passive activity passive activity limits and at-risk rules · net passive income. passive activity...

ContentsIntroduction ........................................ 1

Passive Activity Limits ...................... 2Who Must Use These Rules? ........ 2Passive Activities ............................ 2Activities That Are Not Passive

Activities ................................... 4Passive Activity Income .................. 5Passive Activity Deductions ............ 6Grouping Your Activities ................. 6Recharacterization of Passive

Income ..................................... 7Dispositions ..................................... 9How To Report Your Passive

Activity Loss ............................. 9

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

At-Risk Limits ..................................... 19Who Is Affected? ............................ 19Activities Covered by the At-Risk

Rules ........................................ 19At-Risk Amounts ............................. 20Amounts Not At Risk ...................... 21Reductions of Amounts At Risk ...... 21Recapture Rule ............................... 21

How To Get More Information .......... 21

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

Important Changefor 1999Photographs 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 1–800–THE–LOST (1–800–843–5678) 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 figureyour allowable losses from any activity, youmust apply the at-risk rules before thepassive activity rules.

Useful ItemsYou may want to see:

Publication

� 527 Residential Rental Property (In-cluding Rental of VacationHomes)

� 541 Partnerships

Departmentof theTreasury

InternalRevenueService

Publication 925Cat. No. 64265X

Passive ActivityandAt-Risk RulesFor use in preparing

1999 Returns

Form (and Instructions)

� 4952 Investment Interest Expense De-duction

� 6198 At-Risk Limitations

� 8582 Passive Activity Loss Limitations

� 8582–CR Passive Activity Credit Limita-tions

� 8810 Corporate Passive Activity Lossand Credit Limitations

See How To Get More Information nearthe end of this publication for informationabout getting these publications and forms.

Passive Activity LimitsGenerally, you are in a passive activity if youhave a trade or business activity in which youdo not materially participate during the taxyear, or a rental activity. These terms areexplained later.

If you have a loss, you must determineyour 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 8582–CR 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 activity

credits to PTPs, see Publicly Traded Part-nerships (PTPs) in the instructions for Forms8582 and 8582–CR, 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.

Personal service corporation. For thepassive activity rules, a corporation is a per-sonal service corporation if it meets all of thefollowing requirements.

1) It is not an S corporation.

2) Its principal activity during the “testingperiod” is performing personal services.The testing period for any tax year is theprevious tax year. If the corporation hasjust been formed, the testing period be-gins on the first day of its tax year andends on the earlier of:

a) The last day of its tax year, or

b) The last day of the calendar year inwhich its tax year begins.

3) Its employee-owners substantially per-form the services in (2), above. This re-quirement is met if more than 20% of thecorporation's compensation cost for itsactivities of performing personal servicesduring the testing period is for personalservices performed by employee-owners.

4) Its employee-owners own more than10% of the fair market value of its out-standing stock on the last day of thetesting period.

Personal services. Personal servicesare those in the fields of health (includingveterinary services), law, engineering, archi-tecture, accounting, actuarial science, per-forming arts, and consulting.

Employee-owners. A person is anemployee-owner of a personal service cor-poration if both of the following apply.

1) He or she is an employee of the corpo-ration, or performs personal services foror on behalf of the corporation (even ifhe or she is an independent contractorfor other purposes), on any day of thetesting period.

2) He or she owns any stock in the corpo-ration at any time during the testing pe-riod.

Closely held corporation. For the passiveactivity rules, a corporation is closely held ifall of the following apply.

1) It is not an S corporation.

2) It is not a personal service corporation,defined earlier.

3) At any time during the last half of the taxyear, more than 50% of the value of itsoutstanding stock is directly or indirectlyowned by five or fewer individuals. “In-dividual” includes certain trusts and pri-vate foundations.

Net active income offset. A closely heldcorporation 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 Activities There are two kinds of passiveactivities—trade 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.If you have net income from a former passiveactivity in the current year and a prior yearunallowed loss from that activity, you mustoffset your net income from that activity by theprior year unallowed loss. Treat any remain-ing prior year unallowed loss like you treatany other passive loss.

You must also offset the allocable part ofyour current year tax liability with any prioryear unallowed passive activity credits froma former passive activity. The allocable partof your current year tax liability refers to thatpart of this year's tax liability that is allocableto the current year net income from the formerpassive activity. You figure this after you re-duce your net income from the activity by anyprior year unallowed loss from that activity(but not below zero).

Trade or Business Activities A 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, C–EZ, F, or in PartII or III of Schedule E.

Rental Activities A 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 representsamounts 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 any of 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 rentals.If the activity involves renting more thanone class of property, multiply the aver-age period of customer use of each classby a fraction. The numerator of the frac-tion is the gross rental income from thatclass of property, and the denominatoris the activity's total gross rental income.The activity's average period of customeruse will 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,

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 orbusiness 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 incomeexceeds 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 returnis required.

The choice is irrevocable and cannot bemade 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 all in-terests 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 includedon Form 8582,

6) Any rental real estate loss allowed be-cause you materially participated in therental activity as a real estate profes-

Salary ......................................................... $42,300Dividends ................................................... 300Interest ....................................................... 1,400Rental loss ................................................. (4,000)

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 1999 John was unmar-ried and was not a real estate professional.For 1999 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 1999 return, he may deductonly $15,000 of his passive activity loss. Hemust carry over the remaining $16,000 pas-sive activity loss to 2000. 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 investmentcredits 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 Activities The following are not passive 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 an

entity 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 1.469–1T(e)(4)(ii).

3) The rental of a dwelling unit that you alsoused for personal purposes during theyear for more than the greater of 14days 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 1.469–1T(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, but on the forms or schedules

you would normally use.

Material Participation A 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 satisfyany of 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 operationsof the activity for your own use, and

3) Monitoring the finances or operations ofthe 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 documentsif 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.

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

Minus required reduction (see above) ..... 10,000

Adjusted special allowance ..................... $15,000

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

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

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

Limited partners. If you owned an activityas a limited partner, you generally did notmaterially participate in the activity. However,you did materially participate in the activity ifyou materially participated for the tax yearunder test (1), (5), or (6).

