IRC §469 – Passive Activities
Part 3
PAGI, PAD, PAI, PAL !
1
PAL General Rule

Loss from passive activity is only usable
against income from a passive activity




Individuals can’t use PAL against active or
portfolio income
Sometimes, what seems to be PAGI will be
treated as not PAGI (recharacterization rules)
§469(i) Special rule for dispositions – generally, an
activity’s PAL is “triggered” upon taxable
disposition of the activity.
2
PAL, PAGI, PAD and relevance

§469(d)(1) – PAL = excess of aggregate losses from all passive
activities for the year, over aggregate income from all passive activities
for the year.



PAGI - an item of gross income if and only if such income is from a
passive activity
PAD - if and only if such deduction—



“(i) Arises (within the meaning of paragraph (d)(8) of this section) in
connection with the conduct of an activity that is a passive activity for the
taxable year; or
(ii) Is treated as a deduction from an activity under §1.469-1T(f)(4) for the
taxable year.”
More details in -2 and -2T regs



So some netting involved, but must track PAL per activity so know how much
suspended PAL might be triggered if activity disposed of
Special rules for gains from dispositions, portfolio and personal service
income
Ordering rules relevant if the loss is also subject to passthrough basis
limitations, 465 and capital loss limitations (discussed later)
Calculations on Form 8582
3
PAL

§1.469-2T(b)


Generally, excess of passive activity deductions
for the year over passive activity gross income for
the year
Different definition used for closely-held
corporation


-1T(g)
PAL = excess of PAD over (PAGI + “net active income”)

Basically just can’t use PAD against portfolio income (but
see -1T(g) for details (not necessary for BUS 225K)
4
What is PAGI? 1.469-2T(c)


Gross income from a passive activity
Not portfolio income


Unless derived in ordinary course of the trade or
business, such as interest earned by a bank
Not income from personal services

PAGI “does not include compensation paid to or
on behalf of an individual for personal services
performed or to be performed by such individual
at any time”
5
Portfolio income
PLR 201005016
 S corp earned interest on construction loan
proceeds it received
 Held: the interest income is portfolio income



Not derived in the ordinary course of a trade or business
No exception for interest arising from working capital
Starting in 2013, 3.8% Medicare tax on unearned
income of high income individuals and trusts starts
(§1411)

Will approach of the 469 regs be used to define unearned
or net investment income?
6
PAGI Questions
Partnership owns one rental property. Had
CODI in 2010 of $40,000. Is it PAGI?
Your client owns an apartment building and
is required to keep security deposits in
separate account. Earns $1,000 of interest
income each year.
1.
2.

3.
Q – Portfolio or rental income?
Client earns royalties from business of
licensing movie rights?
Q – Portfolio or trade/business income?
7
More PAGI Questions
4.
5.
6.
Positive §481(a) adjustment
Income from a covenant not to compete
Gross income or gain allocable to business
or rental use of a dwelling unit for any year
in which §280A(c)(5) applies
8
PAGI – disposition gain rules


General rule -2T(c)(2) – “Treatment of gain. Except as otherwise
provided in the regulations under section 469, any gain
recognized upon the sale, exchange, or other disposition (a
“disposition”) of an interest in property used in an activity at the
time of the disposition or of an interest in an activity held through
a partnership or S corporation is treated in the following manner:

(1) The gain is treated as gross income from such activity for the
taxable year or years in which it is recognized;

(2) If the activity is a passive activity of the taxpayer for the
taxable year of the disposition, the gain is treated as passive
activity gross income for the taxable year or years in which it is
recognized; and

(3) If the activity is not a passive activity of the taxpayer for the
taxable year of the disposition, the gain is treated as not from a
passive activity.”
Interest in p/s and S corp stock are not property used in a PA
9
Classification of disposition gain - 1

1.
§1.469-2T(c) and -2(c)
12-month lookback rule – if property used in
more than one activity in 12 months
preceding disposition, gain characterized
and allocated among the activities on a
reasonable basis
10
Classification of disposition gain - 2

2.
§1.469-2T(c) and -2(c)
Substantially appreciated property rule –
prop is SA if its FMV > 120% of its adjusted
basis. If SA property previously used in a
nonpassive activity, gain is NOT treated as
passive unless property was used in a PA
for either 20% of time it was held, or during
the entire 24-month period ending on
disposition date.
11
Disposition Question

T sells office building which he held for 3
years. During 12 months prior to sale, T used
building 7 months as rental and 5 months in
his business.

