Passive Activity Deductions

To figure your overall gain or overall loss from all passive activities or any passive activity, take into account only passive activity deductions.

Passive activity deductions include all deductions from activities that are passive activities for the current tax year and all deductions from passive activities that were disallowed under the PAL rules in prior tax years and carried forward to the current tax year under section 469(b). See Regulations section 1.469-1(f)(4).

Passive activity deductions include losses from a disposition of property used in a passive activity at the time of the disposition and losses from a disposition of less than your entire interest in a passive activity. See Dispositions on page 7 for the treatment of losses upon disposition of your entire interest in an activity.

Passive activity deductions do not include the following:

• Deductions for expenses (other than interest expense) that are clearly and directly allocable to portfolio income.
• Interest expense (other than self-charged interest treated as a passive activity deduction) or interest expense properly allocable under Temporary Regulations section 1.163-8T to passive activities (for example, qualified home mortgage interest and capitalized interest expense are not passive activity deductions).
• Losses from dispositions of property that produce portfolio income or property held for investment.
• State, local, and foreign income taxes.
• Miscellaneous itemized deductions that may be disallowed under section 67.
• Charitable contribution deductions.
• Net operating loss deductions, percentage depletion carryovers under section 613A(d), and capital loss carryovers.
• Deductions and losses that would have been allowed for tax years beginning before 1987, but for basis or at-risk limitations.
• Net negative section 481 adjustments allocated to activities other than passive activities. See Temporary Regulations section 1.469-2T(d)(7).
• Deductions for losses from fire, storm, shipwreck, or other casualty or from theft if losses similar in cause and severity do not recur regularly in the activity.
• The deduction allowed under section 164(f) for one-half of self-employment taxes.

Former Passive Activities

A former passive activity is any activity that was a passive activity in a prior tax year but is not a passive activity in the current tax year. A prior year unallowed loss from a former passive activity is allowed to the extent of current year income from the activity.

If current year net income from the activity is less than the prior year unallowed loss,   enter the prior year unallowed loss and any current year net income from the activity on Form 8582 and the applicable worksheets.

If current year net income from the activity is more than or equal to the prior year unallowed loss from the activity,   report the income and loss on the forms and schedules normally used; do not enter the amounts on Form 8582.

If the activity has a net loss for the current year,   enter the prior year unallowed loss (but not the current year loss) on Form 8582 and the applicable worksheets.

To report a disposition of a former passive activity, follow the rules under Dispositions on page 7.

Dispositions

Disposition of an Entire Interest

If you disposed of your entire interest in a passive activity or a former passive activity to an unrelated person in a fully taxable transaction during the tax year, your losses allocable to the activity for the year are not limited by the PAL rules.

A fully taxable transaction is a transaction in which you recognize all realized gain or loss.

If you are using the installment method to report this kind of disposition, figure the loss for the current year that is not limited by the PAL rules by multiplying your overall loss (which does not include losses allowed in prior years) by the following fraction:

Gain recognized in the current year

Unrecognized gain as of the beginning of the current year

A partner in a PTP is not treated as having disposed of an entire interest in an activity of a PTP until there is an entire disposition of the partner's interest in the PTP.

Reporting an Entire Disposition on Schedule D or Form 4797

If you completely dispose of your entire interest in a passive activity or a former passive activity, you may have to report net income or loss and prior year unallowed losses from the activity. All the net income and losses are reported on the forms and schedules normally used.

Combine all income and losses (including any prior year unallowed losses) from the activity for the tax year to see if you have an overall gain or loss.

If you have an overall gain from a passive activity and you have other passive activities to report on Form 8582, include the income, losses, and prior year unallowed losses on Worksheet 1, 2, or 3.

If this is your only passive activity or a former passive activity, report all income and losses (including any prior year unallowed losses) on the forms and schedules normally used and do not include the income or losses on the worksheets or Form 8582.

If you have an overall loss when you combine the income and losses, do not use the worksheets or Form 8582 for the activity. All losses (including prior year unallowed losses) are allowed in full. Report the income and losses on the forms and schedules normally used.

An overall loss from an entire disposition of a passive activity is a nonpassive loss if you have an aggregate loss from all other passive activities. When figuring your modified adjusted gross income for line 7 of Form 8582, be sure to take into account the overall loss from the disposition of the activity.

Example 1. Activity with overall gain.   You sell your entire interest in a rental real estate activity in which you actively participated for a gain of $15,525. $7,300 of the gain is section 1231 gain reported on Form 4797, Part I, and $8,225 is ordinary recapture income reported on Form 4797, Part II. On line 23 of Schedule E (Form 1040), you report a total loss of $15,450, which includes a current year $2,800 net loss and a $12,650 prior year unallowed loss. You have an overall gain from the disposition ($15,525 - $15,450 = $75).