You are not treated as a limited partner,however, if you were a general partner in thepartnership at all times during the partner-ship's tax year ending with or within your taxyear (or, if shorter, during that part of thepartnership's tax year in which you directlyor indirectly owned your limited partner inter-est).

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

Real Estate Professional Generally, 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 activityis 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 1999, 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 estateprofessional 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 were performed in real propertytrades or businesses in which youmaterially participated.

2) You performed more than 750 hours ofservices in real property trades or busi-

nesses in which you materially partic-ipated.

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.

• Constructs or reconstructs.

• Acquires.

• Converts.

• Rents or leases.

• Operates or manages.

• Brokers.

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 Income In 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 PubliclyTraded 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 underthe interest expense allocation rules.See chapter 8 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 marketvalue 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'suse 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 tax year and all deductions frompassive activities that were disallowed underthe passive loss rules in prior tax years andcarried forward to the tax year. They also in-clude losses from dispositions of propertyused in a passive activity at the time of thedisposition and losses from a disposition ofless than your entire interest in a passive ac-tivity.

Passive activity deductions do not includethe following items.

1) Expenses (other than interest) that areclearly and directly allocable to portfolioincome.

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

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 Activities You 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. Onthe 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 Units Generally, to determine if more than one ac-tivity forms an appropriate economic unit, youmust consider all the relevant facts and cir-cumstances. You can use any reasonablemethod of applying the relevant facts andcircumstances in grouping activities. The fol-lowing factors have the greatest weight indetermining whether activities form an ap-propriate economic unit. All of the factors donot have to apply to treat more than one ac-tivity as a single activity. The factors that youshould 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 theextent 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 morethan 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 jointreturn, 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-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 1245property under 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 thatactivity 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 onlyto determine whether you materially or sig-nificantly participated in those other activities.See Material Participation under ActivitiesThat Are Not Passive Activities, earlier, andSignificant Participation Passive Activitiesunder Recharacterization of Passive Income,later.

Publicly traded partnership (PTP). Youmay not group activities conducted through aPTP with any other activity, including an ac-tivity conducted through another PTP. SeePublicly Traded Partnerships (PTPs) in theinstructions for Form 8582.

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

Significant ParticipationPassive Activities A 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.See Material Participation under ActivitiesThat Are Not Passive Activities, earlier.

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.

Worksheet A. Complete Worksheet A, Sig-nificant Participation Passive Activities, if youhave income or losses from any significantparticipation activity. Enter the names of theactivities in the 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 activitiesare 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.

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 (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 theTotals row 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.

If column (d) shows net income and youmust complete Form 8582 because you haveother passive activities to report, completeWorksheet B. However, you do not have tocomplete Form 8582 if column (d) shows netincome and you have only significant partici-pation activities. If you do not have to com-plete Form 8582, skip Worksheet B and re-port 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.

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 totalof 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. (But see Limit onrecharacterized passive income under Re-characterization of Passive Income, 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 1.469–2T(f)(4).

Rental of Property Incidentalto a Development ActivityNet passive income from this type of activitywill be treated as nonpassive income if all ofthe 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 whole

or in part by reference to the basis of thatitem of property).

For more information, see Regulationssection 1.469–2(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 areincludable 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.

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

Dispositions Any 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 passiveactivity, the loss may be limited by the

capital loss rules. The limit is generally $3,000for individuals. See Publication 544, Salesand Other Dispositions of Assets, for moreinformation.

Treatment of excess losses. If all gain orloss realized on the disposition is recognized,do not treat as a loss from a passive activitythe excess of:

1) Any loss from the activity for the tax year(including losses carried over from prioryears and any loss realized on the dis-position), over

2) Net income or gain for the tax year fromall other passive activities (taking intoaccount prior year disallowed losses).

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:

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 as 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 thecurrent 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.

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 beincreased 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 of

disposition. 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 ofdeath, 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 part of the activity disposed ofas a separate activity. See Partial dispositionsunder 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 andtypes 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 8582–CR, 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 Form

Sales price ................................................. $30,000

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

1040, 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 1999. 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 1999 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 1999. Their records alsoshow a gain of $2,776 in 1999 from thesale of section 1231 assets used in theactivity. That section 1231 gain is re-ported in Part I of Form 4797. In 1998they completed the Worksheets in theinstructions for Form 8582 and calcu-lated that $6,667 of Activity A's ScheduleE loss for 1998 was disallowed by thepassive activity rules. That loss is carriedover to 1999 as a prior year unallowedSchedule E loss.

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$11,600 in 1999. In 1998 they com-pleted the Worksheets in the instructionsfor Form 8582 and calculated that$8,225 of Activity B's Schedule E loss for1998 was disallowed by the passive ac-tivity rules. That loss is carried over to1999 as a prior year unallowed ScheduleE loss.

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 1999profits to Charles and Lily on line 1 ofSchedule K–1 (Form 1065). They reportthat profit on Schedule E. In 1998 theycompleted the Worksheets in the in-structions for Form 8582 and calculatedthat $2,600 of their distributive share ofthe loss from Partnership #1 in 1998 wasdisallowed by the passive activity rules.That loss is carried over to 1999 as aprior year unallowed Schedule E loss.

4) Partnership #2 is a trade or businessactivity and also a PTP. In 1999 Charlesand Lily disposed of their entire interestin Partnership #2. They do not report thatgain on Form 8582 because Partnership#2 is 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 1999 losses to them on line1 of Schedule K–1 (Form 1065). Theyreport that loss on Schedule E. In 1998they followed the instructions for Form8582 and calculated that $2,445 of their

distributive share of Partnership #2's1998 loss was disallowed by the passiveactivity rules. That loss is carried overfrom 1998 and added to the $1,200Schedule E loss for 1999. (For dis-cussion of PTPs, see the instructions forForm 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 1999. Theyrecognize a $4,000 ($15,000 sellingprice minus $11,000 adjusted basis)long-term capital gain, which they reporton Schedule D.

