J will treat $2,500 (50% x $5,000) of his interest income on the loan to A as passive activity income
. This represents J's interest income ($5,000) multiplied by his share of the LLC's passive interest expense from all member loans ($2,500) divided by the greater of (1) J's share of A's interest expense on all member loans used for passive activities or otherwise ($2,500), or (2) J's interest income from A ($5,000).
This passive activity income
from Property B can be offset by the $6,400 loss from Property A, so Brett reports a taxable profit of only a net $1,100.
Interest, capital gains, dividends, annuities, passive activity income
and rental income are all considered investment income.
Taxpayers may only deduct passive activity losses to the extent they receive passive activity income
. In addition, any excess loss can be carried forward to offset passive income in future years, or taxpayers may choose to deduct the loss when the property is sold in a fully taxable transaction.
Because IRC section 1411(c)(2) treats passive activity income
as net investment income, such income will be exposed to the Medicare contribution tax.
Certain income and expenses of a passive activity are not considered passive activity income
or expenses in determining passive activity income
and loss: income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business; expenses allocable to such income; and gain or loss not derived in the ordinary course of a trade or business that is attributable to the disposition of property either producing such income or held for investment.
If there is no passive activity income
to use as an offset, the losses are suspended indefinitely until the investor sells his entire investment in the passive activity in a taxable transaction.
In general, losses from passive activities are deductible in a given year to the extent the passive activity income
exceeds the losses from passive activities.
IRC section 469 states that a taxpayer can use losses from a passive activity only to offset passive activity income
. In other words, passive losses cannot shelter active income such as salaries, commissions, wages or portfolio income such as interest, dividend or annuity income.
Considerations include the size of the interest payments, the amount of rental income received from the property, the availability of other passive activity income
, and, of course, the taxpayer's AGI.
That means that any loss attributable to rental real estate - whether it's derived from a cash loss via a poor marketplace, or whether it's a `phantom loss' generated primarily through depreciation - falls into the passive category and can only be offset against passive activity income
. The Tax Act thereby created a disincentive for putting money into property.
* Passive activity credits are not affected by the disposition of the activity and remain suspended until they can offset tax attributable to passive activity income