September 14, 2012
Maximizing Losses from Passive Activities by Properly Identifying Activity Groupings
The 1986 Tax Act brought into existence the rules related to the deductibility of passive activity losses. However, prior to the adaption of Revenue Procedure 2010-13, taxpayers were not truly required to disclose how they grouped activities together for the purpose of determining if an activity is considered passive. With the release of Revenue Procedure 2010-13, the IRS uses the rules under Section 469 of the Internal Revenue Code to target passive activities; specifically, how such activities are grouped for income tax purposes.
Although the grouping rules may oftentimes prove burdensome to taxpayers, improper use of or failure to utilize these rules can result in a large tax bill because passive losses allowed for a particular tax year are limited to the extent there is passive income. Specifically, excess passive losses cannot be used to offset other types of income and are carried forwarded to future years in which they can offset passive income. When an activity is eventually disposed of, the passive loss carryovers and current year losses are allowed. With Revenue Procedure 2010-13, the IRS now officially dictates how taxpayers should disclose various changes to activity groupings. Before examining the new reporting requirements with respect to grouping of activities, a brief overview of the passive activity rules is warranted.
All individuals, estates, trusts (other than grantor trusts), personal service corporations and closely held corporations are subject to the passive activity rules. A passive activity is defined as: 1) any activity which involves a trade or business in which the taxpayer does not materially participate, or 2) rental activities (there are limited exceptions) without regard to material participation, unless the taxpayer is considered a real estate professional. In determining if a trade or business activity is a passive activity, it must be determined if the taxpayer “materially participates” in the activity.
If the activity is a “trade or business,” then whether the activity is passive is determined by whether or not the taxpayer materially participates. If the taxpayer does not materially participate, then the activity is passive. Accordingly, if the activity generates a loss then the preferred outcome is generally a determination that the taxpayer materially participates since the deduction for passive activity losses is limited to passive activity income. Generally, a taxpayer will be considered to materially participate in a trade or business activity if he/she satisfies one of several participation tests. Among these tests are that the taxpayer participates in the activity in aggregate greater than 500 hours or at least 100 hours during the tax year with no one else participating a greater amount of time. In essence, to be considered a material participant one must be involved in the operations of the activity on a regular, continuous, and substantial basis. When a taxpayer figures the amount of time he/she participates in an activity for a particular year, he/she cannot include the hours spent each year on investor type activities. It should be noted that a taxpayer should be able to use any reasonable method to prove his/her participation in any given activity. One should also be aware that the test for material participation by a limited partner is more stringent.
“Real Estate Professional”
As stated earlier, rental activities will generally be treated as passive activities regardless of whether or not the taxpayer materially participates in the activity. A “qualified real estate professional,” however, will not have rental activities in which he/she materially participates treated as a passive activity. For determining material participation for an activity, each activity will be treated separately unless an election is made on a tax return to treat all rental activities as one activity. For an individual to be treated as a qualified real estate professional, he/she must meet both of the following requirements:
- More than half of the personal services the taxpayer performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated, and
- The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which he/she materially participated.
For taxpayers who are involved in multiple separate trades or businesses it may be quite difficult to act materially in any one activity. To accommodate such situations, the IRS allows for grouping of multiple activities. Without being able to group, activities a taxpayer may not be allowed to take losses from his/her activities in a current year. For grouped activities, a taxpayer must meet the material participation tests for the group as a whole rather than meet the test for each individual activity. Additionally, the activities which are grouped together should also be part of an appropriate economic unit. To be considered an appropriate economic unit, these five factors are considered: 1) similarities of the business, 2) extent of common control, 3) extent of common interest, 4) geographic location, and 5) business interdependence of the activities.
Regardless of the economic appropriateness, there are certain activities that a taxpayer cannot group together. Partnerships and S corporations must follow the same rules as individuals when grouping activities. An individual partner or shareholder cannot treat activities that were grouped together by the partnership or S corporation as separate activities. On his/her individual filing the taxpayer can, however, group the separate activities on each Form K-1 with each other, with the other activities the taxpayer participates in and with activities within other entities.