In 1998 they completed the Work-sheets in the Form 8582 instructions andcalculated that $3,000 of their distributiveshare of the partnership's loss for 1998was disallowed by the passive activityrules. That loss is carried over to 1999as a prior year unallowed Schedule Eloss. Charles and Lily's distributive shareof partnership losses for 1999 reportedon line 1 of Schedule K–1 (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 of1999 partnership loss, reported on line1 of Schedule K–1 (Form 1065), is$2,400. In 1998 they completed theWorksheets in the Form 8582 in-structions and calculated that $1,500 oftheir distributive share of loss for 1998was disallowed by the passive activityrules. That loss is carried over to 1999as a prior year unallowed Schedule Eloss.

Step One—Completing 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. Theycomplete line 8 of Schedule D showing long-term capital gains of $15,300 from Partner-ship #2 and $4,000 from Partnership #3. Be-cause Partnership #2 is a PTP, it is notentered on Form 8582. Because the disposi-tion of Partnership #3 is a disposition of anentire interest in an activity with an overallloss of $5,000 ($4,000 − $3,000 − $6,000),that partnership is also not entered on Form8582. They combine the PTP $1,200 currentyear loss with its $2,445 prior year loss, andalso combine the Partnership #3 $6,000 cur-rent year loss with its $3,000 prior year loss,and enter the two combined amounts in col-umn (g) on line 27 of Schedule E, Part II.They enter the $4,000 profit from Partnership#1 in column (h). Before completing Part IIof Schedule E, they must complete Form8582 to figure out how much of their lossesfrom Partnerships #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 Two—Form 8582and its WorksheetsCharles and Lily now complete Form 8582and the worksheets that apply to their passiveactivities. Because they are at risk for theirinvestment 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. Charles and Lily enter thegains and losses on Worksheet 1 for ActivityA and Activity B (rental real estate activitieswith active participation). They enter allamounts from the activities even though theyalready reported the gain of $2,776 from Ac-tivity A on Form 4797, since all income or lossfrom these activities must be taken into ac-count to figure 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 1998.

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 1998 work-sheets.

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

3) They separately add columns (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 appropriateinformation 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, overall gain activities should beentered on the forms or schedules that wouldnormally be used. Charles and Lily have one

activity with an overall gain ($4,000 − $2,600= $1,400). This is Partnership #1, which isshown in Worksheet 2. They report this part-nership income directly on Part II, ScheduleE.

Step Three—CompletingForm 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 theyare 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 partner-ship #3 disposition. Also, on ScheduleE they combined the PTP 1999 loss of$1,200 with its prior year loss of $2,445,and combined the Partnership #3 1999loss of $6,000 with its prior year loss of$3,000. Netting these amounts givesthem the PTP overall gain of $11,655($15,300 − $1,200 − $2,445) and thePartnership #3 overall loss of $5,000($4,000 − $6,000 − $3,000) that wereused in figuring modified adjusted grossincome.

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 Four—CompletingWorksheet 3Charles and Lily must complete Worksheet 3since they have an activity with an overall lossin column (e) of Worksheet 1 and an amounton line 9 of Form 8582. This worksheet allo-cates the amount on line 9 (their special al-lowance for active participation rental real

estate activities) between Activity A and Ac-tivity B.

1) In the two left columns, they write thenames of the activities, A and B, and theschedules 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) Total lineand entering the result in (b). The totalof 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 Five—CompletingWorksheet 4Worksheet 4 must be completed if there isan overall loss in column (e) of Worksheet 2or losses in column (d) of Worksheet 3 (orcolumn (e) of Worksheet 1 if Worksheet 3 wasnot needed). This worksheet allocates theunallowed loss among the activities with anoverall loss. Charles and Lily fill out Work-sheet 4 with the activities from Worksheet 3and the one activity showing a loss in Work-sheet 2, column (e). They fill in the names ofthe activities and the schedules or forms onwhich each loss will be reported in the two leftcolumns 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 Total line.

2) They divide each of the losses in column(a) by the amount on the column (a)Total line, 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 4in 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 in

column (c). These amounts are the unal-lowed loss from each activity and must addup to $35,543.

Step Six—UsingWorksheets 5 and 6Charles and Lily now decide whether theymust use Worksheet 5, Worksheet 6, or bothto figure their allowed losses. If the loss froman activity entered on Worksheet 4 is reportedon only one form or schedule, then Work-sheet 5 is used. If an activity has a loss thatis reported on two or more schedules or forms(for example, a loss that must be reportedpartly on Schedule C and partly on Form4797), Worksheet 6 is used. Charles and Lilydetermine that all of the activities they enteredon Worksheet 4 will be reported on ScheduleE. Therefore, they use Worksheet 5 to figurethe allowed loss for each activity. (Worksheet6 is not illustrated.)

Worksheet 5. They fill out Worksheet 5 withthe 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. These losses include thecurrent year loss plus the prior year un-allowed loss. They find these amountsby adding columns (b) and (c) on Work-sheets 1 and 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 1999 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 Seven—Finishing 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.

Charles Woods

Lily Woods

6925 Country Road

Anytown, VA 22306

123 00 4567

567 00 1234

�

2

2

132,000

22,076

(21,094)

132,982

132,982

�

�

�

�

Department of the Treasury—Internal Revenue Service1040 U.S. Individual Income Tax ReturnOMB No. 1545-0074For the year Jan. 1–Dec. 31, 1999, or other tax year beginning , 1999, ending ,

Last nameYour first name and initial Your social security number

(Seeinstructionson page 18.)

LABEL

HERE

Last name Spouse’s social security numberIf a joint return, spouse’s first name and initial

Use the IRSlabel.Otherwise,please printor type.

Home address (number and street). If you have a P.O. box, see page 18. Apt. no. IMPORTANT!

City, town or post office, state, and ZIP code. If you have a foreign address, see page 18.

PresidentialElection Campaign(See page 18.)

Note. Checking“Yes” will notchange your tax orreduce your refund.

NoYes

Do you want $3 to go to this fund?If a joint return, does your spouse want $3 to go to this fund?

