How ‘Passive Activity’ Rules Affect Investors

Before 1986, investment in real estate was generally considered a “profit-making activity.” An investor could buy a rental property, receive rental income and was able to take so-called “paper losses” to obtain a very significant tax shelter.

For example, if you bought a piece of property for $200,000 and the land value was $50,000, the depreciable basis for the building was $150,000. In the good old days, you could take accelerated depreciation, and take a large paper loss each year. Indeed, if you decided to elect a straight line depreciation, depending on what year you were in, you might have the option to depreciate the property on a basis of 18 or 19 years. Assuming that you took an 18-year basis, you could take a paper loss of $8,333 each year from your tax return ($150,000 divided by 18).

Thus, after declaring the rental income, you were able to deduct from this income your actual out of pocket expenses--such as mortgage interest payments, real estate taxes, leasing commissions, repairs.

On top of these actual expenses, you were eligible for the paper loss called depreciation.

Congress was quite concerned with the growth of the tax-shelter industry. Often, promoters of so-called tax shelters would buy property that would not necessarily be a good investment for the future, but would generate a significant write-off each year.

When Congress enacted the Tax Reform Act of 1986, it established a new concept called “passive activities.” Although the primary motivation for the new law as it affected real estate was to curtail the tax-shelter abuse, the net result was a dramatic impact on the average real estate investor.

Passive activity regulations are very complex. As we have mentioned in other stories in this series, investors must discuss their particular circumstances with their tax advisers.

However, here is a very brief summary of passive activities as they relate to real estate transactions.

For all practical purposes, most real estate transactions fall into the category of “passive activity.” Over-simplified, this means that any real estate losses may only be used to offset income from other real estate activities.

Before the 1986 Tax Reform Act, you were able to deduct your real estate losses from other income sources, such as dividends and wages. However, beginning 1987, this situation changed.

To understand this complex law, let us suppose that you have two buckets. One bucket is labeled “passive income generators (PIGs)” and the other bucket is labeled “passive activity losses (PALs).”

If you are involved in a real estate investment activity, all of your losses are put in the PAL bucket, and all of your gains are put in the PIG bucket. One of the primary objectives of any real estate investor is to make a lot of profit while at the same time not having to pay a lot of tax on that gain.

Under the Tax Reform Act of 1986, real estate gains in the PIG bucket can only be offset by real estate losses in the PAL bucket.

There are provisions, however, for carrying forward the losses. This is referred to as net operating loss (NOL).

You can carry forward these losses indefinitely and can use them as deductions against passive income in later years. Unused losses are allowed in full when the taxpayer disposes of the entire interest in the passive activity.

There is one major exclusion from these passive activity rules.

Under certain circumstances, a taxpayer may be able to deduct up to $25,000 of passive rental losses from other (non-passive) activities. This special rule is known as the “$25,000 exemption.”

To qualify for this exemption, the taxpayer must “actively participate” in the rental activity. To be an active participant, this primarily requires a “bona fide” participation by the owner of the property. For example, making management decisions, approving new tenants, approving repairs or writing checks are illustrations of such active participation. A taxpayer seeking to use this $25,000 exemption must own at least 10% of the property, or must be a limited partner in a partnership owning the property.

However, the $25,000 exemption is applicable only to taxpayers whose adjusted gross income (AGI) is $100,000 or less. Where the taxpayer’s AGI exceeds $100,000, the $25,000 maximum amount is reduced by 50% of the amount by which the individual’s adjusted gross income exceeds $100,000. In other words, if the taxpayer’s AGI exceeds $150,000, no passive losses can be used for any offset against other income.

For married taxpayers who file separate returns and live apart, up to $12,500 of passive losses may be used to offset income, again with the same phase-out rules.

The Internal Revenue Service is constantly attempting to refine these passive activity regulations. Indeed, there has been significant pressure on Congress to relax--if not repeal--the investor rules.

However, as you are preparing your 1992 tax returns, and if you are involved in real estate investment activities, you have to follow the current rules. You should obtain a copy of IRS Form 8582 entitled “Passive Activity Loss Limitations,” which must be filed with your tax return.

It should also be pointed out that under the 1986 tax law, property purchased beginning in 1987 is to be depreciated at 31.5 years for non-residential property and 27.5 years for residential property. Property is residential if at least 80% of all gross rental income comes from the rental of dwelling units.

Understanding and using the passive activity rules may give the taxpayer some tax savings, but again you are urged to discuss your individual situation with your own tax adviser.