us internal revenue service: p925--2000

8/14/2019 US Internal Revenue Service: p925--2000

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ContentsImportant Change .............................. 1

Introduction ........................................ 1

Passive Activity Limits ...................... 2

Who Must Use These Rules? ........ 2Passive Activities ............................ 2

Activities That Are Not PassiveActivities ................................... 4

Passive Activity Income .................. 5Passive Activity Deductions ............ 6

Grouping Your Activities ................. 6

Recharacterization of PassiveIncome ..................................... 7

Dispositions ..................................... 8

How To Report Your PassiveActivity Loss ............................. 9

Comprehensive Example .................. 9

At-Risk Limits ..................................... 19

Who Is Affected? ............................ 19

Activities Covered by the At-RiskRules ........................................ 19

At-Risk Amounts ............................. 20

Amounts Not At Risk ...................... 21Reductions of Amounts At Risk ...... 21

Recapture Rule ............................... 21

How To Get Tax Help ......................... 21

Index .................................................... 23

Important Change

Photographs of missing children. TheInternal Revenue Service is a proud partnerwith the National Center for Missing and Ex-ploited Children. Photographs of missingchildren selected by the Center may appearin this publication on pages that would other-wise be blank. You can help bring thesechildren home by looking at the photographsand calling 1800THELOST (18008435678) if you recognize a child.

IntroductionThis publication discusses two sets of rulesthat may limit the losses you can deduct onyour tax return from any trade, business,rental, or other income-producing activity. Thefirst part of the publication contains the pas-sive activity rules. The second part discussesthe at-risk rules. However, when you figure

your allowable losses from any activity, youmust apply the at-risk rules before thepassive activity rules.

Comments and suggestions. We welcomeyour comments about this publication andyour suggestions for future editions.

You can e-mail us while visiting our website at www.irs.gov/help/email2.html.

You can write to us at the following ad-dress:

Internal Revenue ServiceTechnical Publications BranchW:CAR:MP:FP:P1111 Constitution Ave. NWWashington, DC 20224

Departmentof theTreasury

InternalRevenueService

Publica tion 925Cat. No. 64265X

Passive ActivityandAt-Risk Rules

For use in preparing

2000 Returns


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We respond to many letters by telephone.Therefore, it would be helpful if you wouldinclude your daytime phone number, includ-ing the area code, in your correspondence.

Useful ItemsYou may want to see:

Publication

527 Residential Rental Property (In-cluding Rental of Vacation

Homes) 541 Partnerships

Form (and Instructions)

4952 Investment Interest Expense De-duction

6198 At-Risk Limitations

8582 Passive Activity Loss Limitations

8582CR Passive Activity Credit Limita-tions

8810 Corporate Passive Activity Lossand Credit Limitations

See How To Get Tax Help near the endof this publication for information about get-ting these publications and forms.

Passive Activity LimitsGenerally, you are in a passive activity if:

You have a trade or business activity inwhich you do not materially participateduring the tax year, or

You have a rental activity, even if you domaterially participate in it (unless you area real estate professional).

These terms are explained later.If you have a loss, you must determine

your at-risk amount in the activity. The at-risk rules are explained in the second part ofthis publication. After you figure your amountat risk, apply the rules in this part to find theamount of your passive activity losses thatyou can deduct.

In general, you can deduct passive activitylosses only from passive activity income. Youcarry any excess loss forward to the followingyear or years until used, or until deducted inthe year you dispose of your entire interest inthe activity in a fully taxable transaction. SeeDispositions, later.

Passive activity credits. You can subtractpassive activity credits only from the tax onnet passive income. Passive activity creditsinclude the general business credit and otherspecial business credits, such as the credit forfuel produced from a nonconventional source.Credits that are more than the tax on incomefrom passive activities are carried forward.

Unallowed passive activity credits, unlikeunallowed passive activity losses, are notdeductible when you dispose of your entireinterest in an activity. However, to determineyour gain or loss from the disposition, you canelect to increase the basis of the credit prop-erty by the amount of the original basis re-duction for the credit, to the extent that thecredit was not allowed because of the passiveactivity limits. You cannot elect to adjust thebasis for a partial disposition of your interestin a passive activity.

See the instructions for Form 8582CR formore information.

Publicly traded partnership. You must ap-ply the rules in this part separately to yourincome or loss from a passive activity heldthrough a publicly traded partnership (PTP).You must also apply the limit on passive ac-tivity credits separately to your credits from apassive activity held through a PTP.

You can offset losses from passive activ-ities of a PTP only against income or gainfrom passive activities of the same PTP.Likewise, you can offset credits from passiveactivities of a PTP only against the tax on thenet passive income from the same PTP.

For more information on how to apply thepassive activity loss rules to PTPs, and onhow to apply the limit on passive activitycredits to PTPs, see Publicly Traded Part-nerships (PTPs) in the instructions for Forms8582 and 8582CR, respectively.

Who Must UseThese Rules?The passive activity rules apply to:

1) Individuals,

2) Estates,3) Trusts (other than grantor trusts),

4) Personal service corporations, and

5) Closely held corporations.

Even though the rules do not apply tograntor trusts, partnerships, and S corpo-rations directly, they do apply to the ownersof these entities.

For information about personal servicecorporations and closely held corporations,including definitions and how the passive ac-tivity rules apply to these corporations, seeForm 8810 and its instructions.

Closely held corporation. A closely held

corporation can offset net active income withits passive activity loss. It can also offset thetax attributable to its net active income withits passive activity credits. However, a closelyheld corporation cannot offset its portfolio in-come (defined, later, under Passive ActivityIncome) with its passive activity loss.

Net active income is the corporation'staxable income figured without any incomeor loss from a passive activity or any portfolioincome or loss.

Passive ActivitiesThere are two kinds of passiveactivitiestrade or business activities inwhich you do not materially participate duringthe tax year and rental activities. Materialparticipation in a trade or business is dis-cussed, later, under Activities That Are NotPassive Activities.

Treatment of former passive activities. Aformer passive activity is an activity that wasa passive activity in any earlier tax year, butis not a passive activity in the current tax year.You can deduct a prior year unallowed lossfrom the activity up to the amount of yourcurrent year net income from the activity.Treat any remaining prior year unallowed losslike you treat any other passive loss.

In addition, any prior year unallowed pas-sive activity credits from a former passiveactivity offset the allocable part of your current

year tax liability. The allocable part of yourcurrent year tax liability is that part of thisyear's tax liability that is allocable to the cur-rent year net income from the former passiveactivity. You figure this after you reduce yournet income from the activity by any prior yearunallowed loss from that activity (but not be-low zero).

Trade or Business ActivitiesA trade or business activity is an activity that:

1) Involves the conduct of a trade or busi-ness (that is, deductions would be al-lowable under section 162 of the InternalRevenue Code if other limitations, suchas the passive activity rules, did not ap-ply),

2) Is conducted in anticipation of starting atrade or business, or

3) Involves research or experimental ex-penditures that are deductible underInternal Revenue Code section 174 (orthat would be deductible if you chose todeduct rather than capitalize them).

A trade or business activity does not includea rental activity or the rental of property thatis incidental to an activity of holding theproperty for investment.

You generally report trade or businessactivities on Schedule C, CEZ, F, or in PartII or III of Schedule E.

Rental ActivitiesA rental activity is a passive activity even ifyou materially participated in that activity,unless you materially participated as a realestate professional. See Real Estate Profes-sional, later, under Activities That Are NotPassive Activities. An activity is a rental ac-tivity if tangible property (real or personal) isused by customers or held for use by cus-tomers, and the gross income (or expectedgross income) from the activity represents

amounts paid (or to be paid) mainly for theuse of the property. It does not matterwhether the use is under a lease, a servicecontract, or some other arrangement.

Exceptions. Your activity is not a rental ac-tivity if anyof the following apply.

1) The average period of customer use ofthe property is 7 days or less. You figurethe average period of customer use bydividing the total number of days in allrental periods by the number of rentalsduring the tax year. If the activity in-volves renting more than one class ofproperty, multiply the average period ofcustomer use of each class by a fraction.The numerator of the fraction is thegross rental income from that class ofproperty, and the denominator is the ac-tivity's total gross rental income. Theactivity's average period of customer usewill equal the sum of the amounts foreach class.

2) The average period of customer use ofthe property, as figured in (1), above, is30 days or less and you provide signif-icant personal services with the rentals.Significant personal services includeonly services performed by individuals.They do not include:

a) Services needed to permit the law-ful use of the property,

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b) Services to repair or improve prop-erty that would extend its useful lifefor a period substantially longerthan the average rental, and

c) Services that are similar to thosecommonly provided with long-termrentals of real estate, such ascleaning and maintenance of com-mon areas or routine repairs.

3) You provide extraordinary personal ser-vices in connection with customer use.Services are extraordinary personal ser-vices if individuals perform them, and thecustomer's use of the property is inci-dental to their receipt of the services.

