Publication 925 (2006), Passive Activity and At-Risk Rules

Publication 925 - Main Contents

This is archived information that pertains only to the 2006 Tax Year. If you
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Table of Contents

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. This separate treatment rule also applies to a regulated investment company holding an interest in a PTP for the items attributable to that interest.

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 year's 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.

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.
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.
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.
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.
You customarily make the rental property available during defined business hours for nonexclusive use by various customers.
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).

Commercial revitalization deduction. The special allowance must first be applied to losses from rental real estate activities figured without the commercial revitalization deduction. Any remaining part of the 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 about the commercial revitalization deduction, see Publication 954, Tax Incentives for Distressed Communities.

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 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 for domestic production activities.
The deduction allowed for interest on student loans.
The deduction for qualified tuition and related expenses.

Example.

During 2006, John was unmarried and was not a real estate professional. For 2006, 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 2006 return, he may deduct only $15,000 of his passive activity loss. He must carry over the remaining $16,000 passive activity loss to 2007. 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 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 or for the commercial revitalization deduction.

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.

The portion of passive activity losses not attributable to the commercial revitalization deduction.
The portion of passive activity losses attributable to the commercial revitalization deduction.
The portion of passive activity credits attributable to credits other than the rehabilitation and low-income housing credits.
The portion of passive activity credits attributable to the rehabilitation credit.
The portion of passive activity credits attributable to the low-income housing credit.

Activities That Are Not Passive Activities

The following are not passive activities.

Trade or business activities in which you materially participated for the tax year.
A working interest in an oil or gas well which you hold directly or through an entity that does not limit your liability (such as a general partner interest in a partnership). It does not matter whether you materially participated in the activity for the tax year. However, if your liability was limited for part of the year (for example, you converted your general partner interest to a limited partner interest during the year) and you had a net loss from the well for the year, some of your income and deductions from the working interest may be treated as passive activity gross income and passive activity deductions. See Temporary Regulations section 1.469-1T(e) (4)(ii).
The rental of a dwelling unit that you also used for personal purposes during the year for more than the greater of 14 days or 10% of the number of days during the year that the home was rented at a fair rental.
An activity of trading personal property for the account of those who own interests in the activity. See Temporary Regulations section 1.469-1T(e)(6).
Rental real estate activities in which you materially participated as a real estate professional. See Real Estate Professional, later.

You should not enter income and losses from these activities on Form 8582. Instead, enter them on the forms or schedules you would normally use.

Material Participation

A trade or business activity is not a passive activity if you materially participated in the activity.

Material participation tests. You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.

You participated in the activity for more than 500 hours.
Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities, under Recharacterization of Passive Income, later.
You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

You did not materially participate in the activity under test (7) if you participated in the activity for 100 hours or less during the year. Your participation in managing the activity does not count in determining whether you materially participated under this test if:

Any person other than you received compensation for managing the activity, or
Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services).

Participation. In general, any work you do in connection with an activity in which you own an interest is treated as participation in the activity.

Work not usually performed by owners. You do not treat the work you do in connection with an activity as participation in the activity if both of the following are true.

The work is not work that is customarily done by the owner of that type of activity.
One of your main reasons for doing the work is to avoid the disallowance of any loss or credit from the activity under the passive activity rules.

Participation as an investor. You do not treat the work you do in your capacity as an investor in an activity as participation unless you are directly involved in the day-to-day management or operations of the activity. Work you do as an investor includes:

Studying and reviewing financial statements or reports on operations of the activity,
Preparing or compiling summaries or analyses of the finances or operations of the activity for your own use, and
Monitoring the finances or operations of the activity in a nonmanagerial capacity.

Spouse's participation. Your participation in an activity includes your spouse's participation. This applies even if your spouse did not own any interest in the activity and you and your spouse do not file a joint return for the year.

Proof of participation. You can use any reasonable method to prove your participation in an activity for the year. You do not have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way. For example, you can show the services you performed and the approximate number of hours spent by using an appointment book, calendar, or narrative summary.

Limited partners. If you owned an activity as a limited partner, you generally are not treated as materially participating in the activity. However, you are treated as materially participating in the activity if you met test (1), (5), or (6) under Material participation tests, discussed earlier, for the tax year.

You are not treated as a limited partner, however, if you also were a general partner in the partnership at all times during the partnership's tax year ending with or within your tax year (or, if shorter, during that part of the partnership's tax year in which you directly or indirectly owned your limited partner interest).

