Passive Activity Loss

Jarrah holds a large suspended passive loss and points to an earlier, very profitable year in which he paid substantial tax. He asks his representative whether he can amend that earlier return to use the loss. The correct response is that:

1. A.He may amend it, because passive losses follow the same carryback rules as business lossesWrong. The two regimes are separate, and this one supplies no backward relief at all.
2. B.He may amend it, but only if the income reported in that earlier year was itself passiveWrong. The character of the earlier income is beside the point when no carryback exists.
3. C.He may not carry the loss back; a passive loss moves forward onlyCorrect. The suspended amount waits for future passive income and cannot reopen a closed year.
4. D.He may not carry it back, but he may deduct it currently against his salary insteadWrong. It swaps one unavailable route for another, since wages are nonpassive.

Why: Passive losses run forward only. There is no carryback, so amending a profitable earlier return to absorb a suspended passive loss is not available to him, however much tax that year produced. The suspended loss remains intact and available against passive income in future years. If Jarrah acquires an interest that allocates him passive income next year, the suspended loss becomes usable then.

Losses allocated to a limited partner by a direct participation program are deductible by that partner:

1. A.Against any income the partner reports, provided the partner's basis is large enough to absorb itWrong. It stops at the basis limitation and never reaches the passive rule that follows it.
2. B.Against the partner's earned income such as salary, but not against dividends and interestWrong. Salary is the one category the passive rule most clearly walls the loss away from.
3. C.Against the partner's dividends and interest, but not against salary or self-employment incomeWrong. Portfolio income is nonpassive, so it cannot absorb an allocated program loss either.
4. D.Only to the extent of the passive income the partner reports for the yearCorrect. Passive income sets the ceiling, and anything above it is suspended rather than deducted.

Why: Losses from a direct participation program are passive losses in the hands of a limited partner, and passive losses are deductible only to the extent of the partner's passive income. Earned income such as salary and portfolio income such as dividends and interest both sit outside that category. Basis and the at-risk amount are separate limitations that can cut a loss down further; clearing them does not make a passive loss usable against nonpassive income. If the partner held passive income from another program, the loss would become deductible up to that amount.

Adele is allocated a 14,000 dollar loss from Program A. Her only other passive activity, Program B, allocates her 6,000 dollars of passive income for the same year. She also earns a 90,000 dollar salary. Her basis and at-risk amount are both large enough that neither limits her. What is the result?

1. A.She deducts 14,000 dollars, applying 6,000 to passive income and 8,000 against her salaryWrong. Reaching into wages is exactly the result the passive limitation is designed to prevent.
2. B.She deducts 6,000 dollars and carries the remaining 8,000 dollars back to a prior yearWrong. The amount deducted is right but the excess moves forward, never backward.
3. C.She deducts 6,000 dollars and carries the remaining 8,000 dollars forwardCorrect. Passive income caps the current deduction and the balance survives as a carryforward.
4. D.She deducts nothing this year and carries the whole 14,000 dollars forward to later yearsWrong. She holds passive income this year, so part of the loss is usable immediately.

Why: A passive loss is deductible only to the extent of passive income, so the 6,000 dollars allocated by Program B sets the ceiling. Adele deducts 6,000 dollars this year and carries the remaining 8,000 dollars forward against future passive income. Her 90,000 dollar salary is earned income and is unavailable to absorb any part of the loss. If Program B had allocated her 14,000 dollars or more of passive income, the entire loss would have been deductible now.

Bertram enters the year carrying 9,000 dollars of suspended passive losses. During the year his programs allocate him a further 5,000 dollar passive loss and 11,000 dollars of passive income. Neither basis nor his at-risk amount limits him. What is his position at year end?

1. A.He deducts 5,000 dollars and the 9,000 dollars of suspended losses stay suspendedWrong. It quarantines the older losses, which are freely available against this year's passive income.
2. B.He deducts 14,000 dollars, with 3,000 dollars of it reducing his other incomeWrong. Losses above the passive income ceiling cannot spill into nonpassive income.
3. C.He deducts 9,000 dollars and carries the current 5,000 dollar loss forwardWrong. It leaves 2,000 dollars of passive income unsheltered for no reason the rules supply.
4. D.He deducts 11,000 dollars and carries 3,000 dollars forwardCorrect. Total passive loss of 14,000 dollars meets a ceiling of 11,000, leaving 3,000 suspended.

Why: Losses carried forward from earlier years join the current year's passive loss and are measured together against the current year's passive income. Bertram has 9,000 dollars suspended plus a 5,000 dollar current loss, or 14,000 dollars of passive loss in total, against 11,000 dollars of passive income. He therefore deducts 11,000 dollars and carries 3,000 dollars forward. Had his passive income reached 14,000 dollars, nothing would have remained suspended.