4) The rental is incidental to a nonrentalactivity. The rental of property is inci-dental to an activity of holding propertyfor investment if the main purpose ofholding the property is to realize a gainfrom its appreciation and the gross rentalincome from the property is less than 2%of the smaller of the property's unad-

justed basis or fair market value. Theunadjusted basis of property is its costnot reduced by depreciation or any otherbasis adjustment. The rental of propertyis incidental to a trade or business ac-

tivity if all of the following apply.a) You own an interest in the trade or

business activity during the year.

b) The rental property was usedmainly in that trade or business ac-tivity during the current year, orduring at least 2 of the 5 precedingtax years.

c) Your gross rental income from theproperty is less than 2% of thesmaller of its unadjusted basis orfair market value.

5) You customarily make the rental prop-erty available during defined businesshours for nonexclusive use by variouscustomers.

6) You provide the property for use in anonrental activity in your capacity as anowner of an interest in the partnership,S corporation, or joint venture conduct-ing that activity.

TIPIf you meet any of the exceptionslisted above, see the instructions forForm 8582 for information about how

to report any income or loss from the activity.

Rental real estate activities. If you or yourspouse actively participated in a passiverental real estate activity, you can deduct upto $25,000 of loss from the activity from yournonpassive income. This special allowance isan exception to the general rule disallowinglosses in excess of income from passive ac-tivities. Similarly, you can offset credits fromthe activity against the tax on up to $25,000of nonpassive income after taking into ac-count any losses allowed under this excep-tion.

If you are married, filing a separate return,and lived apart from your spouse for the entiretax year, your special allowance cannot bemore than $12,500. If you lived with yourspouse at any time during the year and arefiling a separate return, you cannot use thespecial allowance to reduce your nonpassiveincome or tax on nonpassive income.

The maximum special allowance is re-duced if your modified adjusted gross income

exceeds certain amounts. See Phaseout rule,later.

Example. Kate, a single taxpayer, has$70,000 in wages, $15,000 income from alimited partnership, a $26,000 loss from rentalreal estate activities in which she activelyparticipated, and less than $100,000 of mod-ified adjusted gross income. She can use$15,000 of her $26,000 loss to offset her$15,000 passive income from the partnership.Because she actively participated in her rentalreal estate activities, she can use the re-

maining $11,000 rental real estate loss tooffset $11,000 of her nonpassive income(wages).

Active participation. Active participationis not the same as material participation, de-fined later. Active participation is a lessstringent standard than material participation.For example, you may be treated as activelyparticipating if you make management deci-sions in a significant and bona fide sense.Management decisions that count as activeparticipation include approving new tenants,deciding on rental terms, approving expendi-tures, and similar decisions.

Only individuals can actively participate inrental real estate activities. However, a de-

cedent's estate is treated as actively partic-ipating for its tax years ending less than 2years after the decedent's death, if the dece-dent would have satisfied the active partici-pation requirement for the activity for the taxyear the decedent died.

A decedent's qualified revocable trust canalso be treated as actively participating if boththe trustee and the executor (if any) of theestate choose to treat the trust as part of theestate. The choice applies to tax years endingafter the decedent's death and before:

2 years after the decedent's death if noestate tax return is required, or

6 months after the estate tax liability isfinally determined if an estate tax return

is required.The choice is irrevocable and cannot be

made later than the due date for the estate'sfirst income tax return (including any exten-sions).

Limited partners are not treated as activelyparticipating in a partnership's rental real es-tate activities.

You are not treated as actively participat-ing in a rental real estate activity unless yourinterest in the activity (including your spouse'sinterest) was at least 10% (by value) of allinterests in the activity throughout the year.

Active participation is not required to takelow-income housing and rehabilitation invest-ment credits from rental real estate activities.

Example. Mike, a single taxpayer, hadthe following income and loss during the taxyear:

The rental loss came from a house Mikeowned. He advertised and rented the houseto the current tenant himself. He also col-lected the rents and either did the repairs orhired someone to do them.

Even though the rental loss is a loss froma passive activity, Mike can use the entire$4,000 loss to offset his other income be-cause he actively participated.

Phaseout rule. The maximum specialallowance of $25,000 ($12,500 for marriedindividuals filing separate returns and livingapart at all times during the year) is reducedby 50% of the amount of your modified ad-

justed gross income that is more than$100,000 ($50,000 if you are married filingseparately). If your modified adjusted grossincome is $150,000 or more ($75,000 or moreif you are married filing separately), you gen-erally cannot use the special allowance.

Modified adjusted gross income for thispurpose is your adjusted gross income fig-ured without the following:

1) Taxable social security and tier 1 railroadretirement benefits,

2) Deductible contributions to individual re-tirement accounts (IRAs) and section501(c)(18) pension plans,

3) The exclusion from income of interestfrom qualified U.S. savings bonds usedto pay qualified higher education ex-penses,

4) The exclusion from income of amountsreceived from an employer's adoptionassistance program,

5) Passive activity income or loss included

on Form 8582,

6) Any rental real estate loss allowed be-cause you materially participated in therental activity as a real estate profes-sional (as discussed, later, under Activ-ities That Are Not Passive Activities),

7) Any overall loss from a publicly tradedpartnership (see Publicly Traded Part-nerships (PTPs) in the instructions forForm 8582),

8) The deduction for one-half of self-employment tax, or

9) The deduction allowed for interest onstudent loans.

Example. During 2000 John was unmar-ried and was not a real estate professional.For 2000 he had $120,000 in salary, and a$31,000 loss from his rental real estate ac-tivities in which he actively participated. Hismodified adjusted gross income is $120,000.When he files his 2000 return, he may deductonly $15,000 of his passive activity loss. Hemust carry over the remaining $16,000 pas-sive activity loss to 2001. He figures his de-duction and carryover as follows:

Phaseout rule for certain credits. Ahigher phaseout range applies to low-incomehousing credits for property placed in servicebefore 1990 and rehabilitation investment

Adjusted gross income, modified asrequired .................................................. $120,000

Minus amount not subject to phaseout ... 100,000

Amount subject to phaseout rule ............. $20,000Multiply by 50% ... .................. .................. 50%

Required reduction to special allowance . $10,000

Maximum special allowance .................... $25,000

Salary ......................................................... $42,300 Minus required reduction (see above) ..... 10,000Dividends ................................................... 300

Adjusted special allowance ..................... $15,000Interest ....................................................... 1,400Rental loss ................................................. (4,000)

Passive loss from rental real estate ........ $31,000

Deduction allowable/ Adjustedspecial allowance (see above) .............. 15,000

Amount that must be carried forward ...... $16,000

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credits from rental real estate activities. Forthose credits, the phaseout of the $25,000special allowance starts when your modifiedadjusted gross income exceeds $200,000($100,000 if you are a married individual filinga separate return and living apart at all timesduring the year).

There is no phaseout of the $25,000 spe-cial allowance for low-income housing creditsfor property placed in service after 1989. Ifyou hold an indirect interest in the propertythrough a partnership, S corporation, or otherpass-through entity, this special exception willnot apply unless you also acquired your in-terest in the pass-through entity after 1989.

You apply the $25,000 special allowancefirst to passive activity losses, then to creditsother than the rehabilitation and low-incomehousing credits, then to rehabilitation creditsand low-income housing credits for propertyplaced in service before 1990. You apply anyremaining part of the special allowance tolow-income housing credits for propertyplaced in service after 1989.

Activities That Are NotPassive ActivitiesThe following are notpassive activities.

1) Trade or business activities in which youmaterially participated for the tax year.

2) A working interest in an oil or gas wellwhich you hold directly or through anentity that does not limit your liability(such as a general partner interest in apartnership). It does not matter whetheryou materially participated in the activityfor the tax year. However, if your liabilitywas limited for part of the year (for ex-ample, you converted your general part-ner interest to a limited partner interestduring the year) and you had a net lossfrom the well for the year, some of yourincome and deductions from the workinginterest may be treated as passive ac-

tivity gross income and passive activitydeductions. See Temporary Regulationssection 1.4691T(e)(4)(ii).

3) The rental of a dwelling unit that you alsoused for personal purposes during theyear for more than the greater of14days or 10% of the number of days dur-ing the year that the home was rentedat a fair rental.

4) An activity of trading personal propertyfor the account of those who own inter-ests in the activity. See TemporaryRegulations section 1.4691T(e)(6).

5) Rental real estate activities in which youmaterially participated as a real estateprofessional. See Real Estate Profes-

sional, later.

CAUTION

!You should not enter income andlosses from these activities on Form8582. Instead, enter them on the

forms or schedules you would normally use.

Material ParticipationA trade or business activity is not a passiveactivity if you materially participated in theactivity. You materially participated in a tradeor business activity for a tax year if you satisfyanyof the following tests.

1) You participated in the activity for morethan 500 hours.

2) Your participation was substantially allthe participation in the activity of all indi-viduals for the tax year, including theparticipation of individuals who did notown any interest in the activity.

3) You participated in the activity for morethan 100 hours during the tax year, andyou participated at least as much as anyother individual (including individualswho did not own any interest in the ac-tivity) for the year.

