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The phase out of passive activity losses due to income levels above a specified threshold is calculated as the net loss resulting from expenses exceeding income. This net loss includes all forms of rental activity expenses and accordingly includes real estate taxes regardless of the taxing entity to which they are paid. The IRS help line addressed the rules concerning real estate taxes on a personal residence which gets reported on Schedule A (Itemized Deductions) but did not address the rental activity real estate taxes which are reported on a Schedule E and limited if your Modified Adjusted Gross Income (MAGI) exceeds $100,000. Thus, the immediate deductibility of real estate taxes which are part of a rental activity can be limited because your MAGI exceeds the level stipulated by law. Here is some information from an IRS audit guide (for IRS agents) to help with this.
JulyJPublication Date - December, 2004
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Table of Contents / Chapter 2Tax Code, Regulations and Official Guidance Search
Chapter 1: Overview
Prior to 1986, a taxpayer could generally deduct losses in full from rental activities and trades or businesses regardless of his or her participation. This gave rise to significant numbers of tax shelters that allowed taxpayers to deduct non-economic losses against wages and investment income. The Tax Reform Act of 1986, added IRC § 469, which limits the taxpayer's ability to deduct losses from businesses in which he or she does not materially participate and from rental activities.
The passive activity loss rules are applied at the individual level and extend beyond tax shelters to virtually every business or rental activity whether reported on Schedule C, Profit or Loss From Business (Sole Proprietorship); Schedule F, Profit Loss From Farming; or Schedule E, Supplemental Income and Loss, as well as to flow through income and losses from partnerships, S Corporations, and trusts.
The passive loss limitations also apply in full to personal service corporations. The IRC § 469 also applies to closely held C Corporations, but has a limited applications.
The following is a brief overview. If an issue arises in any specific area, see the referenced chapters for in-depth discussions.
Types of Passive Activities
In general, losses generated by passive activities can only be used to offset income generated by passive activities.
There are two kinds of passive activities (IRC § 469(c)):
What is Passive?
Income and losses from the following activities are generally passive:
Income and losses from the following are generally non-passive:
For more information on activities, refer to Chapter 8.
The general rule in IRC § 469 provides that passive losses can offset only passive income. There are, however, exceptions:
Beginning in 1994, a real estate professional may be able to deduct all current rental real estate losses regardless of how high his MAGI might be. To deduct losses without limit, the taxpayer must spend more than half of his time in real property businesses and work more than 750 hours a year and materially participate in each separate rental real estate activity. Again, see Chapter 2.
Disallowed passive losses can be carried forward indefinitely until there is passive income or an entire disposition in a fully taxable transaction. Net gain on the sale of a passive activity is generally passive income, which can be offset by unrelated passive losses. See Chapter 5.
There are two distinct types of participation:
Material participation generally applies to business activities. The IRC § 469(h)(1) provides that if the taxpayer works on a regular, continuous, and substantial basis in operations, his losses are non-passive, i.e. deductible in full. There are seven tests discussed in Chapter 5.
Active participation relates only to rental real estate activities and is a less stringent standard than material participation. If the taxpayer makes management decisions, he generally can deduct up to $25,000 in losses against non-passive income, subject to the $150,000 MAGI limitation. See exhibit at end of Chapter 2.
Neither the material participation standard nor the active participation standard generally applies to long-term equipment rentals. Equipment leasing losses are generally passive regardless of the level of participation. Thus, equipment leasing losses are generally not deductible unless the taxpayer has passive income from other sources.
Passive losses and income are most commonly found on Schedule E. The computational form used to limit these losses is Form 8582, Passive Activity Loss Limitations, with line 16 being the sum of passive losses allowed for the current year (line 11 for tax years before 2002). See exhibit at the end of this chapter for more help. The following breaks down Form 8582 for 2002 and later years:
Part I of Form 8582 simply breaks down all passive activities in which the taxpayer is involved into three categories:
Part II is the calculation for allowable losses from rental real estate with active participation on line 1. See MAGI computation in Chapter 2.
Part III calculates the total allowable passive activity losses for the entire return. Line 16 (bottom line) allows losses up to total passive income, plus any allowable rental real estate losses and the commercial revitalization deduction up to $25,000.
Beginning in tax year 2002, Form 8582 contains line changes due to the commercial revitalization deduction enacted in 2000. If the taxpayer enters his passive business losses on Form 8582 line 2b as he did in past years, he will incorrectly be permitted the $25,000 offset. In 2002, if he properly enters his losses on line 3b, no loss will be allowed in the absence of passive income.
Some of the important line changes are as follows:
 The LLC will file as either Partnerships, C Corporations, or are disregarded, in which case, the activity is reported on an individual's Form 1040 Schedule C. See IRC § 301.7701-3(a). For the sake of simplicity in this text, where we use "partnership", included are multi-member LLCs taxed as partnerships. When we use "sole proprietorship", we also mean single-owner LLCs.
 See IRC § 469(c)(2). There are exceptions discussed later in the text in Reg. § 1.469-1T(e)(3).
 See Chapter 4 and Reg. >§ 1.469-5T(e).
 IRC § 469(h)(1)
 Reg. § 1.469-4(c)
 IRC § 469(g)
 If married filing separately and living apart from spouse at all times during the tax year, up to $12,500 in rental real estate losses may be deducted if MAGI is less than $50,000. See IRC § 469(i).
 IRC § 469(c)(7) and Reg. 1.469-9
 IRC § 69(b)
 Reg. § 1.469-5T(a)
 IRC §469(i)(6)
 IRC § 469(c)(2)&(4)
 Generally, FORM 8582 should be attached to the return. See the instructions for FORM 8582 for exceptions. Publication 925, Passive Activity and At-Risk Rules also provides good information.