Retired or disabled farmer and surviving spouse of a farmer. If you are a retired or disabled farmer, you are treated as materially participating in a farming activity if you materially participated for 5 or more of the 8 years before your retirement or disability. Similarly, if you are a surviving spouse of a farmer, you are treated as materially participating in a farming activity if the real property used in the activity meets the estate tax rules for special valuation of farm property passed from a qualifying decedent, and you actively manage the farm.

Corporations. A closely held corporation or a personal service corporation is treated as materially participating in an activity only if one or more shareholders holding more than 50% by value of the outstanding stock of the corporation materially participate in the activity.

A closely held corporation can also satisfy the material participation standard by meeting the first two requirements for the qualifying business exception from the at-risk limits. See Special exception for qualified corporations under Activities Covered by the At-Risk Rules, later.

Real Estate Professional

Generally, rental activities are passive activities even if you materially participated in them. However, if you qualified as a real estate professional, rental real estate activities in which you materially participated are not passive activities. For this purpose, each interest you have in a rental real estate activity is a separate activity, unless you choose to treat all interests in rental real estate activities as one activity. See the instructions for Schedule E (Form 1040) for information about making this choice.

If you qualified as a real estate professional for 2006, report income or losses from rental real estate activities in which you materially participated as nonpassive income or losses, and complete line 43 of Schedule E (Form 1040). If you also have an unallowed loss from these activities from an earlier year when you did not qualify, see Treatment of former passive activities under Passive Activities, earlier.

Qualifications. You qualified as a real estate professional for the year if you met both of the following requirements.

More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

Do not count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer. You were a 5% owner if you owned (or are considered to have owned) more than 5% of your employer's outstanding stock, outstanding voting stock, or capital or profits interest.

If you file a joint return, do not count your spouse's personal services to determine whether you met the preceding requirements. However, you can count your spouse's participation in an activity in determining if you materially participated.

Real property trades or businesses. A real property trade or business is a trade or business that does any of the following with real property.

Develops or redevelops it.
Constructs or reconstructs it.
Acquires it.
Converts it.
Rents or leases it.
Operates or manages it.
Brokers it.

Closely held corporations. A closely held corporation can qualify as a real estate professional if more than 50% of the gross receipts for its tax year came from real property trades or businesses in which it materially participated.

Passive Activity Income and Deductions

In figuring your net income or loss from a passive activity, take into account only passive activity income and passive activity deductions.

Self-charged interest. Certain self-charged interest income or deductions may be treated as passive activity gross income or passive activity deductions if the loan proceeds are used in a passive activity.

Generally, self-charged interest income and deductions result from loans between you and a partnership or S corporation in which you had a direct or indirect ownership interest. This includes both loans you made to the partnership or S corporation and loans the partnership or S corporation made to you.

It also includes loans from one partnership or S corporation to another partnership or S corporation if each owner in the borrowing entity has the same proportional ownership interest in the lending entity.

Exception. The self-charged interest rules do not apply to your interest in a partnership or S corporation if the entity made an election under Regulations section 1.469-7(g) to avoid the application of these rules. For more details on the self-charged interest rules, see Regulations section 1.469-7.

Passive Activity Income

Passive activity income includes all income from passive activities and generally includes gain from disposition of an interest in a passive activity or property used in a passive activity.

Passive activity income does not include the following items.

Income from an activity that is not a passive activity. These activities are discussed under Activities That Are Not Passive Activities, earlier.
Portfolio income. This includes interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business. It includes gain or loss from the disposition of property that produces these types of income or that is held for investment.
The exclusion for portfolio income does not apply to self-charged interest treated as passive activity income. For more information on self-charged interest, see Self-charged interest, earlier.
Personal service income. This includes salaries, wages, commissions, self-employment income from trade or business activities in which you materially participated, deferred compensation, taxable social security and other retirement benefits, and payments from partnerships to partners for personal services.
Income from positive section 481 adjustments allocated to activities other than passive activities. (Section 481 adjustments are adjustments that must be made due to changes in your accounting method.)
Income or gain from investments of working capital.
Income from an oil or gas property if you treated any loss from a working interest in the property for any tax year beginning after 1986 as a nonpassive loss, as discussed in item (2) under Activities That Are Not Passive Activities, earlier. This also applies to income from other oil and gas property the basis of which is determined wholly or partly by the basis of the property in the preceding sentence.
Any income from intangible property, such as a patent, copyright, or literary, musical, or artistic composition, if your personal efforts significantly contributed to the creation of the property.
Any other income that must be treated as nonpassive income. See Recharacterization of Passive Income, later.
Overall gain from any interest in a publicly traded partnership. See Publicly Traded Partnerships (PTPs) in the instructions for Form 8582.
State, local, and foreign income tax refunds.
Income from a covenant not to compete.
Reimbursement of a casualty or theft loss included in gross income to recover all or part of a prior year loss deduction, if the loss deduction was not a passive activity deduction.
Alaska Permanent Fund dividends.
Cancellation of debt income, if at the time the debt is discharged the debt is not allocated to passive activities under the interest expense allocation rules. See chapter 4 of Publication 535, Business Expenses, for information about the rules for allocating interest.