4) The activity is a significant participationactivity, and you participated in all sig-nificant participation activities for morethan 500 hours. A significant partici-pation activity is any trade or businessactivity in which you participated formore than 100 hours during the year andin which you did not materially participateunder any of the material participationtests, other than this test. See SignificantParticipation Passive Activities, later,under Recharacterization of Passive In-come.

5) You materially participated in the activityfor any 5 (whether or not consecutive)of the 10 immediately preceding taxyears.

6) The activity is a personal service activityin which you materially participated forany 3 (whether or not consecutive) pre-ceding tax years. An activity is a per-sonal service activity if it involves theperformance of personal services in thefields of health (including veterinary ser-vices), law, engineering, architecture,accounting, actuarial science, perform-ing arts, consulting, or any other tradeor business in which capital is not amaterial income-producing factor.

7) Based on all the facts and circum-stances, you participated in the activityon a regular, continuous, and substantialbasis.

You did not materially participate in theactivity under test (7) if you participated in theactivity for 100 hours or less during the year.Your participation in managing the activitydoes not count in determining whether youmaterially participated under this test if:

1) Any person other than you receivedcompensation for managing the activity,or

2) Any individual spent more hours duringthe tax year managing the activity thanyou did (regardless of whether the indi-vidual was compensated for the man-agement services).

Participation. In general, any work you doin connection with an activity in which youown an interest is treated as participation inthe activity.

Work not usually performed by owners.You do not treat the work you do in con-nection with an activity as participation in theactivity if both of the following are true.

1) The work is not work that is customarilydone by the owner of that type of activity.

2) One of your main reasons for doing thework is to avoid the disallowance of anyloss or credit from the activity under thepassive activity rules.

Participation as an investor. You do nottreat the work you do in your capacity as aninvestor in an activity as participation unlessyou are directly involved in the day-to-daymanagement or operations of the activity.Work you do as an investor includes:

1) Studying and reviewing financial state-ments or reports on operations of theactivity,

2) Preparing or compiling summaries oranalyses of the finances or operations

of the activity for your own use, and3) Monitoring the finances or operations of

the activity in a nonmanagerial capacity.

Spouse's participation. Your participationin an activity includes your spouse's partici-pation. This applies even if your spouse didnot own any interest in the activity and youand your spouse do not file a joint return forthe year.

RECORDS

Proof of participation. You can useany reasonable method to prove yourparticipation in an activity for the year.

You do not have to keep contemporaneousdaily time reports, logs, or similar documents

if you can establish your participation in someother way. For example, you can show theservices you performed and the approximatenumber of hours spent by using an appoint-ment book, calendar, or narrative summary.

Limited partners. If you owned an activityas a limited partner, you generally are nottreated as materially participating in the ac-tivity. However, you are treated as materiallyparticipating in the activity if you met materialparticipation test (1), (5), or (6) for the taxyear.

You are not treated as a limited partner,however, if you also were a general partnerin the partnership at all times during thepartnership's tax year ending with or withinyour tax year (or, if shorter, during that partof the partnership's tax year in which you di-rectly or indirectly owned your limited partnerinterest).

Retired or disabled farmer and survivingspouse of a farmer. If you are a retired ordisabled farmer, you are treated as materiallyparticipating in a farming activity if you mate-rially participated for 5 or more of the 8 yearsbefore your retirement or disability. Similarly,if you are a surviving spouse of a farmer, youare treated as materially participating in afarming activity if the real property used in theactivity meets the estate tax rules for special

valuation of farm property passed from aqualifying decedent, and you actively managethe farm.

Corporations. A closely held corporationor a personal service corporation is treatedas materially participating in an activity onlyif one or more shareholders holding morethan 50% by value of the outstanding stockof the corporation materially participate in theactivity.

A closely held corporation can also satisfythe material participation standard by meetingthe first two requirements for the qualifyingbusiness exception from the at-risk limits.See Special exception for qualified corpo-

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rations under Activities Covered by the At-Risk Rules, later.

Real Estate ProfessionalGenerally, rental activities are passive activ-ities even if you materially participated inthem. However, if you qualified as a real es-tate professional, rental real estate activitiesin which you materially participated are notpassive activities. For this purpose, each in-terest you have in a rental real estate activity

is a separate activity, unless you choose totreat all interests in rental real estate activitiesas one activity. See the instructions forSchedule E (Form 1040) for information aboutmaking this choice.

If you qualified as a real estate profes-sional for 2000, report income or losses fromrental real estate activities in which youmaterially participated as nonpassive incomeor losses, and complete line 42 of ScheduleE (Form 1040). If you also have an unallowedloss from these activities from an earlier yearwhen you did not qualify, see Treatment offormer passive activities under Passive Ac-tivities, earlier.

Qualifications. You qualified as a real estate

professional for the year if you met both of thefollowing requirements.

1) More than half of the personal servicesyou performed in all trades or busi-nesses during the tax year were per-formed in real property trades or busi-nesses in which you materiallyparticipated.

2) You performed more than 750 hours ofservices during the tax year in realproperty trades or businesses in whichyou materially participated.

Do not count personal services you per-formed as an employee in real propertytrades or businesses unless you were a 5%

owner of your employer. You were a 5%owner if you owned (or are considered tohave owned) more than 5% of your employ-er's outstanding stock, outstanding votingstock, or capital or profits interest.

If you file a joint return, do not count yourspouse's personal services to determinewhether you met the preceding requirements.However, you can count your spouse's par-ticipation in an activity in determining if youmaterially participated.

Real property trades or businesses. Areal property trade or business is a trade orbusiness that does any of the following withreal property.

Develops or redevelops it.

Constructs or reconstructs it.

Acquires it.

Converts it.

Rents or leases it.

Operates or manages it.

Brokers it.

Closely held corporations. A closelyheld corporation can qualify as a real estateprofessional if more than 50% of the grossreceipts for its tax year came from real prop-erty trades or businesses in which it materiallyparticipates.

Passive Activity IncomeIn figuring your net income or loss from apassive activity, take into account only pas-sive activity income and passive activity de-ductions (discussed later). Passive activityincome includes all income from passive ac-tivities and generally includes gain from dis-position of an interest in a passive activity orproperty used in a passive activity.

Passive activity income does not includethe following items.

1) Income from an activity that is not apassive activity. These activities arediscussed, earlier, under Activities ThatAre Not Passive Activities.

2) Portfolio income. This includes interest,dividends, annuities, and royalties notderived in the ordinary course of a tradeor business. It includes gain or loss fromthe disposition of property that producesthese types of income or that is held forinvestment.

3) Personal service income. This includessalaries, wages, commissions, self-employment income from trade or busi-ness activities in which you materiallyparticipated, deferred compensation,

taxable social security and other retire-ment benefits, and payments from part-nerships to partners for personal ser-vices.

4) Income from positive section 481 ad-justments allocated to activities otherthan passive activities. (Section 481 ad-

justments are adjustments that must bemade due to changes in your accountingmethod.)

5) Income or gain from investments ofworking capital.

6) Income from an oil or gas property if youtreated any loss from a working interestin the property for any tax year beginningafter 1986 as a nonpassive loss, as dis-

cussed, earlier, in item (2) under Activ-ities That Are Not Passive Activities. Thisalso applies to income from other oil andgas property the basis of which is deter-mined wholly or partly by the basis of theproperty in the preceding sentence.

7) Any income from intangible property,such as a patent, copyright, or literary,musical, or artistic composition, if yourpersonal efforts significantly contributedto the creation of the property.

8) Any other income that must be treatedas nonpassive income. See Recharac-terization of Passive Income, later.

9) Overall gain from any interest in a pub-licly traded partnership. See Publicly

Traded Partnerships (PTPs) in the in-structions for Form 8582.

10) State, local, and foreign income tax re-funds.

11) Income from a covenant not to compete.

12) Reimbursement of a casualty or theftloss included in gross income to recoverall or part of a prior year loss deduction,if the loss deduction was not a passiveactivity deduction.

13) Alaska Permanent Fund dividends.

14) Cancellation of debt income, if at thetime the debt is discharged the debt isnot allocated to passive activities under

the interest expense allocation rules.See chapter 5 of Publication 535, Busi-ness Expenses, for information about therules for allocating interest.

Disposition of property interests. Gain onthe disposition of an interest in property gen-erally is passive activity income if, at the timeof the disposition, the property was used inan activity that was a passive activity in theyear of disposition. The gain generally is notpassive activity income if, at the time of dis-position, the property was used in an activitythat was not a passive activity in the year ofdisposition. An exception to this general rulemay apply if you previously used the propertyin a different activity.

Exception for more than one use in thepreceding 12 months. If you used theproperty in more than one activity during the12-month period before its disposition, youmust allocate the gain between the activitieson a basis that reasonably reflects the prop-erty's use during that period. Any gain allo-cated to a passive activity is passive activityincome.

