Passive Activity Losses - John R. Dundon II, Enrolled Agent
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Passive Activity Losses

The Perturbing New Treatment of Patents Under the Tax Cut & Jobs Act (TCJA)

Passive Activity Losses

Code Section 469 provides that individuals, trusts, estates, personal service corporations and closely held C corps may only deduct passive-activity losses from passive-activity income. The rules do not apply to S corps and partnerships, but do apply to their respective shareholders and partners.

Passive activity is trade or business activity in which the taxpayer does not materially participate.

Rental activity is passive activity without regard to a taxpayer’s material participation, except for real estate professionals, and certain taxpayers primarily providing services and short-term rentals. Individuals who own and actively participate in the management of rental real estate may offset up to $25,000 of passive-activity loss from rental real estate against active income in any tax year. The offset amount is reduced by 50 percent of the amount by which the taxpayer’s adjusted gross income exceeds $100,000, phasing out completely at $150,000 of AGI.

Losses from passive activities must be carried forward and applied against income from passive activities in future years. Remaining passive-activity losses are deductible against non-passive income when the taxpayer disposes of the passive activity.

In general, limited partners are not deemed to materially participate in partnership activities. Thus, a limited partner’s share of partnership income is passive income. However, general partners or acting general partners may hold limited partnership interests and materially participate in the partnership.

In a recent Tax Court opinion, however, the court determined that interests in LLPs and LLCs are not considered limited partnership interests for purposes of the passive-activity loss rules (Garnett, 132 T.C. No. 19, June 30, 2009). As a result, interests in LLCs and LLPs would not be presumed passive in nature and taxpayers may prove material participation in order to claim any resulting losses. A similar ruling by the U.S. Court of Federal Claims (Thompson, FedCl. July 20, 2009) decided that, to be a limited partnership under the passive-activity loss rules, the entity must be treated as a partnership under state law, not merely taxed as one under the Internal Revenue Code. No official response to these rulings has been put forth by the IRS, but taxpayers should be advised that elimination of the presumption will not mean that the IRS will not litigate that the taxpayer’s proof of material participation is not adequate.