Disposition of property interests. Gain on the disposition of an interest in property generally is passive activity income if, at the time of the disposition, the property was used in an activity that was a passive activity in the year of disposition. The gain generally is not passive activity income if, at the time of disposition, the property was used in an activity that was not a passive activity in the year of disposition. An exception to this general rule may apply if you previously used the property in a different activity.

Exception for more than one use in the preceding 12 months. If you used the property in more than one activity during the 12-month period before its disposition, you must allocate the gain between the activities on a basis that reasonably reflects the property's use during that period. Any gain allocated to a passive activity is passive activity income.

For this purpose, an allocation of the gain solely to the activity in which the property was mainly used during that period reasonably reflects the property's use if the fair market value of your interest in the property is not more than the lesser of:

$10,000, or
10% of the total of the fair market value of your interest in the property and the fair market value of all other property used in that activity immediately before the disposition.

Exception for substantially appreciated property. The gain is passive activity income if the fair market value of the property at disposition was more than 120% of its adjusted basis and either of the following conditions applies.

You used the property in a passive activity for 20% of the time you held your interest in the property.
You used the property in a passive activity for the entire 24-month period before its disposition.

If neither condition applies, the gain is not passive activity income. However, it is treated as portfolio income only if you held the property for investment for more than half of the time you held it in nonpassive activities.

For this purpose, treat property you held through a corporation (other than an S corporation) or other entity whose owners receive only portfolio income as property held in a nonpassive activity and as property held for investment. Also, treat the date you agree to transfer your interest for a fixed or determinable amount as the disposition date.

If you used the property in more than one activity during the 12-month period before its disposition, this exception applies only to the part of the gain allocated to a passive activity under the rules described in the preceding discussion.

Disposition of property converted to inventory. If you disposed of property that you had converted to inventory from its use in another activity (for example, you sold condominium units you previously held for use in a rental activity), a special rule may apply. Under this rule, you disregard the property's use as inventory and treat it as if it were still used in that other activity at the time of disposition. This rule applies only if you meet all of the following conditions.

At the time of disposition, you held your interest in the property in a dealing activity (an activity that involves holding the property or similar property mainly for sale to customers in the ordinary course of a trade or business).
Your other activities included a nondealing activity (an activity that does not involve holding similar property for sale to customers in the ordinary course of a trade or business) in which you used the property for more than 80% of the period you held it.
You did not acquire or hold your interest in the property for the main purpose of selling it to customers in the ordinary course of a trade or business.

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 passive loss rules in prior tax years and carried forward to the current tax year. They also include losses from dispositions 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.

Passive activity deductions do not include the following items.

Deductions for expenses (other than interest expense) that are clearly and directly allocable to portfolio income.
Qualified home mortgage interest, capitalized interest expenses, and other interest expenses (other than self-charged interest) properly allocable to passive activities. For more information on self-charged interest, see Self-charged interest under Passive Activity Income and Deductions, earlier.
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 because of the 2%-of-adjusted-gross-income limit.
Charitable contribution deductions.
Net operating loss deductions.
Percentage depletion carryovers for oil and gas wells.
Capital loss carrybacks and carryovers.
Deductions and losses that would have been allowed for tax years beginning before 1987 but for basis or at-risk limits.
Net negative section 481 adjustments allocated to activities other than passive activities. (Section 481 adjustments are adjustments required due to changes in accounting methods.)
Casualty and theft losses, unless losses similar in cause and severity recur regularly in the activity.
The deduction for one-half of self-employment tax.

Grouping Your Activities

You can treat one or more trade or business activities, or rental activities, as a single activity if those activities form an appropriate economic unit for measuring gain or loss under the passive activity rules.