For this purpose, an allocation of the gainsolely to the activity in which the property wasmainly used during that period reasonablyreflects the property's use if the fair market

value of your interest in the property is notmore than the smaller of:

1) $10,000, or

2) 10% of the total of the fair market valueof your interest in the property and thefair market value of all other propertyused in that activity immediately beforethe disposition.

Exception for substantially appreciatedproperty. The gain is passive activity incomeif the fair market value of the property at dis-position was more than 120% of its adjustedbasis and either of the following conditionsapplies.

1) You used the property in a passive ac-tivity for 20% of the time you held yourinterest in the property.

2) You used the property in a passive ac-tivity for the entire 24-month period be-fore its disposition.

If neither condition applies, the gain is notpassive activity income. However, it is treatedas portfolio income only if you held the prop-erty for investment for more than half of thetime you held it in nonpassive activities.

For this purpose, treat property you heldthrough a corporation (other than an S cor-poration) or other entity whose owners re-ceive only portfolio income as property heldin a nonpassive activity and as property heldfor investment. Also, treat the date you agreeto transfer your interest for a fixed or deter-minable amount as the disposition date.

If you used the property in more than oneactivity during the 12-month period before itsdisposition, this exception applies only to thepart of the gain allocated to a passive activityunder the rules described in the precedingdiscussion.

Disposition of property converted to in-ventory. If you disposed of property that youhad converted to inventory from its use inanother activity (for example, you sold con-dominium units you previously held for use ina rental activity), a special rule may apply.Under this rule, you disregard the property's

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use as inventory and treat it as if it were stillused in that other activity at the time of dis-position. This rule applies only if you meet allthe following conditions.

1) At the time of disposition, you held yourinterest in the property in a dealing ac-tivity (an activity that involves holding theproperty or similar property mainly forsale to customers in the ordinary courseof a trade or business).

2) Your other activities included a nondeal-

ing activity (an activity that does not in-volve holding similar property for sale tocustomers in the ordinary course of atrade or business) in which you used theproperty for more than 80% of the periodyou held it.

3) You did not acquire or hold your interestin the property for the main purpose ofselling it to customers in the ordinarycourse of a trade or business.

Passive Activity DeductionsPassive activity deductions include all de-ductions from activities that are passive ac-tivities for the current tax year and all de-

ductions from passive activities that weredisallowed under the passive loss rules inprior tax years and carried forward to thecurrent tax year. They also include lossesfrom dispositions of property used in a pas-sive activity at the time of the disposition andlosses from a disposition of less than yourentire interest in a passive activity.

Passive activity deductions do notincludethe following items.

1) Deductions for expenses (other than in-terest) that are clearly and directlyallocable to portfolio income.

2) Interest expense other than interestproperly allocable to passive activities(e.g., qualified home mortgage interest

and capitalized interest expense are notpassive activity deductions).

3) Losses from dispositions of property thatproduce portfolio income or propertyheld for investment.

4) State, local, and foreign income taxes.

5) Miscellaneous itemized deductions thatmay be disallowed because of the2%-of-adjusted-gross-income limit.

6) Charitable contribution deductions.

7) Net operating loss deductions.

8) Percentage depletion carryovers for oiland gas wells.

9) Capital loss carryovers.

10) Deductions and losses that would havebeen allowed for tax years beginningbefore 1987 but for basis or at-risk limits.

11) Net negative section 481 adjustmentsallocated to activities other than passiveactivities. (Section 481 adjustments areadjustments required due to changes inaccounting methods.)

12) Casualty and theft losses, unless lossessimilar in cause and severity recur regu-larly in the activity.

13) The deduction for one-half of self-employment tax.

Grouping Your ActivitiesYou can treat one or more trade or businessactivities, or rental activities, as a single ac-tivity if those activities form an appropriateeconomic unit for measuring gain or lossunder the passive activity rules.

Grouping is important for a number ofreasons. If you group two activities into onelarger activity, you need only show materialparticipation in the activity as a whole. But ifthe two activities are separate, you mustshow material participation in each one. On

the other hand, if you group two activities intoone larger activity and you dispose of one ofthe two, then you have disposed of only partof your entire interest in the activity. But if thetwo activities are separate and you disposeof one of them, then you have disposed ofyour entire interest in that activity.

Grouping can also be important in deter-mining whether you meet the 10% ownershiprequirement for actively participating in arental real estate activity.

Appropriate Economic UnitsGenerally, to determine if activities form anappropriate economic unit, you must considerall the relevant facts and circumstances. Youcan use any reasonable method of applyingthe relevant facts and circumstances ingrouping activities. The following factors havethe greatest weight in determining whetheractivities form an appropriate economic unit.All of the factors do not have to apply to treatmore than one activity as a single activity. Thefactors that you should consider are:

1) The similarities and differences in thetypes of trades or businesses,

2) The extent of common control,

3) The extent of common ownership,

4) The geographical location, and

5) The interdependencies between oramong activities, which may include the

extent to which the activities:

a) Buy or sell goods between oramong themselves,

b) Involve products or services thatare generally provided together,

c) Have the same customers,

d) Have the same employees, or

e) Use a single set of books and rec-ords to account for the activities.

Example 1. John Jackson owns a bakeryand a movie theater at a shopping mall inBaltimore and a bakery and movie theater inPhiladelphia. Depending on all the relevantfacts and circumstances, there may be more

than one reasonable method for groupingJohn's activities. For example, John may beable to group the movie theaters and thebakeries into:

1) One activity,

2) A movie theater activity and a bakeryactivity,

3) A Baltimore activity and a Philadelphiaactivity, or

4) Four separate activities.

Example 2. Betty is a partner in ABCpartnership, which sells nonfood items togrocery stores. Betty is also a partner in DEF

(a trucking business). ABC and DEF are un-der common control. The main part of DEF'sbusiness is transporting goods for ABC. DEFis the only trucking business in which Betty isinvolved. Following the rules of this section,Betty treats ABC's wholesale activity andDEF's trucking activity as a single activity.

Consistency and disclosure requirement.Generally, when you group activities into ap-propriate economic units, you may not re-group those activities in a later tax year. Youmust meet any disclosure requirements thatthe Internal Revenue Service (IRS) may havewhen you first group your activities and whenyou add or dispose of any activities in yourgroupings.

However, if the original grouping is clearlyinappropriate or there is a material change inthe facts and circumstances that makes theoriginal grouping clearly inappropriate, youmust regroup the activities and comply withany disclosure requirements that the IRS mayhave.

Regrouping by IRS. If any of the activitiesresulting from your grouping is not an appro-priate economic unit and one of the primarypurposes of your grouping (or failure to re-group) is to avoid the passive activity rules,

the IRS may regroup your activities.

Rental activities. In general, you cannotgroup a rental activity with a trade or businessactivity. However, you can group them to-gether if the activities form an appropriateeconomic unit and:

1) The rental activity is insubstantial in re-lation to the trade or business activity,

2) The trade or business activity is insub-stantial in relation to the rental activity,or

3) Each owner of the trade or business ac-tivity has the same ownership interest inthe rental activity, in which case the partof the rental activity that involves therental of items of property for use in thetrade or business activity may begrouped with the trade or business ac-tivity.

Example. Herbert and Wilma are marriedand file a joint return. Healthy Food, an Scorporation, is a grocery store business.Herbert is Healthy Food's only shareholder.Plum Tower, an S corporation, owns andrents out the building. Wilma is Plum Tower'sonly shareholder. Plum Tower rents part of itsbuilding to Healthy Food. Plum Tower's gro-cery store rental business and Healthy Food'sgrocery business are not insubstantial in re-lation to each other.

Because Herbert and Wilma file a joint

return, they are treated as one taxpayer forpurposes of the passive activity rules. Thesame owner (Herbert and Wilma) owns bothHealthy Food and Plum Tower with the sameownership interest (100% in each). If thegrouping forms an appropriate economic unit,as discussed earlier, Herbert and Wilma cangroup Plum Tower's grocery store rental andHealthy Food's grocery business into a singletrade or business activity.

Grouping of real and personal propertyrentals. In general, you cannot treat an ac-tivity involving the rental of real property andan activity involving the rental of personalproperty as a single activity. However, youcan treat them as a single activity if you pro-

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vide the personal property in connection withthe real property or the real property in con-nection with the personal property.

Certain activities may not be grouped. Ingeneral, if you own an interest as a limitedpartner or a limited entrepreneur in one of thefollowing activities, you may not group thatactivity with any other activity in another typeof business.

1) Holding, producing, or distributing motionpicture films or video tapes.

2) Farming.

3) Leasing any section 1245 property (asdefined in section 1245(a)(3) of theInternal Revenue Code). For a list ofsection 1245 property, see Section 1245propertyunder Activities Covered by theAt-Risk Rules, later.

4) Exploring for, or exploiting, oil and gasresources.

5) Exploring for, or exploiting, geothermaldeposits.

If you own an interest as a limited partneror a limited entrepreneur in an activity de-scribed in the list above, you may group that

activity with another activity in the same typeof business if the grouping forms an appro-priate economic unit as discussed earlier.

