Passive Losses and Their Role in Your Tax Planning

Navigating the complex terrain of tax laws is an essential skill for business owners, particularly when it comes to Passive Activity Losses (PALs). Our previous article, Passive Activity Losses: A Simplified Overview, provided an important foundation for understanding these rules. If you haven’t yet read it, we recommend doing so to gain a baseline understanding before delving into the more nuanced aspects we’re addressing here.

Why do you want to be an active participant?

If you are an owner of a passive activity, you can only deduct PALs against passive activity income. Congress granted an exception to this rule allowing an active participant to deduct up to $25,000 in PALs against other income if you meet the following rules.

  • Your passive activity must be rental real estate (beware, this definition is not as straightforward as you might expect),
  • You qualify as an active participant and
  • Your modified adjusted gross income (MAGI) must be below $150,000. MAGI is equal to the Adjusted Gross Income shown on your tax return with multiple adjustments, that you should discuss with your tax advisor.

At or below a MAGI of $100,000, you can deduct $25,000 of the PAL against other types of income. Between a MAGI of $100,000 and $150,000, the $25,000 tax-favored allowance phases out at the rate of 50 cents on the dollar. It is important to note these numbers are cut in half if you are filing using the status of married filing separately.

How do I meet the rules for being an active participant?

Active participation and material participation are two different concepts. Active participation can be satisfied without regular, continuous and substantial involvement in operations, if the taxpayer participates in the making of management decisions or arranging for others to provide services (such as repairs). The participant may hire a rental agent and others to provide services so long as they maintain involvement in a significant and bona fide sense.

Who cannot qualify as an active participant?

Following is a list of those who cannot qualify for the $25,000 active participation loss deduction allowance:

  • you own less than 10% of the activity,
  • your interest is as a limited partner,
  • you operate as a corporation or
  • you operate as a trust other than a grantor trust owned by a natural person.

Active Participant vs Activity

The way an ‘Activity’ is defined in the tax code has significant implications on your tax responsibilities.

What is an Activity?

A Passive Activity is:

  • Any activity involving the conduct of any trade or business you do not materially participate in. It is important to note that a Working Interest in an oil or gas property, that the taxpayer either holds directly or through an entity that does not limit the taxpayer’s liability with respect to the interest, is not considered to be a passive activity.
  • Any rental activity for which you are not being treated as a material participant or real estate professional in.

The above is a simplified overview of what an Activity is. It is recommended that you discuss this further with your tax advisor.

What is a Single Unit/Group?

The IRS treats one or more trade or business activities as a single activity/group if the following conditions are satisfied.

  • They form an “appropriate economic unit” to measure gain or loss for passive loss purposes.
  • The combination of activities is justified by all relevant facts and circumstances.
  • IRS regulations outline five factors that are assigned the greatest weight to determine an appropriate economic unit.
    • Similarities or differences in types of businesses.
    • Extent of common control.
    • Extent of common ownership.
    • Geographic location.
    • Business interdependence among the activities.

The following example shows how two different types of activities may be treated as one activity.

  • R, an individual, is a partner in a business (partnership A) that sells merchandise to retail stores. R is also a partner in a partnership, B, that owns and operates a trucking business. The two partnerships are under common control (see the factors for consideration above). Most of the operations of B’s trucking business consist of transporting A’s merchandise. B is the only trucking business in which R is involved.  Therefore, R can properly treat the merchandise wholesale activity and the trucking business as one activity.

Single Unit or Combined Operations Activity Discussion

One must consider multiple factors in order to determine whether to combine all or part of their Passive Activities into a Group before making a decision to do so or not. Following are just a few pros and cons that, among others, need to be considered:

  • Pro – it may be easier to qualify the group for material participation and/or the real estate professional treatment. This will be more thoroughly discussed in a future article.
  • Pro – it may be easier to be an active participant for the Group than for each property.
  • Con – if a property sells at a loss, the loss might be deductible only against the income of the group.
  • Con – Hard to remove entities from group once combined.

Taxpayers interested in investing in passive investments should have a basic understanding of the passive activity rules related to:

  • what it takes to be an active participant in a passive activity and why one would want this status and
  • what an Activity is and the complex issue of whether to form a Group of passive investments into a combined unit.

Questions?

Navigating the intricacies of passive activities and their tax implications can be challenging, but with the right guidance and understanding, you can make informed decisions to optimize your tax position. Tax services are not just about keeping in compliance with filing requirements; they are also about leveraging opportunities. An experienced tax advisor can help you not only understand the rules but also how to capitalize on them to your advantage. Whether it’s finding ways to utilize suspended losses or determining how best to categorize your investments, a proactive approach can yield significant benefits. Contact an Adams Brown advisor today to request a tax planning meeting.