Grouping is important for a number of reasons. If you group two activities into one larger activity, you need only show material participation in the activity as a whole. But if the two activities are separate, you must show material participation in each one. On the other hand, if you group two activities into one larger activity and you dispose of one of the two, then you have disposed of only part of your entire interest in the activity. But if the two activities are separate and you dispose of one of them, then you have disposed of your entire interest in that activity.

Grouping can also be important in determining whether you meet the 10% ownership requirement for actively participating in a rental real estate activity.

Appropriate Economic Units

Generally, to determine if activities form an appropriate economic unit, you must consider all the relevant facts and circumstances. You can use any reasonable method of applying the relevant facts and circumstances in grouping activities. The following factors have the greatest weight in determining whether activities form an appropriate economic unit. All of the factors do not have to apply to treat more than one activity as a single activity. The factors that you should consider are:

The similarities and differences in the types of trades or businesses,
The extent of common control,
The extent of common ownership,
The geographical location, and
The interdependencies between or among activities, which may include the extent to which the activities:
1. Buy or sell goods between or among themselves,
2. Involve products or services that are generally provided together,
3. Have the same customers,
4. Have the same employees, or
5. Use a single set of books and records to account for the activities.

Example 1.

John Jackson owns a bakery and a movie theater at a shopping mall in Baltimore and a bakery and movie theater in Philadelphia. Based on all the relevant facts and circumstances, there may be more than one reasonable method for grouping John's activities. For example, John may be able to group the movie theaters and the bakeries into:

One activity,
A movie theater activity and a bakery activity,
A Baltimore activity and a Philadelphia activity, or
Four separate activities.

Example 2.

Betty is a partner in ABC partnership, which sells nonfood items to grocery stores. Betty is also a partner in DEF (a trucking business). ABC and DEF are under common control. The main part of DEF's business is transporting goods for ABC. DEF is the only trucking business in which Betty is involved. Based on the rules of this section, Betty treats ABC's wholesale activity and DEF's trucking activity as a single activity.

Consistency and disclosure requirement. Generally, when you group activities into appropriate economic units, you may not regroup those activities in a later tax year. You must meet any disclosure requirements of the Internal Revenue Service (IRS) when you first group your activities and when you add or dispose of any activities in your groupings.

However, if the original grouping is clearly inappropriate or there is a material change in the facts and circumstances that makes the original grouping clearly inappropriate, you must regroup the activities and comply with any disclosure requirements of the IRS.

Regrouping by the IRS. If any of the activities resulting from your grouping is not an appropriate economic unit and one of the primary purposes of your grouping (or failure to regroup) is to avoid the passive activity rules, the IRS may regroup your activities.

Rental activities. In general, you cannot group a rental activity with a trade or business activity. However, you can group them together if the activities form an appropriate economic unit and:

The rental activity is insubstantial in relation to the trade or business activity,
The trade or business activity is insubstantial in relation to the rental activity, or
Each owner of the trade or business activity has the same ownership interest in the rental activity, in which case the part of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.

Example.

Herbert and Wilma are married and file a joint return. Healthy Food, an S corporation, is a grocery store business. Herbert is Healthy Food's only shareholder. Plum Tower, an S corporation, owns and rents out the building. Wilma is Plum Tower's only shareholder. Plum Tower rents part of its building to Healthy Food. Plum Tower's grocery store rental business and Healthy Food's grocery business are not insubstantial in relation to each other.

Herbert and Wilma file a joint return, so they are treated as one taxpayer for purposes of the passive activity rules. The same owner (Herbert and Wilma) owns both Healthy Food and Plum Tower with the same ownership interest (100% in each). If the grouping forms an appropriate economic unit, as discussed earlier, Herbert and Wilma can group Plum Tower's grocery store rental and Healthy Food's grocery business into a single trade or business activity.

Grouping of real and personal property rentals. In general, you cannot treat an activity involving the rental of real property and an activity involving the rental of personal property as a single activity. However, you can treat them as a single activity if you provide the personal property in connection with the real property or the real property in connection with the personal property.

Certain activities may not be grouped. In general, if you own an interest as a limited partner or a limited entrepreneur in one of the following activities, you may not group that activity with any other activity in another type of business.

Holding, producing, or distributing motion picture films or video tapes.
Farming.
Leasing any section 1245 property (as defined in section 1245(a)(3) of the Internal Revenue Code). For a list of section 1245 property, see Section 1245 property under Activities Covered by the At-Risk Rules, later.
Exploring for, or exploiting, oil and gas resources.
Exploring for, or exploiting, geothermal deposits.