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 � 19 ). (See page 18.)5

6a Yourself. If your parent (or someone else) can claim you as a dependent on his or her taxreturn, do not check box 6aExemptions

Spouseb(4) if qualifyingchild for child tax

credit (see page 19)

Dependents:c (2) Dependent’ssocial security number

(3) Dependent’srelationship to

you(1) First name Last name

If more than sixdependents,see page 19.

d Total number of exemptions claimed

7Wages, salaries, tips, etc. Attach Form(s) W-278a8a Taxable interest. Attach Schedule B if requiredIncome

8bb Tax-exempt interest. DO NOT include on line 8aAttach Copy B of yourForms W-2 andW-2G here.Also attachForm(s) 1099-Rif tax waswithheld.

99 Ordinary dividends. Attach Schedule B if required1010 Taxable refunds, credits, or offsets of state and local income taxes (see page 21)1111 Alimony received1212 Business income or (loss). Attach Schedule C or C-EZ

Enclose, but donot staple, 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 479715a 15bTotal IRA distributions b Taxable amount (see page 22)15a

16b16aTotal pensions and annuities b Taxable amount (see page 22)16a1717 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E1818 Farm income or (loss). Attach Schedule F1919 Unemployment compensation

20b20a b Taxable amount (see page 24)20a Social security benefits2121

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

23IRA deduction (see page 26)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 28)

262727

Keogh and self-employed SEP and SIMPLE plans

2828

Penalty on early withdrawal of savings

2929

Alimony paid b Recipient’s 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 20.

Form

Married filing separate return. Enter spouse’s social security no. above and full name here. �

Cat. No. 11320B

�

�

Label

Form 1040 (1999)

IRS Use Only—Do not write or staple in this space.

Head of household (with qualifying person). (See page 18.) If the qualifying person is a child but not your dependent,enter this child’s name here. �

Other income. List type and amount (see page 24)

Moving expenses. Attach Form 3903

24 24

(99)

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see page 54.

No. of boxeschecked on6a and 6bNo. of yourchildren on 6cwho:

Dependents on 6cnot entered above

Add numbersentered onlines above �

● lived with you● did not live withyou due to divorceor separation(see page 19)

32

31a

Student loan interest deduction (see page 26)

30

33

You must enteryour SSN(s) above.

� �

1999

Charles and Lily Woods 123 00 4567

Partnership #2(entire disposition of

passive activity) 12-2-91 12-4-99 25,300 10,000 15,300Partnership #3

(entire disposition ofpassive activity) 12-15-92 11-18-99 15,000 11,000 4,000

2,776

22,076

40,300

*28% Rate Gain or Loss includes all “collectibles gains and losses” (as defined on page D-5) 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 Losses—Assets Held One Year or Less(f) GAIN or (LOSS)Subtract (e) from (d)

(e) Cost orother basis

(see page D-5)

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

(d) Sales price(see page D-5)

(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 2

33

5

Short-term gain from Form 6252 and short-term gain or (loss) from Forms 4684,6781, and 8824

5

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 your1998 Capital Loss Carryover Worksheet

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

Long-Term Capital Gains and Losses—Assets 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 1998 Capital Loss Carryover Worksheet ( )

Combine lines 8 through 14 in column (g)

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

For Paperwork Reduction Act Notice, see Form 1040 instructions. Schedule D (Form 1040) 1999Cat. No. 11338H

( )

44

Part I

Part II7

13

(b) Dateacquired

(Mo., day, yr.)

2

9

(99)

(f) GAIN or (LOSS)Subtract (e) from (d)

(e) Cost orother basis

(see page D-5)

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

(d) Sales price(see page D-5)

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

(b) Dateacquired

(Mo., day, yr.)

(g) 28% RATE GAINor (LOSS)

*(see instr. below)

Next: Go to Part III on the back.

1999

( )

Charles and Lily Woods 123 00 4567

Brick Duplex -- 6924 -- 26 Country RoadAnytown, VA 22306

Condo -- 6915 Country RoadAnytown, VA 22306

�

�

25,000

600

1,5001,200

2,0001,000

9,000

700600

2,0002,4009,000Wages and

salaries

30,000

10,00040,000

(15,000)

6,155

8,300

210

525420700390

8,510

245210

700840

3,150

15,900

4,00019,900

(11,600)

3,546

33,300

17,510

45,900

14,000

9,701

(9,701)

SCHEDULE E OMB No. 1545-0074Supplemental Income and Loss(Form 1040) (From rental real estate, royalties, partnerships,

S corporations, estates, trusts, REMICs, etc.)� Attach to Form 1040 or Form 1041. � See Instructions for Schedule E (Form 1040).

Department of the TreasuryInternal Revenue Service

Attachment Sequence No. 13

Your social security numberName(s) shown on return

Income or Loss From Rental Real Estate and Royalties Note: Report income and expenses from your business of rentingpersonal property on Schedule C or C-EZ (see page E-1). Report farm rental income or loss from Form 4835 on page 2, line 39.

Show the kind and location of each rental real estate property:1

A

B

C

NoYes2

A

B

CProperties Totals

(Add columns A, B, and C.)Income: CBA3 33 Rents received

4 Royalties received 44

Expenses:5Advertising56Auto and travel (see page E-2)67Cleaning and maintenance78Commissions89Insurance9

1010 Legal and other professional fees11

Mortgage interest paid to banks,etc. (see page E-2) 12

11

12

Other interest

12

13

Repairs13

14

Supplies14

15

Taxes15

16

Utilities16

1717Other (list) �18

18

1919Add lines 5 through 1819

Depreciation expense or depletion(see page E-3)

2020 2021Total expenses. Add lines 19 and 2021

Income or (loss) from rental realestate or royalty properties.Subtract line 21 from line 3 (rents)or line 4 (royalties). If the result isa (loss), see page E-3 to find outif you must file Form 6198

22

22

Deductible rental real estate loss.Caution: Your rental real estateloss on line 22 may be limited. Seepage E-3 to find out if you mustfile Form 8582. Real estateprofessionals must complete line42 on page 2

23

)( )()(232424 Income. Add positive amounts shown on line 22. Do not include any losses

)(25Losses. Add royalty losses from line 22 and rental real estate losses from line 23. Enter total losses here2526 Total rental real estate and royalty income or (loss). Combine lines 24 and 25. Enter the result here.

