Passive Activity Losses and At-Risk


Several financial institutions, such as banks offer mortgages. The first point to accessing the mortgage would be to go to a bank or mortgage institution. Here a variety of options will be discussed as well as the payments and interest charges. The other institution is the Internal Revenue Service that is responsible for collecting taxes on specific incomes. Lastly, the bank that J.P works for is also an important institution. As the employer, the bank may be responsible for directing payments, such as the principal payments to the mortgage lender. The last institution is Management Company that is in charge of managing the company.


According to the Internal Revenue Code,26 U.S. Code § 469, specifies that all rental activities are passive activities, unless if the taxpayer is a qualified real estate professional with material participation in running the property. IRS section 425, “material participation” is regular and continuous involvement in a business. IRS has provided materiality tests that distinguish active from passive activities. The most common being that the participant should have worked for at least 500 hours in the course of the table year. Therefore, losses from rental incomes can only be deducted from other passive incomes. JP does not have a material involvement in managing the rental property. Thus, he cannot offset the net loss from the office building.  This is because passive losses can only be matched against passive incomes and cannot be offset against dividend income or salaries.  In this regard, the annual income from employment will be assessed for taxation based on the State and income bracket while the dividend will also be taxed, a 15% is assessed for qualified dividends (26 U.S. Code § 316).


Passive Active Losses that are not allowed in the current year are carried off until they can be netted off against passive activity income or special allowance (only if applicable) or when the interest in the property is sold in a taxable transaction to an unrelated party (IRS Code,26 U.S. Code § 469). Therefore, year one losses will be netted off from year 2 rental income ($10,000+ ($386,000). There is also the exemption for deducting up to $25,000 of rental losses against active income if the “materiality test,” is met. However, the above allowance phases out for taxpayers whose annual income is more than $100,000. In our case, J.P does not meet the materiality test and thus cannot offset the loss against other incomes. His tax bracket is also higher than the $100,000.


IRS Code,26 U.S. Code § 469 (f) for treatment of former passive activities stipulates that you can deduct suspended losses from passive activities when you dispose of the property that generated the losses to a non-related third party. In this context, all the losses can be deducted after the sale of the property. Similar to section 1231(capital assets) losses, the suspended losses from rental income can offset other oncomes and create net operating loss (NOL) that can be carried backward or forward. If the Loss is large enough then it can reduce other incomes to zero and can be carried forward for at least two years, thus providing the opportunity to recover some of the taxes that were paid in the previous years. If the NOL is left after two years, the rest can be carried forward into future tax years to offset the taxable income for up to 20 years.

We also need to ascertain whether the property qualifies for a taxable disposition and depreciation recapture. Depreciation recapture is assessed when the sale price exceeds the adjusted cost basis or the tax basis. The property was disposed of at $460,000 which was the outstanding amount. However, if we consider the depreciation then the property would have been sold off at again.

Gain or Loss on Disposal
Purchase Cost 500,000
Depreciation -64,000
Value 436,000
Disposal value 460,000
Disposal gain 24,000


Since depreciation is used to deduct ordinary income, then any gains from the disposal must be reported as an ordinary income and not the lower capital gain tax rate.

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