Because you had other passive activities reportable on Form 8582, you make the following entries on Worksheet 1. You enter the $15,525 gain on the disposition in column (a), the current year loss of $2,800 in column (b), and the prior year unallowed loss of $12,650 in column (c).

Example 2. Activity with overall loss.   You sell your entire interest in an oil and gas limited partnership that was your only passive activity for a gain of $2,000. You have a current year Schedule E loss of $3,330 and a Schedule E prior year unallowed loss of $1,115.

Because you have an overall loss of $2,445 after combining the gain and losses, none of the amounts are entered on Worksheet 3 or on Form 8582.

You enter the net loss plus the prior year unallowed loss ($3,330 + $1,115 = $4,445) on Schedule E, Part II, column (i), and the $2,000 gain on the sale on Schedule D, in either Part I or Part II, depending on how long you held the partnership interest.

Disposition of Less Than an Entire Interest

Gains and losses from the disposition of less than an entire interest in an activity are treated as part of the net income or net loss from the activity for the current year.

Note:   A disposition of less than substantially all of an entire interest does not trigger the allowance of prior year unallowed losses.

Disposition of substantially all of an activity.   You may treat the disposition of substantially all of an activity as a separate activity if you can prove with reasonable certainty:

1. The prior year unallowed losses, if any, allocable to the part of the activity disposed of and
2. The net income or loss for the year of disposition allocable to the part of the activity disposed of.

Specific Instructions

Part I - 2002 Passive Activity Loss (PAL)

Use Part I to combine the net income and net loss from all passive activities to determine if you have a PAL for 2002.

Note:   See Pub. 925 for examples showing how to complete the worksheets.

Worksheet 1

Individuals and qualifying estates who actively participated in rental real estate activities must include the income or loss from those activities in Worksheet 1 to figure the amounts to enter on lines 1a through 1c of Form 8582. Do not include any commercial revitalization deductions (CRDs) from these activities in the net income or loss reported in Worksheet 1. Use Worksheet 2 to report CRDs from rental real estate activities (with or without active participation). Use Worksheet 3 to figure the amounts (other than CRDs) to enter on lines 3a through 3c if you did not actively participate in a rental real estate activity.

Note:   Do not enter a prior year unallowed loss in column (c) of Worksheet 1 unless you actively participated in the activity in both the year the loss arose and the current tax year. If you did not actively participate in both years, enter the prior year unallowed loss in column (c) of Worksheet 3.

Married individuals who file separate returns and lived with their spouses at any time during the tax year do not qualify under the active participation rule and must use Worksheet 3 instead of Worksheet 1.

Column (a).   Enter the current year net income from each activity. Enter the total of column (a) on line 1a of Form 8582.

Example.   A Schedule C activity has current year profit of $5,000 and a Form 4797 gain of $2,000. You enter $7,000 in column (a).

Column (b).   Enter the current year net loss for each activity. Do not enter any prior year unallowed losses in this column. Enter the total of column (b) on line 1b of Form 8582.

If an activity has net income on one form or schedule and a net loss on another form or schedule, report the net amounts separately in columns (a) and (b) of Worksheet 1.

Example.   A Schedule E rental activity has current year income of $1,000 on line 22 of Schedule E and a current year Form 4797 loss of $4,500. You enter $1,000 in column (a) and ($4,500) in column (b).

Column (c).   Enter the prior year unallowed losses for each activity. You find these amounts on Worksheet 4, column (c), of your 2001 Form 8582. Enter the total of column (c) from your 2002 Worksheet 1 on line 1c of Form 8582.

Columns (d) and (e).   Combine income and losses in columns (a) through (c) for each activity, and either enter the overall gain for the activity in column (d) or enter the overall loss for the activity in column (e). Do not enter amounts from columns (d) and (e) on Form 8582. These amounts will be used when Form 8582 is completed to figure the loss allowed for the current year.

Worksheet 2

Use Worksheet 2 to figure the amounts to enter on lines 2a and 2b for commercial revitalization deductions (CRD) from rental real estate activities (see Commercial revitalization deduction (CRD) on page 4). Do not include:

• Income or other deductions from the same activity. Instead, report any net income or net loss from the activity, except for the CRD, in Worksheet 1 if you actively participated in the activity or in Worksheet 3 if you did not actively participate.
• CRDs from passive activities other than rental real estate activities. Instead, report these deductions as part of the net income or loss from the passive activity in Worksheet 3.