If Parts II, III, IV, and line 39 on page 2 do not apply to you, also enter this amount on Form 1040,line 17. Otherwise, include this amount in the total on line 40 on page 2 26

For Paperwork Reduction Act Notice, see Form 1040 instructions. Cat. No. 11344L Schedule E (Form 1040) 1999

Part I

Management fees

(99)

For each rental real estate propertylisted on line 1, did you or your familyuse it during the tax year for personalpurposes for more than the greater of:● 14 days, or● 10% of the total days rented at

fair rental value?(See page E-1.)

1999

Partnership #2Partnership #3Partnership #1Partnership #4

(entire disposition of passive activity) P 10-167281010-987624310-556665010-7435837

�

PTP (3,645)(9,000)(2,600)

(148)4,000

4,000(15,393)

4,00015,393

(11,393)

(21,094)

(entire disposition of passive activity) PPP

��

From

Page 2Attachment Sequence No. 13Schedule E (Form 1040) 1999

Your social security numberName(s) shown on return. Do not enter name and social security number if shown on other side.

Note: If you report amounts from farming or fishing on Schedule E, you must enter your gross income from those activities on line41 below. Real estate professionals must complete line 42 below.

Income or Loss From Partnerships and S Corporations Note: If you report a loss from an at-risk activity, you MUST checkeither column (e) or (f) on line 27 to describe your investment in the activity. See page E-5. If you check column (f), you must attach Form 6198.

(b) Enter P forpartnership; S

for S corporation

(c) Check ifforeign

partnership

Investment At Risk?(d) Employeridentification

number(a) Name27 (e) All is

at risk(f) Some isnot at risk

ABCDE

Nonpassive Income and LossPassive Income and Loss

(i) Nonpassive lossfrom Schedule K–1

(h) Passive income from Schedule K–1

(k) Nonpassive income from Schedule K–1

(g) Passive loss allowed(attach Form 8582 if required)

(j) Section 179 expensededuction

from Form 4562

ABCDE

Totals28aTotalsb

2929 Add columns (h) and (k) of line 28a)(3030 Add columns (g), (i), and (j) of line 28b

Total partnership and S corporation income or (loss). Combine lines 29 and 30. Enter the resulthere and include in the total on line 40 below

3131

Income or Loss From Estates and Trusts(b) Employer

identification number(a) Name32

AB

Passive Income and Loss Nonpassive Income and Loss(e) Deduction or lossfrom Schedule K–1

(d) Passive incomefrom Schedule K–1

(f) Other income fromSchedule K–1

(c) Passive deduction or loss allowed(attach Form 8582 if required)

AB

Totals33ab Totals

34Add columns (d) and (f) of line 33a34)(3535 Add columns (c) and (e) of line 33b

36 Total estate and trust income or (loss). Combine lines 34 and 35. Enter the result here and includein the total on line 40 below 36

Income or Loss From Real Estate Mortgage Investment Conduits (REMICs)—Residual Holder(c) Excess inclusion fromSchedules Q, line 2c (see

page E-6)

(e) Income from Schedules Q,line 3b

(d) Taxable income (net loss)from Schedules Q, line 1b

(b) Employeridentification number(a) Name37

38 Combine columns (d) and (e) only. Enter the result here and include in the total on line 40 below 38Summary

39Net farm rental income or (loss) from Form 4835. Also, complete line 41 below39TOTAL income or (loss). Combine lines 26, 31, 36, 38, and 39. Enter the result here and on Form 1040, line 17 �40 40

Reconciliation of Farming and Fishing Income. Enter your grossfarming and fishing income reported on Form 4835, line 7; ScheduleK-1 (Form 1065), line 15b; Schedule K-1 (Form 1120S), line 23; andSchedule K-1 (Form 1041), line 14 (see page E-6)

41

41

Part III

Part V

Part IV

Part II

Reconciliation for Real Estate Professionals. If you were a real estateprofessional (see page E-4), enter the net income or (loss) you reportedanywhere on Form 1040 from all rental real estate activities in whichyou materially participated under the passive activity loss rules

42

42

Schedule E (Form 1040) 1999

Charles and Lily Woods 123-00-4567

Land fromActivity A

1-4-91 1-5-99 6,000 3,224 2,776(From passiveactivity)

2,776

Sales of Business Property(Also Involuntary Conversions and Recapture Amounts

Under Sections 179 and 280F(b)(2))Department of the Treasury Internal Revenue Service

Attachment Sequence No. 27� Attach to your tax return. � See separate instructions.

Identifying numberName(s) shown on return

Sales or Exchanges of Property Used in a Trade or Business and Involuntary Conversions From OtherThan Casualty or Theft—Property Held More Than 1 Year

Enter here the gross proceeds from the sale or exchange of real estate reported to you for 1999 on Form(s) 1099-S(or a substitute statement) that you will be including on line 2, 10, or 20

11

(f) Cost or otherbasis, plus

improvements andexpense of sale

(e) Depreciationallowed

or allowable sinceacquisition

(g) GAIN or (LOSS)Subtract (f) fromthe sum of (d)

and (e)

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

(b) Date acquired(mo., day, yr.)(a) Description of property (d) Gross sales

price

2

Gain, if any, from Form 4684, line 393

Section 1231 gain from installment sales from Form 6252, line 26 or 374

Gain, if any, from line 32, from other than casualty or theft

5

Combine lines 2 through 6. Enter the gain or (loss) here and on the appropriate line as follows:

6

7Partnerships (except electing large partnerships). Report the gain or (loss) following the instructions for Form1065, Schedule K, line 6. Skip lines 8, 9, 11, and 12 below.S corporations. Report the gain or (loss) following the instructions for Form 1120S, Schedule K, lines 5 and 6.Skip lines 8, 9, 11, and 12 below, unless line 7 is a gain and the S corporation is subject to the capital gains tax.All others. If line 7 is zero or a loss, enter the amount from line 7 on line 11 below and skip lines 8 and 9. If line7 is a gain and you did not have any prior year section 1231 losses, or they were recaptured in an earlier year,enter the gain from line 7 as a long-term capital gain on Schedule D and skip lines 8, 9, and 12 below.

