Travis H. Long, CPA, Inc. Blog

Originally published in the Cedar Street Times

October 16, 2015

Prior to the Tax Reform Act of 1986, both the nation and Congress were gripped with the ideas that the rich were not paying any taxes and that the tax code was overly complex.  Sound familiar?  The Tax Reform Act of 1986 was heralded as the biggest change to the income tax system since World War II.  It did have sweeping changes and drastic effects.  In the nearly 30 years since its enactment, all kinds of new exceptions and complexities have entered the code.  That said, there are still a lot of landmark changes that affect our tax system today.  One of these is in the area of passive losses.

Prior to 1986, wealthy individuals could invest in tax shelters which combined borrowed money and depreciation expense, while taking advantage of tax subsidies and tax preferences on certain types of investments to push out massive losses well in advance of their current, real economic investment and loss.  Some of the tax subsidies and preferences were true reductions in tax, and the tax deferral parts of these plans essentially created interest-free loans from the government.  The losses would then be used to offset income generating activities from wages, profitable business activities, and portfolio activities, virtually eliminating income tax for a lot of wealthy people.  Tax shelters were popping up faster than Starbucks coffee houses, and draining capital which could have otherwise been invested in productive activities in America.  There was also a lot of legal and accounting brain power being siphoned off to tax shelter creation.

The Tax Reform Act of 1986 (among many other things) setup three buckets for income, 1) earned income – such as from working for someone else or running a business yourself, 2) portfolio income – such as interest, dividends and capital gains from the sale of stocks, bonds, mutual funds, etc., and 3) passive income – such as investments in rental real estate properties and ownership interests of businesses in which you do not really work.  The basic tenant, is that the three buckets are generally kept separate, and in order to deduct losses in one bucket, you have to have offsetting income in that same bucket, otherwise the losses get suspended to be used at a future time.  Prior to 1986, there was just one bucket – income.  After this three bucket concept was introduced, most of these tax shelters became useless.  For some that managed to survive in other ways, another arm of the Tax Reform of Act of 1986 had to be reckoned with –  Alternative Minimum Tax (I discussed AMT in a prior article which is posted on my website at  www.tlongcpa.com/blog).

The passive activity rules are laid out in Section 469 of the Internal Revenue Code.  There are a lot of rules in Section 469, but the short of it is that you usually need to work at least 500 hours a year in a business you own to be considered a material participant and keep the income or losses in the earned income bucket.  So, if you own part of a business, but do not materially participate, any losses will be stuck in the passive activity bucket and get suspended until you have some passive activity income to offset, or until you liquidate your interest in the business.

For rental real estate activities, you generally have to spend 750 hours a year and have no other activity in which you spend more than 750 hours to throw the income or losses in the earned income bucket.  People meeting this rule are considered “real estate professionals.”  Rental real estate losses are a huge issue for California rental property owners, since massive losses accrue in the early years due to high mortgage interest and depreciation stemming from high purchase prices.  Real estate professionals are allowed to deduct all their losses from rental properties against their other earned income.  All other people are limited to using 0-$25,000 of losses per year against earned income depending on their modified adjusted gross income and whether or not they “actively participate.”  Active participation is a pretty easy standard to meet.  If you make managerial decisions, you are an active participant, and are eligible for the special $25,000 loss deduction.  (The act of simply choosing a property manager to handle everything for you is a managerial decision, for instance.)  If your modified adjusted gross income is over $125,000, however, the $25,000 active participation loss deduction starts to phase out.  By the time you reach $150,000, it is gone.

All of this bring us to the point of today’s article – the Form 8582 – Passive Activity Loss Limitations.  The Form 8582 is simply the vehicle used to track the activities in the passive income bucket and show which ones have suspended losses from year to year.  The form is three pages long.  The first page is the summary, and the second two pages are the detailed worksheets supporting page one.  Rental real estate activities are separated on the form from all other passive activities, since they have the special $25,000 active participation rule that must be applied.  Part I summarizes the items within those two categories and further breaks them down into activities with income, activities with losses, and prior year losses that have been suspended.  You then net everything within each of the two categories.  The rental real estate category then runs through Part II to see if you qualify for all or a portion of the special $25,000 loss allowance against earned income.  Part III deals with Commercial Revitalization Deductions, which are just a favorable twist on the $25,000 rule for people who are rehabilitating certain buildings in distressed communities.  Part IV sums the total losses that are allowed for the year.

The next two pages are the details for each business activity or rental property you own.  This is where you would look to see how much suspended losses you may have on each property.  Although you might not like the idea of having your losses limited each year, you will certainly enjoy the benefits down the road when you sell a property or business for a gain, and all those suspended passive losses come to your rescue!  And it is also nice to know that if you sell one property for a large gain and the losses freed up from that particular property are not enough to offset its gain, then the suspended losses from all other properties are drawn from on a pro-rata basis until exhausted to help offset the gain as well.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.