive income. The total amount that you treat as nonpassive income under the rules described later in this discussion for significant participation passive activities, rental of nondepreciable property, and equity-financed lending activities cannot exceed the greatest amount that you treat as nonpassive income under any one of these rules.
Investment income and investment expense. To figure your investment interest expense limitation on Form 4952, treat as investment income any net passive income recharacterized as nonpassive income from rental of nondepreciable property, equity-financed lending activity, or licensing of intangible property by a pass-through entity.
Significant Participation
Passive Activities
A significant participation passive activity is any trade or business activity in which you participated for more than 100 hours during the tax year but did not materially participate.
If your gross income from all significant participation passive activities is more than your deductions from those activities, a part of your net income from each significant participation passive activity is treated as nonpassive income.
Corporations. An activity of a personal service corporation or closely held corporation is a significant participation passive activity if both of the following statements are true.
- The corporation is not treated as materially participating in the activity for the year.
- One or more individuals, each of whom is treated as significantly participating in the activity, directly or indirectly hold (in total) more than 50% (by value) of the corporation's outstanding stock. Generally, an individual is treated as significantly participating in an activity if the individual participates in it for more than 100 hours during the tax year.
Worksheet A. Complete Worksheet A,
Significant Participation Passive Activities (shown on the next page), if you have income or losses from any significant participation activity. Begin by entering the name of each activity in the left column.
Worksheet A. Significant Participation Passive Activities - (Keep for your records)
| Name of activity
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(a) Hours of participation
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(b) Net loss
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(c) Net income
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(d) Combine totals of cols. (b) and (c)
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Column (a). Enter the number of hours you participated in each activity and total the column.
If the total is more than 500, do not complete Worksheet A or B. None of the activities are passive activities because you satisfy test 4 for material participation. (See
Material participation tests, earlier.) Report all the income and losses from these activities on the forms and schedules you normally use. Do not include the income and losses on Form 8582.
Column (b). Enter the net loss, if any, from the activity. Net loss from an activity means either:
- The activity's current year net loss (if any) plus prior year unallowed losses (if any), or
- The excess of prior year unallowed losses over the current year net income (if any). Enter -0- here if the prior year unallowed loss is the same as the current year net income.
Column (c). Enter net income, if any, from the activity. Net income means the excess of the current year's net income from the activity over any prior year unallowed losses from the activity.
Column (d). Combine amounts in the
Totals row for columns (b) and (c) and enter the total net income or net loss in the
Totals row of column (d). If column (d) is a net loss, skip Worksheet B,
Significant Participation Activities With Net Income. Include the income and losses in Worksheet 3 of Form 8582 (or Worksheet 2 of Form 8810).
If column (d) shows net income and you must complete Form 8582 because you have other passive activities to report, complete Worksheet B on page 9. However, you do not have to complete Form 8582 if column (d) shows net income and you have only significant participation activities. If you do not have to complete Form 8582, skip Worksheet B and report the net income and net losses from columns (b) and (c) on the forms and schedules you normally use.
Worksheet B. List only the significant participation passive activities that have net income as shown in column (c) of Worksheet A.
Column (a). Enter the net income of each activity from column (c) of Worksheet A.
Column (b). Divide each of the individual net income amounts in column (a) by the total of column (a). The result is a ratio. In column (b), enter the ratio for each activity as a decimal (rounded to at least three places). The total of these ratios must equal 1.000.
Column (c). Multiply the amount in the
Totals row of column (d) of Worksheet A by each of the ratios in column (b). Enter the results in column (c).
Column (d). Subtract column (c) from column (a). To this figure, add the amount of prior year unallowed losses, if any, that reduced the current year net income. Enter the result in column (d). Enter these amounts on Worksheet 3 of Form 8582 or Worksheet 2 of Form 8810. (Also, see
Limit on recharacterized passive income, earlier.)
Rental of Nondepreciable Property
If you have net passive income (including prior year unallowed losses) from renting property in a rental activity, and less than 30% of the unadjusted basis of the property is subject to depreciation, you treat the net passive income as nonpassive income.
Example. Calvin acquires vacant land for $300,000, constructs improvements at a cost of $100,000, and leases the land and improvements to a tenant. He then sells the land and improvements for $600,000, realizing a gain of $200,000 on the disposition.
The unadjusted basis of the improvements ($100,000) equals 25% of the unadjusted basis of all property ($400,000) used in the rental activity. Calvin's net passive income from the activity (which is figured with the gain from the disposition, including gain from the improvements) is treated as nonpassive income.
Equity-Financed
Lending Activities
If you have gross income from an equity-financed lending activity, the lesser of the net passive income or the equity-financed interest income is nonpassive income.
For more information, see Temporary Regulations section 1.469-2T(f)(4).
Rental of Property Incidental
to a Development Activity
Net passive income from this type of activity will be treated as nonpassive income if
all of the following apply.
- You recognize gain from the sale, exchange, or other disposition of the rental property during the tax year.
- You started to rent the property less than 12 months before the date of disposition.
- You materially participated or significantly participated for any tax year in an activity that involved the performance of services for the purpose of enhancing the value of the property (or any other item of property if the basis of the property disposed of is determined in whole or in part by reference to the basis of that item of property).
For more information, see Regulations section 1.469-2(f)(5).
