Passive Activity And At-Risk Rules - Introduction
Prior to several of the newly enacted tax codes, taxpayers were able to successfully utilize "tax shelters" to help defer or eliminate tax liability.
The two major changes to the code that reduced the benefits of tax shelters include:
1) Passive Activity Loss Limits
2) At-Risk Limits
To understand why the tax laws were changed, you'll need to understand why different investments and activities are now taxed in different ways according to participation and how the investment is now classified.
Active Participation – You do not have to be considered a material participant to qualify as an "active participant." To be "active" simply requires a bona fide involvement in management decisions. The individual must have at least a 10% interest in order to qualify. Limited partners are not considered active participants.
Passive Activity – This is generally defined as a business or trade interest of which the taxpayer does not materially participate.
Material Participation – A taxpayer is considered to "materially participate" if they are involved in the operation or activity on a regular, continuous and substantial basis. General partners will qualify while limited partners would not.
At-Risk Limits – The maximum deduction for losses is limited to the amount of capital invested in the activity. This includes the total cash, property invested and the debt for which the investor is liable. The portion of the loss in excess of the invested capital is the "at-risk" loss amount.
Suspended Loss – These are passive losses that cannot be claimed in a given tax year because the investor did not have any passive income to offset the loss. The loss can be carried forward indefinitely until the investor has passive income.
Non-Publicly Traded Partnerships – A partnership interest that does not trade on a listed stock exchange. Income and losses from investments in this activity are considered "passive." Loss can only be offset by income from non-public limited partnerships.
Publicly Traded Partnerships – A partnership interest that is traded on an established securities exchange, or readily traded in a secondary market. Income from this investment cannot be sheltered by passive losses from any other source. Losses cannot be used to offset passive income from other sources.
- Net loss from a publicly traded partnership must be carried forward and used only against the future income from that SAME partnership.