One of the areas that the Internal Revenue Service has focused many of their audits and reviews on over the past couple of years are the issues associated with passive activities.  Taxpayers may not even know that they have a passive activity or how they are treated for tax purposes.  Some of these rules can be very cumbersome and complex.

The Internal Revenue service defines a passive activity as any trade or business activity in which a taxpayer does not materially participate (IRC § 469(c)(1)).  A passive activity also includes all rental activity no matter what the participation (IRC § 469(c)(2)).  There are some exceptions to the rental property rules that will be discussed later.

"Passive Activity Losses (PALs)" are losses that are generated from passive activities.  Generally losses generated from passive activities are limited and can only be used to offset the amount of net passive income in the current year.  The net passive income that the PALs can offset can be generated from that same activity in future years or income generated from other passive activities in the current or future years.  Therefore losses generated from passive activities cannot be used against income from other "non-passive" sources or "ordinary" income.  Credits generated by a passive activity function the same way as passive losses.  They can only be used to offset current tax only to the extent attributable to net passive income.  Unused PALs and passive activity credits are suspended and carryforward indefinitely to offset future passive activity income.

Another downside to having an investment or rental property be classified as a "passive activity" is that net passive income is considered investment income and can be subject to the relatively new additional 3.8% surtax on investment income.  Therefore, if you have activities generating passive income (above the net investment income tax limitations) you could be paying more tax which you were not otherwise anticipating.

Material Participation:

Generally, a taxpayer is treated as “materially participating” in an activity only if the taxpayer is involved in the activity’s operations on a regular, continuous, and substantial basis. A taxpayer materially participates if the taxpayer (or his spouse, whether or not they file jointly) meets one of seven material participation tests detailed in Reg. § 1.469-5T(a).  The seven tests for “material participation” are as follows:

1)      More Than 500 Hours of Participation During the Tax Year

An individual is treated as materially participating in an activity for a tax year if the individual participates in the activity for more than 500 hours during the year.

2)      Substantially All the Participation

An individual is treated as materially participating in an activity for the tax year if the individual’s participation in the activity is substantially all of the participation in the activity of all individuals for the year, including individuals who are not owners of interests in the activity.

3)      More than 100 Hours/Comparative Participation

An individual is treated as materially participating in an activity for the tax year if the individual participates in the activity for more than 100 hours, but less than 500 hours (more than 500 hours would qualify under 1) above), and the individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual, including individuals who do not own interests in the activity.

4)      Significant Participation Activity

An individual is treated as materially participating in an activity for the tax year if the activity is a significant participation activity and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours (can be for multiple passive activities). This standard applies only to business activities, not to rental activities. A “significant participation activity” is a trade or business activity in which the individual significantly participates for the tax year and would be an activity in which the individual does not materially participate for the year if material participation for the year was determined without regard to the significant participation activity test (as described in the preceding paragraphs). An individual significantly participates in an activity for a tax year if the individual participates for more than 100 hours in the activity during the year.

5)      Material Participation for Any Five of Last 10 Years

An individual is treated as materially participating in an activity for a tax year if the individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year.

6)      Three-Year Lookback Test

An individual is treated as materially participating in an activity for the tax year if the activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year.

An activity is a “personal service activity” for purposes of the above test if the activity involves the performance of personal services in the fields of health, 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.

7)      Facts-and-Circumstances Test

An individual is treated as materially participating in an activity for the tax year if, based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year. This test is not available when the individual has participated in an activity for 100 hours or less during the tax year. Also, services performed in the management of the activity are not taken into account unless, for the tax year, (1) no person (other than the taxpayer) who performs services in the management of the activity receives fees or compensation for those services, and (2) no individual performs management services that exceed the number of hours of management services performed by the taxpayer.

Rental Activities:

Pursuant to the Internal Revenue Code all rental activities are inherently passive activities, with certain exceptions. The materially participation rules mentioned above do not in and of themselves make a rental activity "non-passive" as they do with other investments that are not rental activities, but they might be required to qualify for certain exceptions.  Generally a rental activity is any activity where payments are principally for the use of tangible property.

One exception allows a taxpayer that owns at least one interest in rental real estate to treat that activity as a non-passive activity is if:

1)      More than 50% of the personal services performed by the taxpayer in all trades or businesses during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and

2)      The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates

A taxpayer who owns the requisite interest and meets both tests, above, is a qualifying “real estate professional” and their ownership interest in a rental activity will not be treated as being passive. In the case of a joint return, the two conditions in the list above are satisfied if and only if either spouse separately satisfies both requirements.

Each rental real estate interest of a qualifying taxpayer is treated as a separate rental real estate activity, unless the taxpayer elects to treat all interests in rental real estate as a single rental real estate activity.

There is a special $25,000 maximum offset for rental real estate activities for qualifying individuals.  Qualifying individuals and certain estates may be able to offset up to $25,000 of net passive losses or passive activity credit deduction equivalents from rental real estate activities against their non-passive income, annually.  To qualify, a taxpayer has to meet special ownership rules and an active participation requirement.  However, there are phase outs at certain modified adjusted gross income thresholds.

The rental real estate allowance phases out as adjusted gross income (AGI) rises. The $25,000 maximum amount is reduced (but not below zero) by 50% of the amount by which the taxpayer’s modified AGI (MAGI) exceeds $100,000 for the tax year.

The rental real estate allowance is $12,500 for a married taxpayer filing separately who lived apart from his spouse for the entire year, reduced by 50% of the amount by which the taxpayer’s MAGI exceeds $50,000 for the tax year.

Accordingly, as a taxpayer’s MAGI increases from $100,000 to $150,000 ($50,000 to $75,000 if married filing separately as described in the previous sentence), the rental real estate allowance decreases from its $25,000 maximum, to zero.

The taxpayer must “actively participate” in the rental activity during the tax year the loss or credit is incurred, and, for a loss or credit carried over, in the year to which the loss/credit is carried.  The active participation standards are less stringent than the standards for material participation mentioned above.  According to the Tax Court, “active participation” does not require regular, continuous, and substantial involvement in operations. Instead, a taxpayer must participate in a significant and bona fide way, such as making management decisions (e.g., approving new tenants, setting rental policies and terms, and approving capital or repair expenditures) or arranging for others to perform services (e.g., repairs). In determining whether a taxpayer actively participates, participation by the taxpayer’s spouse is taken in account. Additionally, a taxpayer must have at least a 10% ownership interest (by value) in the activity (including any interest held by a spouse).

As you can see the rules governing passive activities are quite complex.  Please contact your Dermody, Burke, and Brown tax professional to discuss some planning opportunities that may mitigate some of the negative effects due to the passive activity rules.  

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.