If you own an interest as a limited partner or a limited entrepreneur in an activity described in the list above, you may group that activity with another activity in the same type of business if the grouping forms an appropriate economic unit as discussed earlier.

Limited entrepreneur. A limited entrepreneur is a person who:

Has an interest in an enterprise other than as a limited partner, and
Does not actively participate in the management of the enterprise.

Activities conducted through another entity. A personal service corporation, closely held corporation, partnership, or S corporation must group its activities using the rules discussed in this section. Once the entity groups its activities, you, as the partner or shareholder of the entity, may group those activities (following the rules of this section):

With each other,
With activities conducted directly by you, or
With activities conducted through other entities.

You may not treat activities grouped together by the entity as separate activities.

Personal service and closely held corporations. You may group an activity conducted through a personal service or closely held corporation with your other activities only to determine whether you materially or significantly participated in those other activities. See Material Participation, earlier, and Significant Participation Passive Activities, later.

Publicly traded partnership (PTP). You may not group activities conducted through a PTP with any other activity, including an activity conducted through another PTP.

Partial dispositions. If you dispose of substantially all of an activity during your tax year, you may treat the part disposed of as a separate activity. However, you can do this only if you can show with reasonable certainty:

The amount of deductions and credits disallowed in prior years under the passive activity rules that is allocable to the part of the activity disposed of, and
The amount of gross income and any other deductions and credits for the current tax year that is allocable to the part of the activity disposed of.

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.

Worksheet A. Complete Worksheet A, Significant Participation Passive Activities, if you have income or losses from any significant participation activity. Begin by entering the name of each activity in the left column.

Name of activity	(a) Hours of participation	(b) Net loss		(c) Net income	(d) Combine totals of cols. (b) and (c)
		(	)		/////////////////////////////////////////
		(	)		/////////////////////////////////////////
		(	)		/////////////////////////////////////////
		(	)		/////////////////////////////////////////
		(	)		/////////////////////////////////////////
		(	)		/////////////////////////////////////////
		(	)		/////////////////////////////////////////
Totals		(	)

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 above. 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 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 reasonably incurred by the entity 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 reasonably incurred by the entity 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.

Name of activity with net income	(a) Net income	(b) Ratio See instructions	(c) Nonpassive income See instructions	(d) Passive income Subtract col. (c) from col. (a)





Totals		1.000

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. In 2006, he sold his entire partnership interest 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 for 2006 is $5,000, figured as follows:

Sales price		$30,000
Minus: adjusted basis		42,000
Capital loss		$12,000
Minus: capital loss limit		3,000
Capital loss carryover		$9,000
Allowable capital loss on sale		$3,000
Carryover losses allowable		2,000
Total current deductible loss		$5,000

Ray deducts the $5,000 total current deductible loss in 2006. 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 of the fraction is the gain recognized in the current year, and the denominator 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 death. 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.

How To Report Your Passive Activity Loss

More than one form or schedule may be required for reporting your passive activities. The actual number of forms depends on the number and types of activities you must report. Some forms and schedules that may be required are:

Schedule C (Form 1040), Profit or Loss From Business,
Schedule D (Form 1040), Capital Gains and Losses,
Schedule E (Form 1040), Supplemental Income and Loss,
Schedule F (Form 1040), Profit or Loss From Farming,
Form 4797, Sales of Business Property,
Form 6252, Installment Sale Income,
Form 8582, Passive Activity Loss Limitations, and
Form 8582-CR, Passive Activity Credit Limitations.

Regardless of the number or complexity of passive activities you have, you should use only one Form 8582.

Comprehensive Example

The following example shows how to report your passive activities. In addition to Form 1040, Charles and Lily Woods use Form 8582 (to figure allowed passive activity deductions), Schedule E (to report rental activities and partnership activities), Form 4797 (to figure the gain and allowable loss from assets sold that were used in the activities), and Schedule D (to report the sale of partnership interests).

General Information

Charles and Lily are married, file a joint return, and have combined wages of $132,000 in 2006. They own interests in the activities listed below. They are at risk for their investment in the activities. They did not materially participate in any of the business activities. They actively participated in the rental real estate activities in 2006 and all prior years. Charles and Lily are not real estate professionals.