Limited entrepreneur. A limited entre-preneur is a person who:

1) Has an interest in an enterprise otherthan as a limited partner, and

2) Does not actively participate in themanagement of the enterprise.

Activities conducted through another en-tity. A personal service corporation, closelyheld corporation, partnership, or S corpo-ration must group its activities using the rulesdiscussed in this section. Once the entitygroups its activities, you, as the partner orshareholder of the entity, may group thoseactivities (following the rules of this section):

With each other,

With activities conducted directly by you,or

With activities conducted through otherentities.

CAUTION

!You may not treat activities groupedtogether by the entity as separateactivities.

Personal service and closely held cor-porations. You may group an activity con-ducted through a personal service or closelyheld corporation with your other activities only

to determine whether you materially or sig-nificantly participated in those other activities.See Material Participation, earlier, and Sig-nificant Participation Passive Activities, later.

Publicly traded partnership (PTP). Youmay not group activities conducted through aPTP with any other activity, including an ac-tivity conducted through another PTP.

Partial dispositions. If you dispose of sub-stantially all of an activity during your tax year,you may treat the part disposed of as a sep-arate activity. But, you can only do this if youcan show with reasonable certainty:

1) The amount of deductions and creditsdisallowed in prior years under the pas-

sive activity rules that is allocable to thepart of the activity disposed of, and

2) The amount of gross income and anyother deductions and credits for the cur-rent tax year that is allocable to the partof the activity disposed of.

Recharacterizationof Passive IncomeNet income from the following passive activ-ities may have to be recharacterized and ex-cluded from passive activity income:

Significant participation passive activities,

Rental of nondepreciable property,

Equity-financed lending activities,

Rental of property incidental to develop-ment activities,

Rental of property to nonpassive activ-ities, and

Licensing of intangible property bypass-through entities.

If you are engaged in or have an interest inone of these activities during the tax year(either directly or through a partnership or an

S corporation), combine the income andlosses from the activity to determine if youhave a net loss or net income from that ac-tivity.

If the result is a net loss, treat the incomeand losses the same as any other income orlosses from that type of passive activity (tradeor business activity or rental activity).

If the result is net income, do not enterany of the income or losses from the activityor property on Form 8582 or its worksheets.Instead, enter income or losses on the formand schedules you normally use. But seeSignificant Participation Passive Activities,later, if the activity is a significant participationpassive activity and you also have a net lossfrom a different significant participation pas-

sive activity.

Limit on recharacterized passive income.The total amount that you treat as nonpassiveincome under the rules described later in thisdiscussion for significant participation passiveactivities, rental of nondepreciable property,and equity-financed lending activities, cannotexceed the greatest amount that you treat asnonpassive income under any one of theserules.

Investment income and investment ex-pense. To figure your investment interestexpense limitation on Form 4952, treat as in-vestment income any net passive income re-characterized as nonpassive income from

rental of nondepreciable property, an equity-financed lending activity, or the licensing ofintangible property by a pass-through entity.

Significant ParticipationPassive ActivitiesA significant participation passive activity isany trade or business activity in which youparticipated for more than 100 hours duringthe tax year but did not materially participate.

If your gross income from all significantparticipation passive activities is more thanyour deductions from those activities, a partof your net income from each significant par-ticipation passive activity is treated as non-passive income.

Corporations. An activity of a personal ser-vice corporation or closely held corporation isa significant participation passive activity ifboth of the following statements are true.

The corporation is not treated as mate-rially participating in the activity for theyear.

One or more individuals, each of whomis treated as significantly participating inthe activity, directly or indirectly hold (intotal) more than 50% (by value) of the

corporation's outstanding stock. Gener-ally, an individual is treated as signif-icantly participating in an activity if theindividual participates in it for more than100 hours during the year.

Worksheet A. Complete Worksheet A, Sig-nificant Participation Passive Activities(shown on the next page), if you have incomeor losses from any significant participationactivity. Enter the names of the activities inthe left column.

Column (a). Enter the number of hoursyou participated in each activity and total thecolumn.

If the total is more than 500, do not com-plete Worksheet A or B. None of the activities

are passive activities because you satisfy test4 for material participation. (See MaterialParticipation under Activities That Are NotPassive Activities, earlier.) Report all the in-come and losses from these activities on theforms and schedules you normally use. Donot include the income and losses on Form8582.

Column (b). Enter the net loss, if any,from the activity. Net loss from an activitymeans either:

1) The activity's current year net loss (ifany) plus prior year unallowed losses (ifany), or

2) The excess of prior year unallowedlosses over the current year net income(if any). Enter -0- here if the prior yearunallowed loss is the same as the cur-rent year net income.

Column (c). Enter net income, if any,from the activity. Net income means the ex-cess of the current year's net income from theactivity over any prior year unallowed lossesfrom the activity.

Column (d). Combine amounts in theTotalsrow for columns (b) and (c) and enterthe total net income or net loss in the Totalsrow of column (d). If column (d) is a net loss,skip Worksheet B, Significant ParticipationActivities With Net Income. Include the in-come and losses in Worksheet 2 of Form8582 (or Worksheet 2 of Form 8810).

If column (d) shows net income and youmust complete Form 8582 because you haveother passive activities to report, completeWorksheet B on page 9. However, you do nothave to complete Form 8582 if column (d)shows net income and you have only signif-icant participation activities. If you do not haveto complete Form 8582, skip Worksheet Band report the net income and net losses fromcolumns (b) and (c) on the forms and sched-ules you normally use.

Worksheet B. List only the significant par-ticipation passive activities that have net in-come as shown in column (c) of WorksheetA.

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Worksheet A. Significant Participation Passive Activities

Name of Activity(a) Hours ofParticipation (b) Net loss (c) Net income

(d) Combine totals of cols. (b)and (c)

Totals

Column (a). Enter the net income of eachactivity from column (c) of Worksheet A.

Column (b). Divide each of the individualnet income amounts in column (a) by the total

of column (a). The result is a ratio. In column(b), enter the ratio for each activity as a dec-imal (rounded to at least three places). Thetotal of these ratios must equal 1.000.

Column (c). Multiply the amount in theTotals row of column (d) of Worksheet A byeach of the ratios in column (b). Enter theresults in column (c).

Column (d). Subtract column (c) fromcolumn (a). To this figure, add the amount ofprior year unallowed losses, if any, that re-duced the current year net income. Enter theresult in column (d). Enter these amounts onWorksheet 2 of Form 8582 or Form 8810.(But see Limit on recharacterized passive in-come under Recharacterization of PassiveIncome, earlier.)

Rental of NondepreciablePropertyIf you have net passive income (includingprior year unallowed losses) from rentingproperty in a rental activity, and less than 30%of the unadjusted basis of the property issubject to depreciation, you treat the netpassive income as nonpassive income.

Example. Calvin acquires vacant land for$300,000, constructs improvements at a costof $100,000, and leases the land and im-provements to a tenant. He then sells the landand improvements for $600,000, realizing again of $200,000 on the disposition.

The unadjusted basis of the improvements

($100,000) equals 25% of the unadjustedbasis of all property ($400,000) used in therental activity. Calvin's net passive incomefrom the activity (which is figured with the gainfrom the disposition, including gain from theimprovements) is treated as nonpassive in-come.

Equity-FinancedLending ActivitiesIf you have gross income from an equity-financed lending activity, the lesser of the netpassive income or the equity-financed interestincome is nonpassive income.

For more information, see TemporaryRegulations section 1.4692T(f)(4).

Rental of Property Incidentalto a Development ActivityNet passive income from this type of activitywill be treated as nonpassive income if allofthe following apply.

1) You recognize gain from the sale, ex-change, or other disposition of the rentalproperty during the tax year.

2) You started to rent the property less than12 months before the date of disposition.

3) You materially participated or signif-icantly participated for any tax year in anactivity that involved the performance ofservices for the purpose of enhancingthe value of the property (or any otheritem of property if the basis of the prop-erty disposed of is determined in wholeor in part by reference to the basis of that

item of property).

For more information, see Regulationssection 1.4692(f)(5).

Rental of Property to aNonpassive ActivityIf you rent property to a trade or businessactivity in which you materially participated,net rental income from the property is treatedas nonpassive income. This rule does notapply to net income from renting propertyunder a written binding contract entered intobefore February 19, 1988. It also does notapply to property just described under Rentalof Property Incidental to a Development Ac-

tivity.

Licensing of Intangible Propertyby Pass-Through EntitiesNet royalty income from intangible propertyheld by a pass-through entity in which youown an interest may be treated as nonpassiveroyalty income. This applies if you acquiredyour interest in the pass-through entity afterthe partnership, S corporation, estate, or trustcreated the intangible property or performedsubstantial services or incurred substantialcosts for developing or marketing the intan-gible property.

