Although the passive activity loss (PAL) rules have been around since 1986, they still aren’t very well understood. This article summarizes two relevant U.S. Tax Court decisions that illustrate how comprehending the complex rules and planning ahead can help result in a favorable outcome.
PAL Basics
The PAL rules limit your ability to claim current federal tax deductions for losses thrown off by passive activities. That’s because you can generally deduct passive losses only to the extent you have passive income from other sources. If you have little or no passive income, your passive losses are suspended until you have sufficient passive income — or until you dispose of the loss-producing activities.
However if you materially participate in an activity for the tax year, you’re generally exempt from the PAL limitations for that activity for that year. Therefore, you can generally deduct the loss from the activity.
Establishing Material Participation
IRS regulations contain seven tests to help determine if you can meet the material participation standard with respect to a business activity. If you can pass one or more of these tests for the tax year, you meet the material participation standard for that activity, which means the unfavorable PAL rules won’t apply.
| Material Participation Test | You Pass this Test if: |
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You participate in the activity for more than 500 hours during the year. |
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Your participation during the year constitutes substantially all participation in the activity by all individuals (including those who aren’t owners of interests in the activity) during that year. |
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You participate more than 100 hours during the year, and other individuals (including non-owners) don’t participate more than you during that year. |
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The activity is a SPA in which you participate for more than 100 hours during the year, and your total participation in all SPAs during the year exceeds 500 hours. |
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You materially participated in the activity for any five of the past 10 years. |
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The activity involves personal service, and you materially participated during any of the three preceding years. |
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The relevant facts and circumstances dictate that you materially participated in the activity on a regular, continuous, and substantial basis and spent more than 100 hours doing so. |
Two PAL Court Cases
Here are the details of two U.S. Tax Court cases involving PALs that had different outcomes for the taxpayers.
- Involvement in Family Businesses Resulted in a Taxpayer Win. In one decision, the court concluded that the taxpayer, who was formerly only a passive investor in several related family businesses, met the PAL material participation standard for the businesses when he stepped in to rescue them.
The court made the determination after considering the following factors:
- The related businesses qualified as a single activity, which meant the taxpayer could combine his hours spent on all of them for purposes of passing one of the material participation tests.
- The taxpayer worked at least 691 hours for two of the businesses during the year in question.
- He didn’t do the work to avoid the PAL rules.
As a result, the court found the taxpayer’s losses from the businesses were exempt from the PAL rules and could be deducted. Because the taxpayer materially participated, he was able to carry the losses back to earlier tax years and obtain significant federal tax refunds. (Lamas, TC Memo 2015-59)
2. Taxpayer Lost Because the Recharacterization Rule Converted S Corp Rental Income into Nonpassive Income. In another decision, the taxpayer didn’t fare as well because of some complex rules involving rental income.
In the case, an S corporation owned commercial real estate and leased it to a C corporation medical business that was 100% owned by the taxpayers, who were a joint-filing married couple. The husband worked full time for the enterprise and materially participated in it. However, the taxpayers didn’t materially participate in the S corporation’s rental real estate activity.
On their return, the taxpayers reported the net rental income passed through to them from the S corp as passive income. Then, they sheltered the income with passive losses from other sources.
As a general rule, rental income is passive income. Unfortunately, IRS regulations include an exception that can recharacterize net rental income recognized by an individual taxpayer as nonpassive if the rental income is paid by a business in which the taxpayer materially participates.
The court agreed with the IRS that the net rental income passed through to the taxpayers from their S corp fell within the self-rental recharacterization rule. The rental income was paid to the S corporation by the medical enterprise, which was a business in which the husband materially participated. Therefore, the net rental income was nonpassive and couldn’t be sheltered with passive losses from other sources. (Williams, TC Memo 2015-76)
Plan Ahead
If you have business or rental activities that throw off tax losses, you could be subject to the PAL rules. However with advance planning, you may be able to minimize — or even eliminate — the adverse effects. Contact your tax adviser for more information.
IRS Guidance: Mortgage Broker
Doesn’t Qualify as a Real Estate Pro
Losses from rental real estate activities are generally subject to the PAL rules, which can limit your ability to claim current federal deductions. That’s because, under the general rules, you can only deduct passive losses to the extent you have passive income from other sources. If you have no passive income, your passive losses are suspended and can’t be deducted until you have passive income or you dispose of the loss-producing rental activities.
A favorable exception allows individuals who devote a substantial amount of time to real property businesses to materially participate in certain rental real estate activities. That means losses from these rental real estate activities are exempt from the PAL rules and you can generally deduct them in the year they’re incurred. This is the real estate professional exception to the PAL rules.
In Chief Counsel Advice (CCA), the IRS distinguished services performed by state-licensed real estate agents from services performed by mortgage brokers for purposes of qualifying for the exception.
A real estate agent brings together property buyers and sellers and negotiates sales between them, whereas a mortgage broker brings together lenders and borrowers to finance property transactions. According to the CCA, Congress didn’t intend for financing operations to meet the definition of real property businesses for purposes of qualifying for the real estate pro exception. Therefore, the CCA concluded, a mortgage broker doesn’t qualify. (CCA 201504010)
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