One drawback of investing in a limited partnership is the hassle of dealing with the K-1 form you receive reporting your share of income and deductions that the partnership passed on to you during the year. Similarly,if you are a shareholder in a Subchapter S corporation,you get a K-1 showing your share of income. In either case, you must transfer the information from the K-1 to the proper place on your tax return. TaxCut will walk you through this process.
For years, Congress chipped away at tax shelters, those investments with more tax appeal than economic sense. And with the "passive loss" rules, the lawmakers struck a powerful blow to deals that thrive on the seemingly daffy promise of huge losses. The weapon is tight restrictions on losses from "passive" activities, a classification that includes businesses in which the investor does not "materially" participate—including all limited partnerships. The material-participation test is a tough one, demanding that you be regularly and substantially involved in the business year-round.
The killer is that losses from investments branded passive can only be deducted against "passive income," that is, income from profitable passive activities. Passive losses can't be used to shelter income from other activities, such as your job or investments in stocks and bonds. The law prevents paper losses generated by a limited partnership—via the pass-through of oil depletion write-offs, perhaps, or real estate depreciation deductions—from wiping out part of the tax bill on your salary or portfolio income. Most passive losses come from limited partnerships and real estate.
Consider the case of two brothers who jointly own a tobacco store. One brother actually runs the store, working 40 hours a week and making most of the purchasing and hiring decisions single-handedly. The other brother's interest is mostly financial, and although he has a voice in major decisions, he is seldom involved in the day-to-day operations. The brother who works in the store would pass the material-participation test and wouldn't have to worry about the passive-activity rule. His brother, however, would be tripped up by the rule and forbidden to use his share of the store's losses to shelter other income.
IRS regulations outline what's required to pass the material-participation test and thus qualify to write off business losses against nonbusiness income. You pass the test if:
Despite the restrictions on passive losses, they are not stripped of all tax value. First of all, any deductions you deserve for passive-activity-related expenses—such as interest payments or depreciation—can still offset income from the investment. Any excess loss can be used to shelter income from other passive activities, such as a profitable rental or partnership.
Beyond that, any leftover loss will be suspended and carried forward until a future year when you have passive income to offset. When you dispose of an investment that has generated unused losses, those losses are unleashed to shelter any income, whether passive or not.
If you are tripped up by the passive loss rules, you have several options. One is to ditch the investment that's throwing off suspended losses. That may be much easier said than done. You may have to take a distress-sale price that could be worse than the suspension of the tax benefits.
Another choice is to seek out investments that produce passive income. Such passive-income generators—affectionately known as PIGs—could give you the income you need to absorb passive losses. With the general crackdown on shelters, many real estate limited partnerships are being designed as income producers—with less debt and therefore less in mortgage interest deductions to be passed on to investors.
Whether it makes sense to search for a PIG depends in part on how long you plan to keep the investment that's generating the losses. If it's a bad deal that you ought to get out of before throwing good money after bad, don't look for a PIG. As soon as you unload the investment, you'll trigger the suspended losses. On the other hand, if the deal is economically sound and you intend to hold on to it for another ten years, a PIG can be attractive.
Another point to keep in mind: The passive loss rules create planning opportunities along with these headaches. Losses suspended now could wind up being worth more to you in the future when you get to use them—to shelter a big profit when you finally dispose of the passive investment, for example. That's particularly true if the alternative to generating unusable passive income now is an investment offering only mediocre return or if future tax laws raise tax rates. Who knows, a loss suspended when you were in the 25% bracket might be triggered when you face a much higher rate.