This recharacterization rule does not applyif:

1) The expenses the entity reasonably in-curred in developing or marketing theproperty exceed 50% of the gross royal-ties from licensing the property that are

includible in your gross income for thetax year, or

2) Your share of the expenses the entityreasonably incurred in developing ormarketing the property for all tax yearsexceeded 25% of the fair market valueof your interest in the intangible propertyat the time you acquired your interest inthe entity.

For purposes of (2) above, capital expen-ditures are taken into account for the entity'stax year in which the expenditure is chargea-ble to a capital account, and your share of theexpenditure is figured as if it were allowed asa deduction for the tax year.

DispositionsAny passive activity losses (but not credits)that have not been allowed (including currentyear losses) generally are allowed in full in thetax year you dispose of your entire interest inthe passive (or former passive) activity.However, for the losses to be allowed, youmust dispose of your entire interest in theactivity in a transaction in which all realizedgain or loss is recognized. Also, the personacquiring the interest from you must not berelated to you.

CAUTION

!If you have a capital loss on the dis-position of an interest in a passive

activity, the loss may be limited by thecapital loss rules. The limit is generally $3,000for individuals. See Publication 544, Salesand Other Dispositions of Assets, for moreinformation.

Example. Ray earned a $60,000 salaryand owned one passive activity through a 5%interest in the B Limited Partnership. He soldhis entire interest in the current tax year toan unrelated person for $30,000. His adjustedbasis in the partnership interest was $42,000,and he had carried over $2,000 of passiveactivity losses from the activity.

Ray's deductible loss is $5,000, figuredas follows:

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Worksheet B. Significant Participation Activities With Net Income(Keep for your records)

Name of Activitywith net income (a) Net income

(b) RatioSee instructions

(c) Nonpassive incomeSee instructions

(d) Passive incomeSubtract col. (c) from col. (a)

Totals 1.000

Ray deducts the $5,000 total currentdeductible loss in the current tax year. Hemust carry over the remaining $9,000 capitalloss, which is not subject to the passive ac-tivity loss limit. He will treat it like any othercapital loss carryover.

Installment sale of an entire interest. If yousell your entire interest in a passive activitythrough an installment sale, to figure the lossfor the current year that is not limited by thepassive activity rules, multiply your overallloss (not including losses allowed in prioryears) by a fraction. The numerator (top part)of the fraction is the gain recognized in the

current year, and the denominator (bottompart) is the total gain from the sale minus allgains recognized in prior years.

Example. John Ash has a total gain of$10,000 from the sale of an entire interest ina passive activity. Under the installmentmethod he reports $2,000 of gain each year,including the year of sale. For the first year,20% (2,000/10,000) of the losses are allowed.For the second year, 25% (2,000/8,000) ofthe remaining losses are allowed.

Partners and S corporation shareholders.Generally, any gain or loss on the dispositionof a partnership interest must be allocated toeach trade or business, rental, or investmentactivity in which the partnership owns an in-terest. If you dispose of your entire interest ina partnership, the passive activity losses fromthe partnership that have not been allowedgenerally are allowed in full. They also will beallowed if the partnership (other than a PTP)disposes of all the property used in that pas-sive activity.

If you do not dispose of your entire inter-est, the gain or loss allocated to a passiveactivity is treated as passive activity incomeor deduction in the year of disposition. Thisincludes any gain recognized on a distributionof money from the partnership that you re-ceive in excess of the adjusted basis of yourpartnership interest.

Sales price ................................................. $30,000 These rules also apply to the dispositionof stock in an S corporation.

Dispositions by gift. If you give away yourinterest in a passive activity, the unusedpassive activity losses allocable to the interestcannot be deducted in any tax year. Instead,the basis of the transferred interest must be

increased by the amount of these losses.

Dispositions by death. If a passive activityinterest is transferred because the ownerdies, unused passive activity losses are al-lowed (to a certain extent) as a deductionagainst the decedent's income in the year ofdisposition. The decedent's losses are al-lowed only to the extent they exceed theamount by which the transferee's basis in thepassive activity has been increased under therules for determining the basis of propertyacquired from a decedent. For example, if thebasis of an interest in a passive activity in thehands of a transferee is increased by $6,000and unused passive activity losses of $8,000were allocable to the interest at the date of

death, then the decedent's deduction for thetax year would be limited to $2,000 ($8,000 $6,000).

Partial dispositions. If you dispose of sub-stantially all of an activity during your tax year,you may treat the part of the activity disposedof as a separate activity. See Partial disposi-tionsunder Grouping Your Activities, earlier.

How To Report YourPassive Activity LossReporting your passive activities may requiremore than one form or schedule. The actualnumber of forms depends on the number and

types of activities you must report. Someforms and schedules that may be requiredare:

Schedule C (Form 1040), Profit or LossFrom Business,

Schedule D (Form 1040), Capital Gainsand Losses,

Schedule E (Form 1040), SupplementalIncome and Loss,

Schedule F (Form 1040), Profit or LossFrom Farming,

Form 4797, Sales of Business Property,

Form 6252, Installment Sale Income,

Form 8582, Passive Activity Loss Limita-tions, and

Form 8582CR, Passive Activity CreditLimitations.

Regardless of the number or complexityof passive activities you have, you should useonly one Form 8582.

ComprehensiveExampleThe following example shows how to reportyour passive activities. In addition to Form1040, Charles and Lily Woods use Form 8582(to figure allowed passive activity deductions),Schedule E (to report rental activities andpartnership activities), Form 4797 (to figurethe gain and allowable loss from assets soldthat were used in the activities), and ScheduleD (to report the sale of partnership interests).

General InformationCharles and Lily are married, file a joint re-turn, and have combined wages of $132,000in 2000. They own interests in the activitieslisted below. They are at risk for their invest-ment in the activities. They did not materiallyparticipate in any of the business activities.They actively participated in the rental realestate activities in 2000 and all prior years.Charles and Lily are not real estate profes-sionals.

1) Activity A is a rental real estate activity.The income and expenses are reportedon Schedule E. Charles and Lily's rec-ords show a loss from operations of$15,000 in 2000. Their records also

show a gain of $2,776 in 2000 from thesale of section 1231 assets used in theactivity. That section 1231 gain is re-ported in Part I of Form 4797. In 1999they completed the Worksheets in theinstructions for Form 8582 and calcu-lated that $6,667 of Activity A's ScheduleE loss for 1999 was disallowed by thepassive activity rules. That loss is carriedover to 2000 as a prior year unallowedloss and will be used in figuring the al-lowed loss for 2000.

2) Activity B is a rental real estate activity.Its income and expenses are reportedon Schedule E. Charles and Lily's rec-ords show a loss from operations of

Minus: adjusted basis ................................ 42,000

Capital loss ................................................ $12,000

Minus: capital loss limit .............................. 3,000

Capital loss carryover ................................ $9,000

Allowable capital loss on sale ................... $3,000

Carryover losses allowable ........................ 2,000

Total current deductible loss ..................... $5,000

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$11,600 in 2000. In 1999 they com-pleted the Worksheets in the instructionsfor Form 8582 and calculated that$8,225 of Activity B's Schedule E loss for1999 was disallowed by the passive ac-tivity rules. That loss is carried over to2000 as a prior year unallowed loss andwill be used in figuring the allowed lossfor 2000.

3) Partnership #1 is a trade or businessactivity and is not a publicly traded part-nership (PTP). Partnership #1 reports a

$4,000 distributive share of its 2000profits to Charles and Lily on line 1 ofSchedule K1 (Form 1065). They reportthat profit on Schedule E. In 1999 theycompleted the Worksheets in the in-structions for Form 8582 and calculatedthat $2,600 of their distributive share ofthe loss from Partnership #1 in 1999 wasdisallowed by the passive activity rules.That loss is carried over to 2000 as aprior year unallowed loss and will beused in figuring the allowed loss for2000.

4) Partnership #2 is a trade or businessactivity and also a PTP. In 2000 Charlesand Lily sold their entire interest in Part-nership #2. They do not report that sale

on Form 8582 because Partnership #2is a PTP. They recognize a long-termcapital gain of $15,300 ($25,300 sellingprice minus $10,000 adjusted basis),which they report on Schedule D. Thepartnership reports a $1,200 distributiveshare of its 2000 losses to them on line1 of Schedule K1 (Form 1065). Theyreport that loss on Schedule E. In 1999they followed the instructions for Form8582 and calculated that $2,445 of theirdistributive share of Partnership #2's1999 loss was disallowed by the passiveactivity rules. That loss is carried overfrom 1999 and added to the $1,200Schedule E loss for 2000. (For dis-cussion of PTPs, see the instructions for

Form 8582.)5) Partnership #3 is a single trade or busi-

ness activity and is not a PTP. Charlesand Lily sold their entire interest in Part-nership #3 in November 2000. Theyrecognize a $4,000 ($15,000 sellingprice minus $11,000 adjusted basis)long-term capital gain, which they reporton Schedule D.

