Important Change

Commercial revitalization deduction.   The $25,000 special allowance must first be applied to losses from rental real estate activities figured without the commercial revitalization deduction. Any remaining part of the $25,000 special allowance is available for the commercial revitalization deduction from the rental real estate activities and is not subject to the active participation rules or the phaseout based on modified adjusted gross income. For more information, see Special $25,000 allowance under Rental Activities.

Important Reminder

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Introduction

This publication discusses two sets of rules that may limit the losses you can deduct on your tax return from any trade, business, rental, or other income-producing activity. The first part of the publication contains the passive activity rules. The second part discusses the at-risk rules. However, when you figure your allowable losses from any activity, you must apply the at-risk rules before the passive activity rules.

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Useful Items

You may want to see:

Publication

• 527   Residential Rental Property (Including Rental of Vacation Homes)
• 541   Partnerships

Form (and Instructions)

• 4952   Investment Interest Expense Deduction
• 6198   At-Risk Limitations
• 8582   Passive Activity Loss Limitations
• 8582-CR   Passive Activity Credit Limitations
• 8810   Corporate Passive Activity Loss and Credit Limitations

See How To Get Tax Help near the end of this publication for information about getting these publications and forms.

Passive Activity Limits

In general, you can deduct passive activity losses only from passive activity income (a limit on loss deductions). You carry any excess loss forward to the following year or years until used, or until deducted in the year you dispose of your entire interest in the activity in a fully taxable transaction. See Dispositions, later.

Before applying this limit on passive activity losses, you must first determine the amount of your loss disallowed under the at-risk rules explained in the second part of this publication.

Passive activity credits.   You can subtract passive activity credits only from the tax on net passive income. Passive activity credits include the general business credit and other special business credits, such as the credit for fuel produced from a nonconventional source. Credits that are more than the tax on income from passive activities are carried forward.

Unallowed passive activity credits, unlike unallowed passive activity losses, cannot be claimed when you dispose of your entire interest in an activity. However, to determine your gain or loss from the disposition, you can elect to increase the basis of the credit property by the amount of the original basis reduction for the credit, to the extent that the credit was not allowed because of the passive activity limits. You cannot elect to adjust the basis for a partial disposition of your interest in a passive activity.

See the instructions for Form 8582-CR for more information.

Publicly traded partnership.   You must apply the rules in this part separately to your income or loss from a passive activity held through a publicly traded partnership (PTP). You also must apply the limit on passive activity credits separately to your credits from a passive activity held through a PTP.

You can offset losses from passive activities of a PTP only against income or gain from passive activities of the same PTP. Likewise, you can offset credits from passive activities of a PTP only against the tax on the net passive income from the same PTP.

For more information on how to apply the passive activity loss rules to PTPs, and on how to apply the limit on passive activity credits to PTPs, see Publicly Traded Partnerships (PTPs) in the instructions for Forms 8582 and 8582-CR, respectively.

Who Must Use
These Rules?

The passive activity rules apply to:

• Individuals,
• Estates,
• Trusts (other than grantor trusts),
• Personal service corporations, and
• Closely held corporations.

Even though the rules do not apply to grantor trusts, partnerships, and S corporations directly, they do apply to the owners of these entities.

For information about personal service corporations and closely held corporations, including definitions and how the passive activity rules apply to these corporations, see Form 8810 and its instructions.

Closely held corporation.   A closely held corporation can offset net active income with its passive activity loss. It also can offset the tax attributable to its net active income with its passive activity credits. However, a closely held corporation cannot offset its portfolio income (defined later, under Passive Activity Income) with its passive activity loss.

Net active income is the corporation's taxable income figured without any income or loss from a passive activity or any portfolio income or loss.

Passive Activities

There are two kinds of passive activities.

• Trade or business activities in which you do not materially participate during the year.
• Rental activities, even if you do materially participate in them, unless you are a real estate professional.

Material participation in a trade or business is discussed later, under Activities That Are Not Passive Activities. Treatment of former passive activities.   A former passive activity is an activity that was a passive activity in any earlier tax year, but is not a passive activity in the current tax year. You can deduct a prior years' unallowed loss from the activity up to the amount of your current year net income from the activity. Treat any remaining prior year unallowed loss like you treat any other passive loss.

In addition, any prior year unallowed passive activity credits from a former passive activity offset the allocable part of your current year tax liability. The allocable part of your current year tax liability is that part of this year's tax liability that is allocable to the current year net income from the former passive activity. You figure this after you reduce your net income from the activity by any prior year unallowed loss from that activity (but not below zero).