The fundamental rule is that passive activity losses must be netted with passive activities income and any passive losses in excess of income will be disallowed. The excess losses will be carried forwarded to future years, but keep in mind that carryover losses and current year losses in excess of passive income from an activity are fully allowed in the year when the activity is disposed of. So generally, a net loss from passive activities will not reduce a taxpayer’s taxable income (save for up to $25,000 of passive rental activities, which is phased out when a taxpayer’s adjusted gross income hits $100,000 and is fully reduced to zero at $150,000). Also worth noting is that when an individual has grouped activities, the disposition of one activity will not free up the carryover or current losses for this individual activity. The losses from this activity will not be allowed until all the grouped activities are disposed of. The taxpayer should consider this when grouping activities.
Prior to the release of Revenue Procedure 2010-13, individuals (with the exception of real estate professionals) were not required to file any disclosure forms or grouping elections. To group activities, though, a real estate professional was and still is required to make an election to treat all rental real estate activities as one activity. This election is made on the taxpayer’s individual tax filing by attaching a statement that declares that the taxpayer is a “qualifying taxpayer” for the year and that he/she is making the election to group all rental real estate activities. This election will apply to the current year and all subsequent years. The election cannot be revoked unless the taxpayer’s facts and circumstances significantly change. If this election is not made on a timely filed return, an individual may be able to make a late election.
Revenue Procedure 2010-13 addresses the new grouping disclosure requirements for individuals that are effective for tax years beginning on or after January 25, 2010. Under Revenue Procedure 2010-13:
- A taxpayer must file a written statement with his/her original income tax return for the first tax year in which two or more trade or business activities or rental activities are originally grouped as a single activity. This is not applicable for partnerships and S corporations.
- A taxpayer who adds a new trade or business activity or a rental activity to an existing grouping for a tax year must file a written statement with the taxpayer’s original income tax return for that tax year. This is not applicable for partnerships and S corporations.
- A taxpayer must regroup his/her activities if it has been determined that the taxpayer’s original grouping was clearly inappropriate or a material change in the facts and circumstances has occurred that makes the original grouping clearly inappropriate. A written statement must be attached to the return. This is not applicable for partnerships and S corporations.
- A partnership or S corporation must generally disclose the entity’s groupings to a partner or shareholder by separately stating the amounts of income and loss for each grouping conducted by the entity on attachments to the entity’s annual Schedule K-1.
- A taxpayer is not required to file a written statement reporting the grouping of the trade or business activities and rental activities that have been made prior to January 25, 2010 unless there is a change to the groupings.
Generally, a taxpayer who is engaged in two or more trade or business activities (or rental activities) that fails to report whether the activities have been grouped as a single activity will have each trade or business activity (or rental activity) treated as a separate activity for purposes of applying the passive activity loss and credit limitation rules. This default rule can have a drastic impact, especially if all of the activities have net losses for the year. Failure to timely disclose such groupings, however, will not necessarily negate a taxpayer’s favorable grouping. Proper grouping disclosure will be deemed made by a taxpayer who has filed any affected income tax returns consistent with the claimed grouping of activities and makes the required disclosure on the income tax return for the year in which the failure to disclose the groupings is first discovered by the taxpayer. If the IRS identifies the requisite failure to disclose the groupings, then the taxpayer will have to show reasonable cause for not initially making the disclosure on the originally filed return. Upshot: It is not impossible to remedy a failure to properly disclose the groupings; however, it is much easier to do so correctly in the initial tax filings.
The tax impact of how taxpayers group their investments in businesses, funds, and real estate is too great to ignore or misinterpret. The rules set forth in Revenue Procedure 2010-13 establish some stringent reporting requirements aimed at increasing taxpayer transparency and compliance with the tax rules. If you are engaged in two or more trade or business activities (or rental activities), then it is important to properly group such activities and examine how best to do so.