Column (a).   Enter the current year CRD from each rental real estate activity. Enter the total of column (a) on line 2a of Form 8582.

Column (b).   Enter the unallowed CRDs from the prior year for each rental real estate activity. You can have a prior year unallowed CRD only if you have a fiscal year beginning in 2001 and ending in 2002. Enter the total of column (b) on line 2b of Form 8582.

Column (c).   Combine the amounts in columns (a) and (b) for each activity and enter the overall loss for the activity in column (c). Do not enter amounts from column (c) on Form 8582. These amounts will be used when Form 8582 is completed to figure the loss allowed for the current year.

Worksheet 3

Use Worksheet 3 to figure the amounts to enter on lines 3a through 3c for:

1. Passive trade or business activities,
2. Passive rental real estate activities that do not qualify for the special allowance (other than CRDs from these activities), and
3. Rental activities other than rental real estate activities.

Column (a).   Enter the current year net income for each activity. Enter the total of column (a) on line 3a of Form 8582. (See the example in the instructions under column (a) for Worksheet 1, on page 7.)

Column (b).   Enter the current year net loss for each activity. Enter the total of column (b) on line 3b of Form 8582. (See the example in the instructions under column (b) of Worksheet 1, beginning on page 7.)

Column (c).   Enter the unallowed losses for the prior years for each activity. You find these amounts on Worksheet 4, column (c), of your 2001 Form 8582. Enter the total of column (c) from your 2002 Worksheet 3 on line 3c of Form 8582.

Columns (d) and (e).   Combine income and losses in columns (a) through (c) for each activity, and either enter the overall gain for the activity in column (d) or enter the overall loss for the activity in column (e). Do not enter amounts from columns (d) and (e) on Form 8582. These amounts will be used when Form 8582 is completed to figure the loss allowed for the current year.

Part II - Special Allowance for Rental Real Estate With Active Participation

Use Part II to figure the maximum amount of rental loss allowed if you have a net loss from a rental real estate activity with active participation.

Enter all numbers in Part II as positive amounts (that is, greater than zero).

Example.   Line 5 has a loss of $42,000 (reported as a positive amount) and line 9 is $25,000. You enter $25,000 on line 10 (the smaller of line 5 or line 9, both treated as positive amounts).

Line 5.   Enter on line 5 the smaller of the loss on line 1d or the loss on line 4.

Example.   Line 1d has a loss of $3,000, line 2c is zero, and line 3d has a gain of $100. The combined loss on line 4 is $2,900. You enter $2,900 as a positive number on line 5 (the smaller of the loss on line 1d or the loss on line 4).

Line 6.   Married persons filing separate returns who lived apart from their spouses at all times during the year must enter $75,000 on line 6 instead of $150,000. Married persons filing separate returns who lived with their spouses at any time during the year are not eligible for the special allowance. They must enter zero on line 10 and go to line 15.

Line 7.   To figure modified adjusted gross income, combine all the amounts used to figure adjusted gross income except do not take into account:

• Passive income or loss included on Form 8582;
• Any rental real estate loss allowed under section 469(c)(7) to real estate professionals (defined under Activities That Are Not Passive Activities on page 2);
• Any overall loss from a PTP;
• The taxable amount of social security and tier 1 railroad retirement benefits;
• The deduction allowed under section 219 for contributions to IRAs and certain other qualified retirement plans;
• The deduction allowed under section 164(f) for one-half of self-employment taxes;
• The exclusion from income of interest from series EE and I U.S. savings bonds used to pay higher education expenses;
• The exclusion of amounts received under an employer's adoption assistance program;
• The student loan interest deduction; or
• The tuition and fees deduction.

Include in modified adjusted gross income any portfolio income and expenses that are clearly and directly allocable to portfolio income. Also include any income that is treated as nonpassive income, such as overall gain from a PTP and net income from an activity or item of property subject to the recharacterization of passive income rules. When figuring modified adjusted gross income, any overall loss from the entire disposition of a passive activity is taken into account as a nonpassive loss. But it is not included on Form 8582.

Example.   Your adjusted gross income on line 35 of Form 1040 is $92,000, and you have taxable social security benefits of $5,500 on line 20b. Your modified adjusted gross income is $86,500 ($92,000 - $5,500).

Line 9.   Do not enter more than $12,500 on line 9 if you are married filing a separate return and you and your spouse lived apart at all times during the year. Married persons filing separate returns who lived with their spouses at any time during the year are not eligible for the special allowance. They must enter zero on line 10 and go to line 15.

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