Nonrecaptured net section 1231 losses from prior years (see instructions)8

9 Subtract line 8 from line 7. If zero or less, enter -0-. Also enter on the appropriate line as follows (see instructions):S corporations. Enter any gain from line 9 on Schedule D (Form 1120S), line 14, and skip lines 11 and 12 below.All others. If line 9 is zero, enter the gain from line 7 on line 12 below. If line 9 is more than zero, enter the amount from line 8 on line 12below, and enter the gain from line 9 as a long-term capital gain on Schedule D.

Ordinary Gains and Losses

Ordinary gains and losses not included on lines 11 through 17 (include property held 1 year or less):

Loss, if any, from line 7

10

Gain, if any, from line 7 or amount from line 8, if applicable

11

Gain, if any, from line 31

12

Net gain or (loss) from Form 4684, lines 31 and 38a

13

Ordinary gain from installment sales from Form 6252, line 25 or 36

14

Recapture of section 179 expense deduction for partners and S corporation shareholders from property dispositionsby partnerships and S corporations (see instructions)

15

Combine lines 10 through 17. Enter the gain or (loss) here, and on the appropriate line as follows:

16

17

For all except individual returns: Enter the gain or (loss) from line 18 on the return being filed.a

For individual returns:b

If the loss on line 11 includes a loss from Form 4684, line 35, column (b)(ii), enter that part of the loss here.Enter the part of the loss from income-producing property on Schedule A (Form 1040), line 27, and the partof the loss from property used as an employee on Schedule A (Form 1040), line 22. Identify as from “Form4797, line 18b(1).” See instructions

(1)

(2) Redetermine the gain or (loss) on line 18, excluding the loss, if any, on line 18b(1). Enter here and on Form1040, line 14

Form 4797 (1999)For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 13086I

Part I

Part II

OMB No. 1545-0184

Section 1231 gain or (loss) from like-kind exchanges from Form 8824

Ordinary gain or (loss) from like-kind exchanges from Form 8824

18

3

4

5

6

7

8

11

12

13

14

15

16

17

18

18b(1)

18b(2)

(99)

9

( )

19994797Form

Charles and Lily Woods 123-00-4567

2,776

26,600

14,892(38,716)

4,000

2,400

4,100(2,500)

(41,216)

38,716

150,000

138,655

11,345

5,673

5,673

6,776

12,449

Caution: See the instructions for Worksheets 1 and 2 on page 7 before completing Part I.

Rental Real Estate Activities With Active Participation (For the definition of active participationsee Active Participation in a Rental Real Estate Activity on page 3.)

Combine lines 2a, 2b, and 2c

Combine lines 1d and 2d. If the result is net income or zero, all losses are allowed, including anyprior year unallowed losses entered on line 1c or 2c. Do not complete Form 8582. Take the lossesto the form or schedule you normally report them on.

Note: Enter all numbers in Part II as positive amounts. See page 7 for examples.

Subtract line 6 from line 5

9

Combine lines 1a, 1b, and 1c

Part I

Part II

Part III

OMB No. 1545-1008Passive Activity Loss LimitationsForm 8582

� See separate instructions.Department of the TreasuryInternal Revenue Service � Attach to Form 1040 or Form 1041.

AttachmentSequence No. 88

Name(s) shown on return Identifying number

1999 Passive Activity Loss

1aActivities with net income (enter the amount from Worksheet 1,column (a))

1a

1bActivities with net loss (enter the amount from Worksheet 1,column (b))

b

1cPrior years unallowed losses (enter the amount from Worksheet1, column (c))

c

1dd

All Other Passive Activities

2aActivities with net income (enter the amount from Worksheet 2,column (a))

2a

2bActivities with net loss (enter the amount from Worksheet 2,column (b))

b

2cc

d

Prior years unallowed losses (enter the amount from Worksheet2, column (c))

3

3Special Allowance for Rental Real Estate With Active Participation

4 Enter the smaller of the loss on line 1d or the loss on line 3 4

5Enter $150,000. If married filing separately, see page 75

66 Enter modified adjusted gross income, but not less than zero (see

page 7)

Note: If line 6 is greater than or equal to line 5, skip lines 7 and8, enter -0- on line 9, and go to line 10. Otherwise, go toline 7.

77Multiply line 7 by 50% (.5). Do not enter more than $25,000. If married filing separately, seepage 8

88

Enter the smaller of line 4 or line 8 9

Total Losses Allowed

1010

1111

Add the income, if any, on lines 1a and 2a and enter the total

Total losses allowed from all passive activities for 1999. Add lines 9 and 10. See page 9 tofind out how to report the losses on your tax return

Form 8582 (1999)For Paperwork Reduction Act Notice, see page 11.

2d

Cat. No. 63704F

( )

( )

( )

( )

If this line and line 1d are losses, go to Part II. Otherwise, enter -0- on line 9 and go to line 10

(99)

1999

Note: If your filing status is marr ied filing separately and you lived with your spouse at any timeduring the year, do not complete Part II. Instead, enter -0- on line 9 and go to line 10.

Activity AActivity B

Partnership #1Partnership #4

Activity AActivity B

Activity AActivity BPartnership #4

Activity AActivity BPartnership #4

2,776

2,776

4,000

4,000

Sch. E

Sch. E

Sch. E

Sch. E

Sch. ESch. E

Sch. ESch. E

(15,000)(11,600)

(26,600)

(2,400)

(2,400)

18,89119,825

38,716

16,12316,9203,900

36,943

21,66719,8253,900

45,392

(6,667)(8,225)

(14,892)

(2,600)(1,500)

(4,100)

1,400

(18,891)(19,825)

(3,900)

.487938

.5120622,7682,905

5,673

16,12316,920

33,043

.436429

.458003

.105568

15,51216,2793,752

35,543

15,51216,2793,752

35,543

6,1553,546

148

9,849

Caution: The worksheets are not required to be filed with your tax return and may be detached before filing Form8582. Keep a copy of the worksheets for your records.

Page 2Form 8582 (1999)

Worksheet 1—For Form 8582, Lines 1a, 1b, and 1c (See page 7.)

Overall gain or lossPrior yearsCurrent year

(c) Unallowedloss (line 1c)

(b) Net loss(line 1b)

(a) Net income(line 1a)

(e) Loss(d) GainName of activity

Total. Enter on Form 8582, lines 1a,1b, and 1c �

Worksheet 2—For Form 8582, Lines 2a, 2b, and 2c (See page 7.)