Trade or Business Activities

A trade or business activity is an activity that:

• Involves the conduct of a trade or business (that is, deductions would be allowable under section 162 of the Internal Revenue Code if other limitations, such as the passive activity rules, did not apply),
• Is conducted in anticipation of starting a trade or business, or
• Involves research or experimental expenditures that are deductible under Internal Revenue Code section 174 (or that would be deductible if you chose to deduct rather than capitalize them).

A trade or business activity does not include a rental activity or the rental of property that is incidental to an activity of holding the property for investment. You generally report trade or business activities on Schedule C, C-EZ, F, or in Part II or III of Schedule E.

Rental Activities

A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional. See Real Estate Professional under Activities That Are Not Passive Activities, later. An activity is a rental activity if tangible property (real or personal) is used by customers or held for use by customers, and the gross income (or expected gross income) from the activity represents amounts paid (or to be paid) mainly for the use of the property. It does not matter whether the use is under a lease, a service contract, or some other arrangement.

Exceptions.   Your activity is not a rental activity if any of the following apply.

1. The average period of customer use of the property is 7 days or less. You figure the average period of customer use by dividing the total number of days in all rental periods by the number of rentals during the tax year. If the activity involves renting more than one class of property, multiply the average period of customer use of each class by a fraction. The numerator of the fraction is the gross rental income from that class of property and the denominator is the activity's total gross rental income. The activity's average period of customer use will equal the sum of the amounts for each class.
2. The average period of customer use of the property, as figured in (1) above, is 30 days or less and you provide significant personal services with the rentals. Significant personal services include only services performed by individuals. To determine if personal services are significant, all relevant facts and circumstances are taken into consideration, including the frequency of the services, the type and amount of labor required to perform the services, and the value of the services relative to the amount charged for use of the property. Significant personal services do not include the following.
   1. Services needed to permit the lawful use of the property,
   2. Services to repair or improve property that would extend its useful life for a period substantially longer than the average rental, and
   3. Services that are similar to those commonly provided with long-term rentals of real estate, such as cleaning and maintenance of common areas or routine repairs.
3. You provide extraordinary personal services in making the rental property available for customer use. Services are extraordinary personal services if they are performed by individuals and the customers' use of the property is incidental to their receipt of the services.
4. The rental is incidental to a nonrental activity. The rental of property is incidental to an activity of holding property for investment if the main purpose of holding the property is to realize a gain from its appreciation and the gross rental income from the property is less than 2% of the smaller of the property's unadjusted basis or fair market value. The unadjusted basis of property is its cost not reduced by depreciation or any other basis adjustment. The rental of property is incidental to a trade or business activity if all of the following apply.
   1. You own an interest in the trade or business activity during the year.
   2. The rental property was used mainly in that trade or business activity during the current year, or during at least 2 of the 5 preceding tax years.
   3. Your gross rental income from the property is less than 2% of the smaller of its unadjusted basis or fair market value. Lodging provided to an employee or the employee's spouse or dependents is incidental to the activity or activities in which the employee performs services if the lodging is furnished for the employer's convenience.
5. You customarily make the rental property available during defined business hours for nonexclusive use by various customers.
6. You provide the property for use in a nonrental activity in your capacity as an owner of an interest in the partnership, S corporation, or joint venture conducting that activity.

If you meet any of the exceptions listed above, see the instructions for Form 8582 for information about how to report any income or loss from the activity.

Special $25,000 allowance.   If you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.

If you are married, filing a separate return, and lived apart from your spouse for the entire tax year, your special allowance cannot be more than $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you cannot use the special allowance to reduce your nonpassive income or tax on nonpassive income.

The maximum special allowance is reduced if your modified adjusted gross income exceeds certain amounts. See Phaseout rule, later.

Example.   Kate, a single taxpayer, has $70,000 in wages, $15,000 income from a limited partnership, a $26,000 loss from rental real estate activities in which she actively participated, and less than $100,000 of modified adjusted gross income. She can use $15,000 of her $26,000 loss to offset her $15,000 passive income from the partnership. She actively participated in her rental real estate activities, so she can use the remaining $11,000 rental real estate loss to offset $11,000 of her nonpassive income (wages).

Active participation.   Active participation is not the same as material participation, defined later. Active participation is a less stringent standard than material participation. For example, you may be treated as actively participating if you make management decisions in a significant and bona fide sense. Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

Only individuals can actively participate in rental real estate activities. However, a decedent's estate is treated as actively participating for its tax years ending less than 2 years after the decedent's death, if the decedent would have satisfied the active participation requirement for the activity for the tax year the decedent died.