Q - How to treat T’s gain?
12
Disposition Question


Anne acquires building on 1/1/97 and uses it
until 3/31/08 in a business activity in which
Anne materially participates. On 4/1/08, Anne
leases the building to Bob and on 12/31/09,
sells it for $500,000. Adjusted basis =
$200,000.
Q – nature of disposition gain?

Q – is the building “substantially appreciated?”
13
Income recharacterization rules -2T(f) and
-2(f) SET 1
Rules preventing conversion of active
business income into PAGI:

1.
2.
3.
SPA rule (f)(2)
Rental of self-developed property* (f)(5)
Self-rented property rule* (f)(6) (self rental rule)
* applies on property by property basis
14
Income recharacterization rules -2T(f) and
-2(f) SET 2
Rules preventing conversion of portfolio
income into PAGI

1.
2.
3.
Rental of non-depreciable property (f)(8)
Equity-financed lending activities (f)(4)
Passthrough entities licensing intangible
property* (f)(7)
* applies on property by property basis
15
Authority for income recharacterization
rules


Regulatory authority Congress gave to IRS at
§469(l)
Preserve intent of §469


Leg history: “to protect underlying purpose of the passive
loss provision, i.e., preventing the sheltering of positive
income sources through the use of tax losses derived from
passive business activities.”
Without such rules, taxpayers would be encouraged to:


Change participation levels
Convert investment activities to passive
16
SPA -2T(f)(2)


SPA – same definition as under -5T MP test
If PAGI from all SPAs > PAD from such
activities, net passive activity income treated
as nonpassive activity income

EX – T has 3 SPAs and aggregate hours are 400



SPA MP test not met, so passive
If generate income, treated as non-passive
IF t/p met the SPA MP test, the
recharacterization rule would not apply
(would not be subject to §469)
17
SPA Example

2008




SPA
$1,000 income
Rental
$1,000 loss
Result: report $1,000 active income and c/f
$1,000 PAL
2009



SPA
$1,000 loss
Rental
$1,000 loss
Result: both losses are PALs and c/f
18
Rental of self-developed property (f)(5)
Net rental activity income not treated as PAI
if,

a.
b.
c.
Any gain from disposition of property is included
in income for the TY
Property was rented out for less than 12 months
prior to its disposition, and
T materially or significantly participated in the
value enhancement of the property
19
Self-rented property rule (f)(6)
(self rental rule)


Rental income from an item of property
rented to a T or B in which T materially
participates is treated as NOT from a PA
EX – Al, a lawyer, rents office space to the
law p/s in which he is a MP. If the rental
activity generates income, it will not be PAI
20
Self-rental rule upheld by courts

Krukowski, 89 AFTR 2d 2002-827, 279 F.3d
547 (7th Cir. 2002)



Congress gave broad grant of authority to IRS in
§469(l)
The rule “comports with Congress’s goal of
eliminating tax shelters.”
Congress referred to example of situation to be
addressed by IRS as including related property
leases which reduce active business income and
create passive income.
21
Rental of nondepreciable property (f)(8)


Net passive activity income from activity of renting
property is not treated as PAI if the unadjusted basis
of the depreciable property is less than 30% of the
unadjusted basis of all property rented in the activity.
EX – rental of a parking lot where avg period of
customer use > 30 days. If unadjusted basis is:
Land
$80,000
 Pavement
$20,000
The rule will apply if rental generates income because
unadjusted basis of depreciable property ($20,000) is less
than 30% of the unadjusted basis of all property rented in
the activity ($100,000)

22
Equity-financed lending activities (f)(4)


Purpose – to prevent individuals,
partnerships and S corps from becoming
lenders in order to generate PAI when it
would otherwise be portfolio income
“Equity-financed lending activity” –


(1) involves T or B of lending money; and
(2) avg outstanding balance of liabilities (deposits)
incurred for the TY does not exceed 80% of avg
outstanding balance of the interest-bearing assets
(loans) held in the activity for the year
23
Passthrough entities licensing intangible
property (f)(7)

If T acquired interest after substantial development
was completed, the royalty income is not PAI, but is
recharacterized as portfolio income unless an
exception is met:


1) expenditures reasonably incurred by development entity
for TY with or within T’s TY wrt development or marketing
of such property, exceed 50% of the gross royalties from
licensing such property; or
2) T’s share of development or marketing expenditure for
all TYs of entity beg with TY of entity in which T acquired
interest and ending with TY of entity ending with or within
T’s current TY exceeds 25% of FMV of T’s interest in such
property at time T acquired interest in the entity.
24
Question 1