Activity A is a rental real estate activity. The income and expenses are reported on Schedule E. Charles and Lily's records show a loss from operations of $15,000 in 2006. Their records also show a gain of $2,776 from the sale in January 2006 of section 1231 assets used in the activity. The section 1231 gain is reported in Part I of Form 4797 and is identified as being from a passive activity (FPA). For 2005, they completed the worksheets for Form 8582 and calculated that $6,667 of Activity A's Schedule E loss for 2005 was disallowed by the passive activity rules. That loss is carried over to 2006 as a prior year unallowed loss and will be used to figure the allowed loss for 2006.
Activity B is a rental real estate activity. Its income and expenses are reported on Schedule E. Charles and Lily's records show a loss from operations of $11,600 in 2006. For 2005, they completed the worksheets for Form 8582 and calculated that $8,225 of Activity B's Schedule E loss for 2005 was disallowed by the passive activity rules. That loss is carried over to 2006 as a prior year unallowed loss and will be used to figure the allowed loss for 2006.
Partnership #1 is a trade or business activity and is not a publicly traded partnership (PTP). Partnership #1 reports a $4,000 distributive share of its 2006 profits to Charles and Lily in box 1 of Schedule K-1 (Form 1065). They report that profit on Schedule E. For 2005, they completed the worksheets for Form 8582 and calculated that $2,600 of their distributive share of the loss from Partnership #1 in 2005 was disallowed by the passive activity rules. That loss is carried over to 2006 as a prior year unallowed loss and will be used to figure the allowed loss for 2006.
Partnership #2 is a trade or business activity and also a PTP. In December 2006 Charles and Lily sold their entire interest in Partnership #2. To indicate they made an entire disposition of a passive activity, they enter EDPA on the appropriate lines. They do not report that sale on Form 8582 because Partnership #2 is a PTP. They recognize a long-term capital gain of $15,300 ($25,300 selling price minus $10,000 adjusted basis) that they report on Schedule D. The partnership reports a $1,200 distributive share of its 2006 losses to them in box 1 of Schedule K-1 (Form 1065). They report that loss on Schedule E. For 2005, they followed the instructions for Form 8582 and calculated that $2,445 of their distributive share of Partnership #2's 2005 loss was disallowed by the passive activity rules. That loss is carried over from 2005 and reported on Schedule E as a loss for 2006. (For a discussion of PTPs, see the instructions for Form 8582.)
Partnership #3 is a single trade or business activity and is not a PTP. Charles and Lily sold their entire interest in Partnership #3 in November 2006. To indicate they made an entire disposition of a passive activity, they enter EDPA on the appropriate lines. They recognize a $4,000 ($15,000 selling price minus $11,000 adjusted basis) long-term capital gain, which they report on Schedule D.

For 2005, they completed the worksheets for Form 8582 and calculated that $3,000 of their distributive share of the partnership's loss for 2005 was disallowed by the passive activity rules. That loss is carried over to 2006 as a prior year unallowed Schedule E loss. Charles and Lily's distributive share of partnership losses for 2006 reported in box 1 of Schedule K-1 (Form 1065) is $6,000.
Partnership #4 is a trade or business activity that is a limited partnership. Charles and Lily are limited partners who did not meet any of the material participation tests. Their distributive share of 2006 partnership loss, reported in box 1 of Schedule K-1 (Form 1065), is $2,400. For 2005 they completed the worksheets for Form 8582 and calculated that $1,500 of their distributive share of loss for 2005 was disallowed by the passive activity rules. That loss is carried over to 2006 as a prior year unallowed loss and will be used to figure the allowed loss for 2006.

Step One—Completing the Tax Forms Before Figuring the Passive Activity Loss Limits

Charles and Lily complete the forms they usually use to report income or expenses from their activities. They enter their combined wages, $132,000, on Form 1040. They complete Schedule D, line 8, showing long-term capital gains of $15,300 from the disposition of Partnership #2 and $4,000 from the disposition of Partnership #3. Partnership #2 is a PTP so it is not entered on Form 8582. The disposition of Partnership #3 is a disposition of an entire interest in an activity with an overall loss of $5,000 ($4,000 - $3,000 - $6,000) so that partnership also is not entered on Form 8582. They combine the PTP $1,200 current year loss with its $2,445 prior year loss and report the combined amount in column (f) on Schedule E, Part II, line 28. They also combine the Partnership #3 $6,000 current year loss with its $3,000 prior year loss, and enter the combined amount in column (h) on Schedule E, Part II, line 28 since they have an overall loss from that activity. Normally, current year and prior year losses should be entered on separate lines of Schedule E. For purposes of this example only, the amounts have been combined on one line. They enter the $4,000 profit from Partnership #1 in column (g). Before completing the rest of Schedule E, Part II, they must complete Form 8582 to figure out how much of their losses from Partnerships #1 and #4 they can deduct.