Overall gain or lossPrior yearsCurrent year

(a) Net income(line 2a)

(b) Net loss(line 2b)

(c) Unallowedloss (line 2c)

(d) Gain (e) LossName of activity

Total. Enter on Form 8582, lines 2a,2b, and 2c �

Worksheet 3—Use this worksheet if an amount is shown on Form 8582, line 9 (See page 8.)(d) Subtract column(c) from column (a)

(c) Specialallowance

(b) Ratio(a) LossForm or scheduleto be reported on

Total � 1.00

Name of activity

Worksheet 4—Allocation of Unallowed Losses (See page 8.)

(c) Unallowed loss(b) Ratio(a) LossForm or scheduleto be reported on

Name of activity

Total � 1.00Worksheet 5—Allowed Losses (See page 8.)

(c) Allowed loss(b) Unallowed loss(a) LossForm or scheduleto be reported on

Name of activity

Total �

Form 8582 (1999)

At-Risk Limits The at-risk rules limit your losses from mostactivities to your amount at risk in the activity.You treat any loss that is disallowed becauseof the at-risk limits as a deduction from thesame activity in the next tax year. If yourlosses from an at-risk activity are allowed,they are subject to recapture in later years ifyour amount at risk is reduced below zero.

CAUTION!

You must apply the at-risk rules be-fore the passive activity rules dis-cussed in the first part of this publi-

cation.

Loss defined. A loss is the excess of al-lowable deductions from the activity for theyear (including depreciation or amortizationallowed or allowable and disregarding the at-risk limits) over income received or accruedfrom the activity during the year. Income doesnot include income from the recapture ofprevious losses (discussed, later, under Re-capture Rule).

Form 6198. Use Form 6198 to figure howmuch loss from an activity you can deduct.You must file Form 6198 with your tax returnif:

1) You have a loss from any part of an ac-tivity that is covered by the at-risk rules,and

2) You are not at risk for some of your in-vestment in the activity.

Loss limits for partners and S corporationshareholders. Three separate limits applyto a partner's or shareholder's distributiveshare of a loss from a partnership or S cor-poration. The limits determine the amount ofthe loss each partner or shareholder can de-duct on his or her own return. These limitsand the order in which they apply are:

1) The adjusted basis of:

a) The partner's partnership interest,or

b) The shareholder's stock plus anyloans the shareholder makes to thecorporation,

2) The at-risk rules, and

3) The passive activity rules.

See Limits on Losses in Publication 541,and Limitations on Losses, Deductions, andCredits in Shareholder's Instructions forSchedule K–1 (Form 1120S).

Who Is Affected?The at-risk limits apply to individuals (includ-ing partners and S corporation shareholders)and to certain closely held corporations (otherthan S corporations).

Closely held corporation. For the at-riskrules, a corporation is a closely held corpo-ration if at any time during the last half of thetax year, more than 50% in value of its out-standing stock is owned directly or indirectlyby or for five or fewer individuals.

To figure if more than 50% in value of thestock is owned by five or fewer individuals,apply the following rules.

1) Stock owned directly or indirectly by orfor a corporation, partnership, estate, ortrust is considered owned proportion-ately by its shareholders, partners, orbeneficiaries.

2) An individual is considered to own thestock owned directly or indirectly by orfor his or her family. Family includes onlybrothers and sisters (including half-brothers and half-sisters), a spouse, an-cestors, and lineal descendants.

3) If a person holds an option to buy stock,he or she is considered to be the ownerof that stock.

4) When applying rule (1) or (2), stockconsidered owned by a person underrule (1) or (3) is treated as actuallyowned by that person. Stock consideredowned by an individual under rule (2) isnot treated as owned by the individualfor again applying rule (2) to consideranother the owner of that stock.

5) Stock that may be considered owned byan individual under either rule (2) or (3)is considered owned by the individualunder rule (3).

Activities Coveredby the At-Risk Rules If you are involved in one of the following ac-tivities as a trade or business or for the pro-duction of income, you are subject to the at-risk rules.

1) Farming.

2) Exploring for, or exploiting, oil and gas.

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

4) Leasing section 1245 property, includingpersonal property and certain other tan-gible property that is depreciable or am-ortizable. See Section 1245 property,later.

5) Exploring for, or exploiting, geothermaldeposits (for wells started after Septem-ber 1978).

6) Any other activity not included in (1)through (5) that is carried on as a tradeor business or for the production of in-come.

Section 1245 property. Section 1245 prop-erty includes any property that is or has beensubject to depreciation or amortization andthat is:

1) Personal property,

2) Other tangible property (other than abuilding or its structural components)that is:

a) Used in manufacturing, production,or extraction or in furnishing trans-portation, communications, elec-trical energy, gas, water, or sewagedisposal,

b) A research facility used for the ac-tivities in (a), or

c) A bulk storage facility used for theactivities in (a),

3) A single purpose agricultural or horticul-tural structure, or

4) A storage facility (other than a buildingor its structural components) used for thedistribution of petroleum.

Exception for holding real property placedin service before 1987. The at-risk rules donot apply to the holding of real propertyplaced in service before 1987. They also donot apply to the holding of an interest ac-quired before 1987 in a pass-through entityengaged in holding real property placed inservice before 1987. This exception does notapply to holding mineral property.

Personal property and services that areincidental to making real property availableas living accommodations are included in theactivity of holding real property. For example,making personal property, such as furniture,and services available when renting a hotelor motel room or a furnished apartment isconsidered incidental to making real propertyavailable as living accommodations.

Exception for equipment leasing by aclosely held corporation. If a closely heldcorporation is actively engaged in equipmentleasing, the equipment leasing is treated asa separate activity not covered by the at-riskrules. A closely held corporation is activelyengaged in equipment leasing if 50% or moreof its gross receipts for the tax year are fromequipment leasing. Equipment leasing meansthe leasing, purchasing, servicing, and sellingof equipment that is section 1245 property.

