The Passive Loss Labyrinth, Part I

How to navigate the Passive Loss rules Labyrinth handed down to us by the IRS.

Continued from “Your vacation home property may cost you in tax $$”

By Gary Krupa, CPA, April 19, 2021

Updated April 25, 2021

Passive loss rules labyrinth

The Passive Laws in biblical times *

“This limitation applies only when the greater of the following occurs for the year. (That is, being able to deduct only up to the amount of rental income.) You use your home as a personal residence for more than 14 days. Or you use it as a personal residence for more than 10% of the number of days rented at a fair market rental.”

Here’s an example from my own experience. One of my tax clients bought a house that he rented to others as an Air BnB. In 2020, he rented it for 167 days in 2020. He and his family lived in it for 16 days. The property was therefore in use for 183 days, or half the year. The greater of 14 days or 10% of the fair rental days is 16.7 (167 days x 10%). As the family resided in the house for 16 days, it barely avoids being classified as a vacation home. Personal residence use is less than 16.7 days.

However, he still can’t claim a loss from the rental for 2020. The reason? To start with, he’s subject to the Passive Loss rules. Generally this means his deductible rental net losses are limited to his rental net income.

Passive income and losses can be from activities such as rentals, in which the taxpayer doesn’t “materially” participate. Another type of passive activity is a limited partnership interest.

Active participation exception

For 2020, he doesn’t have any passive income. However, there’s an exception to the passive income offset rule. That is, “active participants” can potentially deduct a rental loss of up to $25,000. Q. How do you become an active participant? A. By making significant management decisions. For rental properties, they include approving new tenants, deciding on rental terms, approving expenditures, and making similar decisions. I’d count the making of decisions affecting accounting policy as management decisions.

Maximum income requirement for active participation

Unfortunately, my client still can only “potentially” benefit from actively participating for 2020. He still can’t claim the rental loss deduction because his income for 2020 was too high. His income was more than the maximum of $150,000 for that exception to apply.

Fortunately, he doesn’t lose the ability to deduct the loss. He can carry it forward to future years when he has sufficient passive income to offset it.

Disposition of property rule

There’s another way he can deduct the loss. He can deduct it when he disposes of his entire interest in the property. No passive income is necessary for this rule to apply.

Update on April 25, 2021.
However, the property, or any passive activity, must be fully disposed of in a taxable transaction. That means that all gain or loss on the disposition is recognized. It must be reported as taxable income or loss. An example of an unrecognized gain is the tax-deferred portion of a Section 1031 exchange.

Then for that year, my client would reduce any loss from the activity by any passive activity net income. The loss would include passive losses carried forward that were disallowed in a previous year. Any loss remaining after deducting the passive income will be active or non-passive, and deductible against other income.

For more information

I recommend reading Part II of “The Passive Loss Rules Labyrinth”. There you’ll find more information about how you can deduct your passive losses in the year you incur them. Here’s one surefire way: to be classified as a Real Estate Professional by the IRS.

Here’s another source of information. You can rely on it since it was written by the IRS. However, it may not be easy to grasp. Read IRS publication 925 for use in preparing 2020 returns.

The Passive Loss Rules Labyrinth

For another perspective by a qualified professional…

Normally, I don’t recommend reading articles written by other CPAs, since I’m in direct competition with them. However, in this case I recommend that you read an article on this topic by a CPA in Florida. His approach to it may just help you understand it better. I admit it’s a complicated subject. Even the client described above had difficulty understanding this when I tried to explain it to him. It’s a reason I wrote this Blog article.

With this and the Part II article I tried to break this subject down into bite-sized pieces. However, the Florida CPA firm’s article directly answers the question, “Are the Passive Loss rules fair”? (Of course the rules aren’t fair! It’s like asking “Is life fair?” and supplying a good answer.) Then it gives recommendations for what you can do about this. Plus they’ve given their article a catchy title.

I don’t suggest you engage the Florida firm to assist with your taxes unless you live in Florida. Then you’d be hiring a local CPA you can more easily visit. If you live anywhere else, especially in Arizona and California, we’ll do the job for you just as well. Or better. Be sure to note that we do Skype and Zoom. I enjoy traveling so I may even visit you. Or you can visit me, or us, when you’re in Arizona.

Here’s the URL for the article by James Moore, CPAs and Consultants: I’m Not Your Friend—I’m a PAL! Passive Activity Loss Rules Explained

* The organization Learn Religions deserves credit for this image which can be found on their website. See Moses and the Ten Commandments Bible Story Study Guide and for other worthwhile spiritual lessons.

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