They complete Schedule E, Part I, through line 22. Their rental activities are passive so they must complete Form 8582 to figure the deductible losses to enter on line 23.

They enter the gain from the sale of the section 1231 assets of Activity A on Form 4797.

Step Two—Form 8582 and Its Worksheets

Charles and Lily now complete Form 8582 including the worksheets that apply to their passive activities. Because they are at risk for their investment in the activities, they do not need to complete Form 6198 before Form 8582. (The second part of this publication explains the at-risk rules.)

Worksheet 1. Worksheet 1 is for rental real estate activities with active participation. Charles and Lily enter the gains and losses from Activity A and Activity B on Worksheet 1. They enter all amounts from the activities even though they already reported the gain of $2,776 from Activity A on Form 4797 because all income or loss from these activities must be taken into account to figure the loss allowed.

They write “Activity A” on the first line under “Name of activity.” Then they enter:
1. $2,776 gain in column (a) from Form 4797, line 2, column (g),
2. ($15,000) loss in column (b) from Schedule E, line 22, column A, and
3. ($6,667) prior year unallowed loss in column (c) from their 2005 worksheets.
They combine the three amounts. The result, ($18,891), is an overall loss so they enter it in column (e).
Charles and Lily write “Activity B” on the second line under “Name of activity.” Then they enter:
1. ($11,600) loss in column (b) from Schedule E, line 22, column B, and
2. ($8,225) prior year unallowed loss in column (c) from their 2005 worksheets.
Then they combine these two figures and enter the total loss, ($19,825), in column (e).
They separately add the amounts in columns (a), (b), and (c).
1. They enter $2,776 in column (a) on the Total line and also on Form 8582, Part I, line 1a.
2. They enter ($26,600) in column (b) on the Total line and also on Form 8582, Part I, line 1b.
3. They enter ($14,892) in column (c) on the Total line and also on Form 8582, Part I, line 1c.
They combine lines 1a, 1b, and 1c, Form 8582, and put the net loss, ($38,716), on line 1d.

Worksheet 3. Partnership #1 and Partnership #4 are nonrental passive activities so Charles and Lily enter the appropriate information about those activities on Worksheet 3 in the same way they reported their rental activities on Worksheet 1. Then they enter the totals on Form 8582, Part I, lines 3a through 3d.

Reporting income from column (d), Worksheets 1 and 3. Activities that have an overall gain in column (d) are not used any further in the calculations for Form 8582. At this point, all income and losses from those activities should be entered on the forms or schedules that would normally be used. Charles and Lily have one activity with an overall gain ($4,000 - $2,600 = $1,400). This is Partnership #1, which is shown in Worksheet 3. They already reported the $4,000 income from this activity on Schedule E, Part II. They now enter the entire $2,600 loss on Schedule E, Part II, as well.

Step Three—Completing Form 8582

Next, Charles and Lily complete Form 8582, Part II, to determine the amount they can deduct for their net losses from real estate activities with active participation (Activities A and B). They enter all amounts as though they were positive (without brackets around losses). They then complete Form 8582, Part IV.

They enter $38,716 on line 5 since this is the smaller of the loss on line 1d or the loss on line 4.
They enter $150,000 on line 6 since they are married and filing a joint return.
They enter $138,655, their modified adjusted gross income, on line 7. (See page 4 for discussion of modified adjusted gross income.) The $138,655 is made up of their wages, $132,000, plus their overall gain of $11,655 from Partnership #2, a PTP, less their $5,000 overall loss from Partnership #3.
On Schedule D, they reported long-term gains of $15,300 from the PTP disposition and $4,000 from the Partnership #3 disposition. On Schedule E, they combined the PTP 2006 loss of $1,200 with its prior year loss of $2,445, and combined the Partnership #3 2006 loss of $6,000 with its prior year loss of $3,000. Netting these amounts gives them the PTP overall gain of $11,655 ($15,300 - $1,200 - $2,445) and the Partnership #3 overall loss of $5,000 ($4,000 - $6,000 - $3,000) that were used in figuring modified adjusted gross income.
They subtract line 7 from line 6 and enter the result, $11,345, on line 8.
They multiply line 8 by 50% and enter the result, $5,673, on line 9. No matter what the result, they cannot enter more than $25,000 on line 9.
They enter the smaller of line 5 or line 9, $5,673, on line 10.
They add the income on lines 1a and 3a and enter the result, $6,776, on line 15.
They add lines 10 and 15 and enter the result, $12,449, on line 16.

