Taxes (MP) The so-called “passive activity loss (PAL) rules have developed into a complicated range of guidelines since their start in the mid-1980s. However, if you bear in mind the general principles that drive loss limitations on this matter, you’ll have a superb foundation for choosing investment strategies that take full advantage of, and not solely react to, the current tax rules.
Under the earlier law, wealthy investors sheltered large incomes from taxes by deducting the “paper losses” which showed rapid depreciation causes. These were called real estate tax shelters and, the big boys abused them back in the day. The rules also covered many other situations, including real estate investors and silent partners in businesses.
The new rules allow the less fortunate to cash in on the benefits of real estate limited partnerships. Generally, the rules provide that you can get deductions from business activities, such as in real estate (see: 10 worst real estate mistakes), even though you have not paid out any money or actually lost any value. This is what created tax shelters. The deduction for depreciation can “shelter” otherwise taxable income as it is deductible although no money actually changed hands. But, wait, just because the law makes it easier for the little guys remember, there’s a very significant limitation on how much “shelter” you can use.
Passive and non-passive activity loss
Income on your tax return is divided into two categories: passive and non-passive. Passive activity is any rental action or whatever business wherein the taxpayer does not materially take part. Both equipment rentals and rental real estate are included no matter how much participation. Pliable income does not include salaries, portfolio or investment income, even though some of that income may seem to be passive, that is earned without participation. Material participation means being involved on a regular, continuous and substantial basis. Generally, that’s what business losses is: Any rental actions OR any business in which the taxpayer does not materially take part, according to the IRS.
Passive activity loss limitations are reported on your tax return using Form 8582. Seek the advice of your attorney and tax accountant before filing passive activity deductions.
In general, pliable losses may be used simply to offset income. However, if your rental real estate falls under PAL, one might offset a loss of up to $25,000 against the non-passive income if you actively take part in the business. The $25,000 allowed passive loss is phased out if your modified adjusted gross income is between $100,000 and $150,000. You lose $1 of deduction for every $2 your earnings goes above $100,000.
“Active participation” implies that you now have significant participation in making management decisions or arranging for others to provide services. These management decisions may include approving new tenants, choosing rental rates and terms, and approving capital or repair expenditures. However, you may not be thought to have “actively participated” if you own less than 10 percent of the property. Losses from non-participatory actions that exceed passive income are disallowed for the current year. They usually are carried forward to the next taxable year or years to be used against losses in a succeeding year.
Beginning in 1993, there’s been an exception to the rules for real estate professionals. Individuals who perform the majority of their personal services and more than 750 hours of such services for real property trades or business wherein they physically take part. If qualified, you can deduct rental losses against other active real estate income. Get a complete guide to Passive Activity Loss at IRS.gov’s Publication 925.