Rental of Property to a Nonpassive Activity
If you rent property to a trade or business activity in which you materially participated, net rental income from the property is treated as nonpassive income. This rule does not apply to net income from renting property under a written binding contract entered into before February 19, 1988. It also does not apply to property just described under
Rental of Property Incidental to a Development Activity.
Licensing of Intangible Property
by Pass-Through Entities
Net royalty income from intangible property held by a pass-through entity in which you own an interest may be treated as nonpassive royalty income. This applies if you acquired your interest in the pass-through entity after the partnership, S corporation, estate, or trust created the intangible property or performed substantial services or incurred substantial costs for developing or marketing the intangible property.
This recharacterization rule does not apply if:
- The expenses the entity reasonably incurred in developing or marketing the property exceed 50% of the gross royalties from licensing the property that are includible in your gross income for the tax year, or
- Your share of the expenses the entity reasonably incurred in developing or marketing the property for all tax years exceeded 25% of the fair market value of your interest in the intangible property at the time you acquired your interest in the entity.
For purposes of (2) above, capital expenditures are taken into account for the entity's tax year in which the expenditure is chargeable to a capital account, and your share of the expenditure is figured as if it were allowed as a deduction for the tax year.
Dispositions
Any passive activity losses (but not credits) that have not been allowed (including current year losses) generally are allowed in full in the tax year you dispose of your entire interest in the passive (or former passive) activity. However, for the losses to be allowed, you must dispose of your entire interest in the activity in a transaction in which all realized gain or loss is recognized. Also, the person acquiring the interest from you must not be related to you.
If you have a capital loss on the disposition of an interest in a passive activity, the loss may be limited by the capital loss rules. The limit is generally $3,000 for individuals ($1,500 in the case of married individuals filing separate returns). See Publication 544, Sales and Other Dispositions of Assets, for more information.
Example. Ray earned a $60,000 salary and owned one passive activity through a 5% interest in the B Limited Partnership. He sold his entire interest in the current tax year to an unrelated person for $30,000. His adjusted basis in the partnership interest was $42,000, and he had carried over $2,000 of passive activity losses from the activity.
Ray's deductible loss is $5,000, figured as follows:
| Sales price
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$30,000
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| Minus: adjusted basis
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42,000
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| Capital loss
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$12,000
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| Minus: capital loss limit
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3,000
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| Capital loss carryover
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$9,000
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| Allowable capital loss on sale
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$3,000
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| Carryover losses allowable
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2,000
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| Total current deductible loss
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$5,000
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Worksheet B. Significant Participation Activities With Net Income - (Keep for your records)
| Name of activity with net income
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(a) Net income
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(b) Ratio See instructions
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(c) Nonpassive income See instructions
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(d) Passive income Subtract col. (c) from col. (a)
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| Totals
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1.000
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Ray deducts the $5,000 total current deductible loss in the current tax year. He must carry over the remaining $9,000 capital loss, which is not subject to the passive activity loss limit. He will treat it like any other capital loss carryover.
Installment sale of an entire interest. If you sell your entire interest in a passive activity through an installment sale, to figure the loss for the current year that is not limited by the passive activity rules, multiply your overall loss (not including losses allowed in prior years) by a fraction. The numerator (top part) of the fraction is the gain recognized in the current year, and the denominator (bottom part) is the total gain from the sale minus all gains recognized in prior years.
Example. John Ash has a total gain of $10,000 from the sale of an entire interest in a passive activity. Under the installment method he reports $2,000 of gain each year, including the year of sale. For the first year, 20% (2,000/10,000) of the losses are allowed. For the second year, 25% (2,000/8,000) of the remaining losses are allowed.
Partners and S corporation shareholders. Generally, any gain or loss on the disposition of a partnership interest must be allocated to each trade or business, rental, or investment activity in which the partnership owns an interest. If you dispose of your entire interest in a partnership, the passive activity losses from the partnership that have not been allowed generally are allowed in full. They also will be allowed if the partnership (other than a PTP) disposes of all the property used in that passive activity.
If you do not dispose of your entire interest, the gain or loss allocated to a passive activity is treated as passive activity income or deduction in the year of disposition. This includes any gain recognized on a distribution of money from the partnership that you receive in excess of the adjusted basis of your partnership interest.
These rules also apply to the disposition of stock in an S corporation.
Dispositions by gift. If you give away your interest in a passive activity, the unused passive activity losses allocable to the interest cannot be deducted in any tax year. Instead, the basis of the transferred interest must be increased by the amount of these losses.
Dispositions by death. If a passive activity interest is transferred because the owner dies, unused passive activity losses are allowed (to a certain extent) as a deduction against the decedent's income in the year of disposition. The decedent's losses are allowed only to the extent they exceed the amount by which the transferee's basis in the passive activity has been increased under the rules for determining the basis of property acquired from a decedent. For example, if the basis of an interest in a passive activity in the hands of a transferee is increased by $6,000 and unused passive activity losses of $8,000 were allocable to the interest at the date of death, then the decedent's deduction for the tax year would be limited to $2,000 ($8,000 - $6,000).
Partial dispositions. If you dispose of substantially all of an activity during your tax year, you may treat the part of the activity disposed of as a separate activity. See
Partial dispositions under
Grouping Your Activities, earlier.
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