A decedent's qualified revocable trust can also be treated as actively participating if both the trustee and the executor (if any) of the estate choose to treat the trust as part of the estate. The choice applies to tax years ending after the decedent's death and before:

• 2 years after the decedent's death if no estate tax return is required, or
• 6 months after the estate tax liability is finally determined if an estate tax return is required.

The choice is irrevocable and cannot be made later than the due date for the estate's first income tax return (including any extensions).

Limited partners are not treated as actively participating in a partnership's rental real estate activities.

You are not treated as actively participating in a rental real estate activity unless your interest in the activity (including your spouse's interest) was at least 10% (by value) of all interests in the activity throughout the year.

Active participation is not required to take the low-income housing credit, the rehabilitation investment credit, or commercial revitalization deduction from rental real estate activities.

Example.   Mike, a single taxpayer, had the following income and loss during the tax year:

Salary		$42,300
Dividends		300
Interest		1,400
Rental loss		(4,000)

The rental loss came from a house Mike owned. He advertised and rented the house to the current tenant himself. He also collected the rents and either did the repairs or hired someone to do them.

Even though the rental loss is a loss from a passive activity, Mike can use the entire $4,000 loss to offset his other income because he actively participated.

Phaseout rule.   The maximum special allowance of $25,000 ($12,500 for married individuals filing separate returns and living apart at all times during the year) is reduced by 50% of the amount of your modified adjusted gross income that is more than $100,000 ($50,000 if you are married filing separately). If your modified adjusted gross income is $150,000 or more ($75,000 or more if you are married filing separately), you generally cannot use the special allowance.

Modified adjusted gross income for this purpose is your adjusted gross income figured without the following.

• Taxable social security and tier 1 railroad retirement benefits,
• Deductible contributions to individual retirement accounts (IRAs) and section 501(c)(18) pension plans,
• The exclusion from income of interest from qualified U.S. savings bonds used to pay qualified higher education expenses,
• The exclusion from income of amounts received from an employer's adoption assistance program,
• Passive activity income or loss included on Form 8582,
• Any rental real estate loss allowed because you materially participated in the rental activity as a real estate professional (as discussed later, under Activities That Are Not Passive Activities),
• Any overall loss from a publicly traded partnership (see Publicly Traded Partnerships (PTPs) in the instructions for Form 8582),
• The deduction for one-half of self-employment tax,
• The deduction allowed for interest on student loans, or
• The deduction for qualified tuition and related expenses.

Example.   During 2002, John was unmarried and was not a real estate professional. For 2002, he had $120,000 in salary and a $31,000 loss from his rental real estate activities in which he actively participated. His modified adjusted gross income is $120,000. When he files his 2002 return, he may deduct only $15,000 of his passive activity loss. He must carry over the remaining $16,000 passive activity loss to 2003. He figures his deduction and carryover as follows:

Adjusted gross income, modified as required		$120,000
Minus amount not subject to phaseout		100,000
Amount subject to phaseout rule		$20,000
Multiply by 50%		× 50%
Required reduction to special allowance		$10,000
Maximum special allowance		$25,000
Minus required reduction (see above)		10,000
Adjusted special allowance		$15,000
Passive loss from rental real estate		$31,000
Deduction allowable/Adjusted special allowance (see above)		15,000
Amount that must be carried forward		$16,000

Exceptions to the phaseout rules.   A higher phaseout range applies to low-income housing credits for property placed in service before 1990 and rehabilitation investment credits from rental real estate activities. For those credits, the phaseout of the $25,000 special allowance starts when your modified adjusted gross income exceeds $200,000 ($100,000 if you are a married individual filing a separate return and living apart at all times during the year).

There is no phaseout of the $25,000 special allowance for low-income housing credits for property placed in service after 1989 or for the commercial revitalization deduction. If you hold an indirect interest in the property through a partnership, S corporation, or other pass-through entity, the special exception for the low-income housing credit will not apply unless you also acquired your interest in the pass-through entity after 1989.

Ordering rules.   If you have more than one of the exceptions to the phaseout rules in the same tax year, you must apply the $25,000 phaseout against your passive activity losses and credits in the following order.

1. The portion of passive activity losses not attributable to the commercial revitalization deduction.
2. The portion of passive activity losses attributable to the commercial revitalization deduction.
3. The portion of passive activity credits attributable to credits other than the rehabilitation and low-income housing credits.
4. The portion of passive activity credits attributable to the rehabilitation credit and low-income housing credit for property placed in service prior to 1990.
5. The portion of passive activity credits attributable to the low-income housing credit for property placed in service after 1989.

For more information about the commercial revitalization deduction, see Publication 954, Tax Incentives for Empowerment Zones and Other Distressed Communities.

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