In 1999 they completed the Work-sheets in the Form 8582 instructions andcalculated that $3,000 of their distributiveshare of the partnership's loss for 1999was disallowed by the passive activityrules. That loss is carried over to 2000as a prior year unallowed Schedule Eloss. Charles and Lily's distributive share

of partnership losses for 2000 reportedon line 1 of Schedule K1 (Form 1065)is $6,000.

6) Partnership #4 is a trade or businessactivity that is a limited partnership.Charles and Lily are limited partners whodid not meet any of the material partici-pation tests. Their distributive share of2000 partnership loss, reported on line1 of Schedule K1 (Form 1065), is$2,400. In 1999 they completed theWorksheets in the Form 8582 in-structions and calculated that $1,500 oftheir distributive share of loss for 1999was disallowed by the passive activityrules. That loss is carried over to 2000

as a prior year unallowed loss and willbe used in figuring the allowed loss for2000.

Step OneCompleting the TaxForms Before Figuring thePassive Activity Loss LimitsCharles and Lily complete the forms theyusually use to report income or expensesfrom their activities. They enter their com-bined wages, $132,000, on Form 1040. They

complete line 8 of Schedule D showing long-term capital gains of $15,300 from the dispo-sition of Partnership #2 and $4,000 from thedisposition of Partnership #3. Because Part-nership #2 is a PTP, it is not entered on Form8582. Because the disposition of Partnership#3 is a disposition of an entire interest in anactivity with an overall loss of $5,000 ($4,000 $3,000 $6,000), that partnership also isnot entered on Form 8582. They combine thePTP $1,200 current year loss with its $2,445prior year loss, and also combine the Part-nership #3 $6,000 current year loss with its$3,000 prior year loss, and enter the twocombined amounts in column (g) on line 27of Schedule E, Part II. They enter the $4,000profit from Partnership #1 in column (h). Be-fore completing the rest of Part II of Schedule

E, they must complete Form 8582 to figureout how much of their losses from Partner-ships #1 and #4 they can deduct.

They complete Schedule E, Part I, throughline 22. Since their rental activities are pas-sive, they must complete Form 8582 to figurethe deductible losses to enter on line 23.

They enter the gain from the sale of thesection 1231 assets of Activity A on Form4797.

Step TwoForm 8582and its WorksheetsCharles and Lily now complete Form 8582and the worksheets that apply to their passiveactivities. Because they are at risk for their

investment in the activities, they do not needto complete Form 6198 before Form 8582.(The second part of this publication explainsthe at-risk rules.)

Worksheet 1. On Worksheet 1, Charles andLily enter the gains and losses for Activity Aand Activity B (rental real estate activities withactive participation). They enter all amountsfrom the activities even though they alreadyreported the gain of $2,776 from Activity Aon Form 4797, since all income or loss fromthese activities must be taken into account tofigure the loss allowed.

1) They write Activity A on the first lineunder Name of activity. Then they enter:

a) $2,776 gain in column (a) fromForm 4797, line 2, column (g),

b) ($15,000) loss in column (b) fromSchedule E, line 22, column A, and

c) ($6,667) prior year unallowed lossin column (c) from their worksheetsused in 1999.

They combine the three amounts.Since the result, ($18,891), is an overallloss, they enter it in column (e).

2) Charles and Lily write Activity B on thesecond line under Name of activity. Thenthey enter:

a) ($11,600) loss in column (b) fromSchedule E, line 22, column B, and

b) ($8,225) prior year unallowed lossin column (c) from their 1999 work-sheets.

Then they combine these two figuresand enter the total loss, ($19,825), incolumn (e).

3) They separately add the amounts incolumns (a), (b), and (c).

a) They enter $2,776 in column (a) onthe Total line and also on Form8582, Part I, line 1a.

b) They enter ($26,600) in column (b)on the Total line and also on Form8582, Part I, line 1b.

c) They enter ($14,892) in column (c)on the Total line and also on Form8582, Part I, line 1c.

4) They combine lines 1a, 1b, and 1c, Form8582, and put the net loss, ($38,716),on line 1d.

Worksheet 2. Because Partnership #1 andPartnership #4 are nonrental passive activ-ities, Charles and Lily enter the appropriate

information on Worksheet 2 similar to the waythey reported their rental activities on Work-sheet 1. Then they enter the totals on Form8582, Part I, lines 2a through 2d.

Reporting income from column (d), Work-sheets 1 and 2. Activities that have anoverall gain in column (d) are not used anyfurther in the calculations for Form 8582. Atthis point, all income and losses from thoseactivities should be entered on the forms orschedules that would normally be used.Charles and Lily have one activity with anoverall gain ($4,000 $2,600 = $1,400). Thisis Partnership #1, which is shown in Work-sheet 2. They already reported the $4,000income from this activity on Part II, ScheduleE. They now enter the entire $2,600 loss on

Schedule E as well.

Step ThreeCompletingForm 8582Next, Charles and Lily complete Part II, Form8582, to determine the amount they can de-duct for their net losses from real estate ac-tivities with active participation (Activities Aand B). They enter all amounts as thoughthey were positive (without brackets aroundlosses). They then complete Part III of Form8582.

1) They enter $38,716 on line 4 since thisis the smaller of line 1d or line 3.

2) They enter $150,000 on line 5 since they

are married and filing a joint return.3) They enter $138,655, their modified ad-

justed gross income, on line 6. (See theinstructions for Form 8582 for a dis-cussion of modified adjusted gross in-come.) The $138,655 is made up of theirwages, $132,000, plus their overall gainof $11,655 from Partnership #2, a PTP,plus their $5,000 overall loss from Part-nership #3.

On Schedule D, they reported long-term gains of $15,300 from the PTPdisposition and $4,000 from the Part-nership #3 disposition. Also, on Sched-ule E they combined the PTP 2000 lossof $1,200 with its prior year loss of

Page 10


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$2,445, and combined the Partnership#3 2000 loss of $6,000 with its prior yearloss of $3,000. Netting these amountsgives them the PTP overall gain of$11,655 ($15,300 $1,200 $2,445)and the Partnership #3 overall loss of$5,000 ($4,000 $6,000 $3,000) thatwere used in figuring modified adjustedgross income.

4) They subtract line 6 from line 5 and enterthe result, $11,345, on line 7.

5) They multiply line 7 by 50% and enterthe result, $5,673, on line 8. No matterwhat the result, they cannot enter morethan $25,000 on line 8.

6) They enter the smaller of line 4 or line8, $5,673, on line 9.

7) They add the income on lines 1a and 2aand enter the result, $6,776, on line 10.

8) They add lines 9 and 10 and enter theresult, $12,449, on line 11.

Step FourCompletingWorksheet 3Charles and Lily must complete Worksheet 3

since they entered an amount on line 9 ofForm 8582 and have two activities, each withan overall loss in column (e) of Worksheet 1.Worksheet 3 allocates the amount on line 9(their special allowance for active partici-pation rental real estate activities) betweenActivity A and Activity B.

1) In the two left columns, they write thenames of the activities, A and B, and theschedule the activities are reported on,Schedule E.

2) They fill in column (a) with the lossesfrom Worksheet 1, column (e). They addup the amounts, and enter the result,$38,716, in the Total line withoutbrackets.

3) They figure the ratios for column (b) bydividing each amount in column (a) bythe amount on the column (a) Totalline.They enter each result in column (b).The total of the ratios must equal 1.00.

4) They multiply the amount from line 9,Form 8582, $5,673, by each of the ratiosin Worksheet 3, column (b) and enter theresults on the appropriate line in column(c). The total must equal $5,673.

5) They subtract column (c) from column(a) and enter each result in column (d).

Step FiveCompletingWorksheet 4Worksheet 4 must be completed if any activityhas an overall loss in column (e) of Work-sheet 2 or a loss in column (d) of Worksheet3 (or column (e) of Worksheet 1 if Worksheet3 was not needed). This worksheet allocatesthe unallowed loss among the activities withan overall loss. Charles and Lily fill outWorksheet 4 with the activities from Work-sheet 3 and the one activity showing a lossin Worksheet 2, column (e). They fill in the

names of the activities and the schedules orforms on which each loss will be reported inthe two left columns of Worksheet 4.

1) In column (a), they enter the losses fromWorksheet 2, column (e) and Worksheet3, column (d). These losses are enteredas positive numbers, not in brackets.They add the numbers and enter thetotal, $36,943, on the Totalline.

2) They divide each of the losses in column(a) by the amount on the column (a)Totalline, and enter each result in col-umn (b). The ratios must total 1.00.

3) Now they use the computation work-sheet for column (c) (see Worksheet 4

in the instructions for Form 8582) to fig-ure the unallowed loss to allocate incolumn (c).

a) On line A of the computation work-sheet, they enter the amount fromline 3 of Form 8582, $41,216, as apositive number.

b) On line B, they enter the amountfrom line 9 of Form 8582, $5,673.

c) They subtract line B from line A andenter the result, $35,543, on lineC. This is the total unallowed loss.

They multiply line C, $35,543, by each of theratios in column (b) and enter the results incolumn (c). These amounts are the unal-lowed loss from each activity and must addup to $35,543.