Step Four—Completing Worksheet 4

Charles and Lily must complete Worksheet 4 because they entered an amount on Form 8582, line 10, and have two activities, each with an overall loss in Worksheet 1, column (e). Worksheet 4 allocates the amount on line 10 (their special allowance for active participation rental real estate activities) between Activity A and Activity B.

In the two left columns, they write the name of each activity, A and B, and the schedule and line number on which each activity is reported.
They fill in column (a) with the losses from Worksheet 1, column (e). They add up the amounts, and enter the result, $38,716, in the Total line without brackets.
They figure the ratios for column (b) by dividing each amount in column (a) by the amount on the column (a) Total line. They enter each result in column (b). The total of the ratios must equal 1.00.
They multiply the amount from line 10, Form 8582, $5,673, by each of the ratios in Worksheet 4, column (b) and enter the results on the appropriate line in column (c). The total must equal $5,673.
They subtract column (c) from column (a) and enter each result in column (d).

Step Five—Completing Worksheet 5

Worksheet 5 must be completed if any activity has an overall loss in Worksheet 3, column (e), or a loss in Worksheet 4, column (d) (or Worksheet 1, column (e), if Worksheet 4 was not needed). This worksheet allocates the unallowed loss among the activities with an overall loss. Charles and Lily complete Worksheet 5 with the activities from Worksheet 4 and the one activity showing a loss in Worksheet 3, column (e). They write the name of each activity and the schedule or form and the line number on which each loss will be reported in the two left columns of Worksheet 5.

In column (a), they enter the losses from Worksheet 3, column (e) and Worksheet 4, column (d). These losses are entered as positive numbers, not in brackets. They add the numbers and enter the total, $36,943, on the Total line.
They divide each of the losses in column (a) by the amount on the column (a) Total line, and enter each result in column (b). The ratios must total 1.00.
Now they use the computation worksheet for column (c) (see the worksheet in the instructions for Form 8582) to figure the unallowed loss to allocate in column (c).
1. On line A of the computation worksheet, they enter the amount from line 4 of Form 8582, $41,216, as a positive number.
2. On line B, they enter the amount from line 10 of Form 8582, $5,673.
3. They subtract line B from line A and enter the result, $35,543, on line C. This is the total unallowed loss.

They multiply line C, $35,543, by each of the ratios in column (b) and enter the results in column (c). These amounts are the unallowed losses from each activity and must add up to $35,543.

Step Six—Using Worksheets 6 and 7

Charles and Lily now decide whether they must use Worksheet 6, Worksheet 7, or both to figure their allowed losses. If the loss from any activity entered on Worksheet 5 is reported on only one form or schedule, then Worksheet 6 is used for that activity. If an activity has a loss that is reported on two or more schedules or forms (for example, a loss that must be reported partly on Schedule C and partly on Form 4797) Worksheet 7 is used for that activity. All of the activities Charles and Lily entered on Worksheet 5 will be reported on Schedule E. Therefore, they use Worksheet 6 to figure the allowed loss for each activity.

Worksheet 6. They complete Worksheet 6 with the activities from Worksheet 5.

They write the name of each activity and the schedule and line number to be used in the two left columns of Worksheet 6.
In column (a), they enter the total loss for each activity. This includes the current year loss plus the prior year unallowed loss. They find these amounts by adding columns (b) and (c) on Worksheets 1 and 3.
In column (b), they enter the unallowed loss for each activity already figured in Worksheet 5, column (c). They must save this information to use next year in figuring their passive losses.
In column (c), they figure their allowed losses for 2006 by subtracting their unallowed losses, column (b), from their total losses, column (a). These allowed losses are entered on the appropriate schedules.

Reporting allowed losses. Charles and Lily enter their allowed losses from Activities A and B on Schedule E, Part I, line 23, because these are rental properties. They report their allowed loss from Partnership #4 on Schedule E, Part II, line 28D.

Step Seven—Finishing the Reporting of the Passive Activities

Charles and Lily summarize the entries on Schedule E, Schedule D, and Form 4797, and enter the amounts on the appropriate lines of their Form 1040. They enter:

The total Schedule D gain, $22,076, on line 13, and
The Schedule E loss, ($21,094), on line 17.

Charles and Lily are now able to complete their tax return, having correctly limited their losses from their passive activities.