George is a lawyer in a law p/s and rents
office space to the p/s. What is the effect to
George?
25
Question 2

A.
B.
C.
D.
Wilma owns:
Video rental store 200 hours
Rental real estate 50 hours
Acctg p/s
2,000 hours
Software consult 250 hours
income
loss
income
loss
What is character of each activity – passive or
active?
26
Question 3
Barbara is evaluating 3 different rental properties
to acquire:

1)
2)
3)

Farm with 5,000 acres of land. The farmhouse would be
rented out and the land rented out for cattle grazing.
Barbara considers retiring there in about 10 years.
Apartment building with 50 units.
Mini-mall that she would construct, rent out for a few
years and sell at a profit and use the money for
retirement.
Which is the better investment. B has 3
partnership interests that all produce PALs.
27
Passive activity deduction


Define per 1.469-2T(d)
NOT PADs:











Portfolio expenses
Nonpassive activity interest expense
Loss from disposition of property producing portfolio income
Triggered loss under §469(g)
State, local, foreign income taxes
Misc. itemized deductions
Charitable contribution deduction
NOL or Capital loss c/f
Casualty or theft loss if not of type that recur regularly in the conduct of the
activity (EX – shoplifting in a store)
Negative §481(a) adj if attributable to passive activity
Loss from dispositions of PA

Also consider 12-month lookback rule
28
PAL




Once know the excess of PAD over PAGI
(the “PAL”) you allocate it to loss activities
using the allocation rules
When a PAL carries forward, it must always
be attached to an activity
-1T(f)(2)
Form 8582 and worksheets
29
Self-charged rule


TRA86 Blue Book page 233 – 234
§1.469-7



Only applies to interest (although legislative
history implied could be broader)
Addresses issues where same debt produces
portfolio income and PAD
EX – lending transaction between individual
and his partnership
30
Self-charged example
Partnership AB
50%
A
50%
B
AB operates a rental activity
A loaned $50K to AB at 10% interest
So, A receives $5K portfolio income and has $2.5K interest
expense on his K-1
Under self-charged rule, A can treat $2.5K of his interest income as
PAGI rather than as portfolio income (see example at 1.469-7(h))
31
Spouses filing joint return -1T(j)



Treat as 1 t/p for 469 purposes
Exceptions at -2T(j)(2)
If stop filing MFJ


PADs and PACs allocable to individual’s activities
for TY must be determined by taking into account
items of deduction and credit attributable to
individual’s interest in PAs for immediately
preceding TY
Participation rule -5T(f)(3)
32
Publicly-traded partnerships - 1



Special rule at §469(k)
Added by Revenue Act of 1987, but effective
as if added by TRA86
Definition: “any partnership if—


(A) interests in such partnership are traded on an
established securities market, or
(B) interests in such partnership are readily
tradable on a secondary market (or the substantial
equivalent thereof).”
33
Publicly-traded partnerships - 2

§469 applies separately for items for each
PTP




Can’t offset loss of a PTP against anything other
than income of a PTP (but not its portfolio income)
§469(i) doesn’t apply to PTP’s rental activities
§469(g) only applies to PTP if partner sells
his entire interest in the PTP
Special reporting on Form 8582
34
Disposition of interest in passthrough
entity




§1.469-2T(e)(3)
If sell p/s interest – allocate among the
passive activities, businesses and
investments of the partnership as if the p/s
had sold its assets
P/S may report the information on its K-1 to
help the selling partner
Details and examples in regs
35
Intro to carryover of PAL and PAC

§1.469-1(f)(4)

For any activity for which any deductions or
credits are disallowed under §469, disallowed loss
or credit is allocated among T’s activitys for
succeeding TY in a manner that reasonably
reflects extent to which each activity continues the
loss activity AND the disallowed loss or credit
allocated to an activity is treated as a deduction or
credit from the activity for the succeeding TY
36
EX (1) - §1.469-1T(f)(2)
(all are
passive
activities)
Gross
income
Activity A Activity B Activity C
Total
$7,000
$4,000
$12,000
$23,000
Deductio
ns
(16,000)
(20,000)
(8,000)
(44,000)
Net
income
(loss)
($9,000) ($16,000)
$4,000 ($21,000)
37
EX - continued






$21,000 PAL is disallowed
Allocated ratably to the activities that
produced losses for the year
A: $21,000 x $9,000/$25,000 = $7,500
B: $21,000 x $16,000/$25,000 = $13,440
These are the PALs that carryforward
attached to an activity
Reported (and computed) using Form 8582
38