Step SixUsingWorksheets 5 and 6Charles and Lily now decide whether theymust use Worksheet 5, Worksheet 6, or bothto figure their allowed losses. If the loss fromany activity entered on Worksheet 4 is re-ported on only one form or schedule, thenWorksheet 5 is used for that activity. If anactivity has a loss that is reported on two ormore schedules or forms (for example, a loss

that must be reported partly on Schedule Cand partly on Form 4797) or on different partsof the same form or schedule (for example,28%-rate and non-28%-rate capital lossesreported in Part II of Schedule D), Worksheet6 is used for that activity. All of the activitiesCharles and Lily entered on Worksheet 4 willbe reported on Schedule E. Therefore, theyuse Worksheet 5 to figure the allowed loss foreach activity. (Worksheet 6 is not shownhere.)

Worksheet 5. They fill out Worksheet 5 with

the activities from Worksheet 4.

1) They enter the names of the activitiesand the schedules to be used in the twoleft columns of Worksheet 5.

2) In column (a), they enter the total loss foreach activity. This includes the currentyear loss plus the prior year unallowedloss. They find these amounts by addingcolumns (b) and (c) on Worksheets 1and 2.

3) In column (b), they enter the unallowedloss for each activity already figured inWorksheet 4, column (c). They mustsave this information to use next year infiguring their passive losses.

4) In column (c), they figure their allowedlosses for 2000 by subtracting their un-allowed losses, column (b), from theirtotal losses, column (a). These allowedlosses are entered on the appropriateschedules.

Reporting allowed losses. Charles and Lilyenter their allowed losses from Activities Aand B on Schedule E, Part I, line 23, becausethese are rental properties. They report theirallowed loss from Partnership #4 on ScheduleE, Part II.

Step SevenFinishing theReporting of the PassiveActivitiesCharles and Lily summarize the entries onSchedule E, Schedule D, and Form 4797, andenter the amounts on the appropriate linesof their Form 1040. They enter:

1) The total Schedule D gain, $22,076, online 13, and

2) The Schedule E loss, ($21,094), on line17.

Charles and Lily are now able to completetheir tax return, having correctly limited theirlosses from their passive activities.

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Charles Woods

Lily Woods

6 925 Count ry Road

Anyt own, VA 223 0 6

123 0 0 456 7

56 7 0 0 123 4

2

2

132,0 0 0

22,076

(21,09 4)

132 ,98 2

132 ,98 2

Department of the TreasuryInternal Revenue Service

1040 U.S. Individual Income Tax ReturnOMB No. 1545-0074For the year Jan. 1Dec. 31, 2000, or other tax year beginning , 2000, ending , 20

Last nameYour first name and initial Your social security number

(Seeinstructionson page 19.)

LABEL

HERE

Last name Spouses social securitynumberIf a joint return, spouses first name and initial

Use the IRSlabel.Otherwise,

please printor type.

Home address (number and st reet ). If you have a P.O. box, see page 19. Apt. no.

City, town or post office, state, and ZIP code. If you have a foreign address, see page 19.

PresidentialElection Campaign(See page 19.)

1 SingleFiling Status 2 Married filing joint return (even if only one had income)

3

Check onlyone box.

4

Qualifying widow(er) with dependent child (year spouse died ). (See page 19.)5

6a Yourself. If your parent (or someone else) can claim you as a dependent on his or her tax

return, do not check box 6aExemptionsSpouseb

(4) if qualifyingchild for child tax

credit (see page 20)Dependents:c (2) Dependentssocial security number

(3) Dependentsrelationship to

you(1) First name Last name

If more than sixdependents,see page 20.

d Total number of exemptions claimed

7Wages, salaries, tips, etc. Attach Form(s) W-27

8a8a Taxable interest. Attach Schedule B if requiredIncome8bb Tax-exempt interest. Do not include on line 8aAttach

Forms W-2 andW-2G here.

Also attachForm(s) 1099-Rif tax waswithheld.

99 Ordinary dividends. Attach Schedule B if required

1010 Taxable refunds, credits, or offsets of state and local income taxes (see page 22) 1111 Alimony received

1212 Business income or (loss). Attach Schedule C or C-EZ

Enclose, but donot attach, anypayment. Also,please useForm 1040-V.

1313 Capital gain or (loss). Attach Schedule D if required. If not required, check here

1414 Other gains or (losses). Attach Form 4797

15a 15bTotal IRA distributions b Taxable amount (see page 23)15a

16b16aTotal pensions and annuities b Taxable amount (see page 23)16a

1717 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E1818 Farm income or (loss). Attach Schedule F

1919 Unemployment compensation

20b20a b Taxable amount (see page 25)20a Social security benefits

2121

22 Add the amounts in the far right column for lines 7 through 21. This is your total income 22

23IRA deduction (see page 27)23

Medical savings account deduction. Attach Form 8853 2525

One-half of self-employment tax. Attach Schedule SE

26

Self-employed health insurance deduction (see page 29)

26

2727

Self-employed SEP, SIMPLE, and qualified plans

2828

Penalty on early withdrawal of savings

2929

Alimony paid b Recipients SSN

32Add lines 23 through 31a

30

Subtract line 32 from line 22. This is your adjusted gross income

31a

AdjustedGrossIncome

33

If you did notget a W-2,see page 21.

Form

Married filing separate return. Enter spouses social security no. above and full name here.

Cat. No. 11320B

Label

Form 1040 (2000)

IRS Use OnlyDo not write or staple in this space.

Head of household (with qualifying person). (See page 19.) If the qualifying person is a child but not your dependent,

enter this childs name here.

Other income. List type and amount (see page 25)

Moving expenses. Attach Form 3903

24 24

(99)

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see page 56.

No. of boxeschecked on6a and 6b

No. of your

children on 6cwho:

Dependents on 6cnot entered above

Add numbersentered onlines above

lived with you

did not live withyou due to divorceor separation(see page 20)

32

31a

Student loan interest deduction (see page 27)

30

33

2000

Important!

NoYes

Note. Checking Yes will not change your tax or reduce your refund.

Do you, or your spouse if filing a joint return, want $3 to go to this fund?

You must enteryour SSN(s) above.

YesNo

SpouseYou

Page 12


13/24

Charles and Lily Woods 123 0 0 456 7

Part nership #2(ent ire disposit ion of

passive act ivit y) 12-2-91 12-4-0 0 25,30 0 10 ,0 0 0 15,30 0Part nership #3

(ent ire disposit ion ofpassive act ivit y) 12-15-92 11-18 -0 0 15,0 0 0 11,0 00 4,0 0 0

2,776

22,076

40,300

*28% rate gain or loss includes all collectibles gains and losses (as defined on page D-6) and up to 50% of the eligible gainon qualified small business stock (see page D-4).

OMB No. 1545-0074SCHEDULE D Capital Gains and Losses(Form 1040)

Attach to Form 1040. See Instructions for Schedule D (Form 1040).Department of the TreasuryInternal Revenue Service

AttachmentSequence No. 12 Use Schedule D-1 for more space to list transactions for lines 1 and 8.

Your social security numberName(s) shown on Form 1040

Short-Term Capital Gains and LossesAssets Held One Year or Less

(f) Gain or (loss)Subtract (e) from (d)

(e) Cost orother basis

(see page D-6)

(a) Description of property(Example: 100 sh. XYZ Co.)

(d) Sales price(see page D-6)

(c) Date sold(Mo., day, yr.)

1

Enter your short-term totals, if any, fromSchedule D-1, line 2

2

Total short-term sales price amounts.

Add column (d) of lines 1 and 23

3

5

Short-term gain from Form 6252 and short-term gain or (loss) from Forms 4684,

6781, and 88245

66

Net short-term gain or (loss) from partnerships, S corporations, estates, and trustsfrom Schedule(s) K-1

7

Short-term capital loss carryover. Enter the amount, if any, from line 8 of your1999 Capital Loss Carryover Worksheet

Net short-term capital gain or (loss). Combine column (f) of lines 1 through 6

Long-Term Capital Gains and LossesAssets Held More Than One Year

8

Enter your long-term totals, if any, fromSchedule D-1, line 9

9

10 Total long-term sales price amounts.

Add column (d) of lines 8 and 9 10

11Gain from Form 4797, Part I; long-term gain from Forms 2439 and 6252; andlong-term gain or (loss) from Forms 4684, 6781, and 8824

11

1212

13

Net long-term gain or (loss) from partnerships, S corporations, estates, and trustsfrom Schedule(s) K-1

14

Capital gain distributions. See page D-1

15 15

14

16

Long-term capital loss carryover. Enter in both columns (f) and (g) the amount, ifany, from line 13 of your 1999 Capital Loss Carryover Worksheet ( )

Combine column (g) of lines 8 through 14

Net long-term capital gain or (loss). Combine column (f) of lines 8 through 14 16

For Paperwork Reduction Act Notice, see Form 1040 instructions. Schedule D (Form 1040) 2000Cat. No. 11338H

us internal revenue service: p925--2000

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