However, equipment leasing does notinclude the leasing of master sound rec-ordings and similar contractual arrangementsfor tangible or intangible assets associatedwith literary, artistic, or musical properties,such as books, lithographs of artwork, ormusical tapes. A closely held corporationcannot exclude these leasing activities fromthe at-risk rules nor count them as equipmentleasing for the gross receipts test.

The equipment leasing exclusion is alsonot available for leasing activities related toother at-risk activities, such as motion picturefilms and video tapes, farming, oil and gasproperties, and geothermal deposits. For ex-ample, if a closely held corporation leases avideo tape, it cannot exclude this leasing ac-tivity from the at-risk rules under the equip-ment leasing exclusion.

Controlled group of corporations. Acontrolled group of corporations is subject tospecial rules for the equipment leasing ex-clusion. See section 465(c) of the InternalRevenue Code.

Special exception for qualified corpo-rations. A qualified corporation is not subjectto the at-risk limits for any qualifying businesscarried on by the corporation. Each qualifyingbusiness is treated as a separate activity.

A qualified corporation is a closely heldcorporation, defined, earlier, under Who IsAffected?, that is not:

1) A personal holding company,

2) A foreign personal holding company, or

3) A personal service corporation (definedin section 269A(b) of the Internal Reve-nue Code, but determined by substitut-ing 5% for 10%).

Qualifying business. A qualifying busi-ness is any active business if all of the fol-lowing apply.

1) During the entire 12-month period end-ing on the last day of the tax year, thecorporation had at least:

a) One full-time employee whose ser-vices were in the active manage-ment of the business, and

b) Three full-time nonowner employ-ees whose services were directlyrelated to the business. A nonowneremployee does not own more than5% in value of the outstanding stockof the corporation at any time duringthe tax year. (The rules for con-structive ownership of stock in sec-tion 318 of the Internal RevenueCode apply. However, in applyingthese rules, an owner of 5% ormore, rather than 50% or more, ofthe value of a corporation's stock isconsidered to own a proportionateshare of any stock owned by thecorporation.)

2) Deductions due to the business that areallowable to the corporation as businessexpenses and as contributions to certainemployee benefit plans for the tax yearexceed 15% of the gross income fromthe business.

3) The business is not an excluded busi-ness. Generally, an excluded businessmeans equipment leasing as defined,earlier, under Exception for equipmentleasing by a closely held corporation,and any business involving the use, ex-ploitation, sale, lease, or other disposi-tion of master sound recordings, motionpicture films, video tapes, or tangible orintangible assets associated with literary,artistic, musical, or similar properties.

Separation of Activities Generally, you treat your activity involvingeach film or video tape, item of leased section1245 property, farm, oil and gas property, orgeothermal property as a separate activity.In addition, each investment that is not a partof a trade or business is treated as a separateactivity.

Leasing by a partnership or S corporation.For a partnership or S corporation, treat allleasing of section 1245 property that is placedin service in any tax year of the partnershipor S corporation as one activity.

Aggregation of Activities Trade or business activities described in (6)under Activities Covered by the At-RiskRules, earlier, are treated as one activity if:

1) You actively participate in the man-agement of the trade or business, or

2) The trade or business is carried on by apartnership or S corporation and 65%or more of its losses for the tax year areallocable to persons who actively partic-ipate in the management of the trade orbusiness.

Similar rules apply to activities described in(1) through (5) of that discussion.

Active participation. Active participation de-pends on all the facts and circumstances.Factors that indicate active participation in-clude making decisions involving the opera-tion or management of the activity, performingservices for the activity, and hiring and dis-

charging employees. Factors that indicate alack of active participation include lack ofcontrol in managing and operating the activity,having authority only to discharge the man-ager of the activity, and having a manager ofthe activity who is an independent contractorrather than an employee.

Partners and S corporation shareholders.Partners or shareholders may aggregate ac-tivities of their partnership or S corporationwithin each of the following categories:

1) Films and video tapes,

2) Farms,

3) Oil and gas properties, and

4) Geothermal properties.

For example, if a partnership or S corpo-ration produces two films or video tapes, thepartners or S corporation shareholders maytreat the production of both films or videotapes as one activity for purposes of the at-risk rules.

At-Risk Amounts You are at risk in any activity for:

1) The money and adjusted basis of prop-erty you contribute to the activity, and

2) Amounts you borrow for use in the ac-tivity if:

a) You are personally liable for repay-ment, or

b) You pledge property (other thanproperty used in the activity) as se-curity for the loan.

Amounts borrowed. You are at risk foramounts borrowed to use in the activity if youare personally liable for repayment. You arealso at risk if the amounts borrowed are se-cured by property other than property used inthe activity. In this case, the amount consid-ered at risk is the net fair market value of yourinterest in the pledged property. The net fairmarket value of property is its fair marketvalue (determined on the date the property ispledged) less any prior (or superior) claims towhich it is subject. However, no property willbe taken into account as security if it is di-rectly or indirectly financed by debt that issecured by property you contributed to theactivity.

CAUTION!

If you borrow money to finance acontribution to an activity, you cannotincrease your amount at risk by the

contribution and the amount borrowed to fi-nance the contribution. You may increaseyour at-risk amount only once.

Certain borrowed amounts excluded.Even if you are personally liable for the re-payment of a borrowed amount or you securea borrowed amount with property other thanproperty used in the activity, you are notconsidered at risk if you borrowed the moneyfrom a person having an interest in the activityor from someone related to a person (otherthan you) having an interest in the activity.This does not apply to:

1) Amounts borrowed by a corporation fromits shareholders,

2) Amounts borrowed from a person havingan interest in the activity as a creditor,or

3) An activity described in (6) under Activ-ities Covered by the At-Risk Rules, ear-lier.

Related persons. Related persons in-clude:

1) Members of the family, but only brothersand sisters, half-brothers and half-sisters, a spouse, ancestors (parents,grandparents, etc.), and lineal descend-ants (children, grandchildren, etc.),

2) Two corporations that are members ofthe same controlled group of corpo-rations determined by applying a 10%ownership test,

3) The fiduciaries of two different trusts, orthe fiduciary and beneficiary of two dif-ferent trusts, if the same person is thegrantor of both trusts,

4) A tax-exempt educational or charitableorganization and a person who directlyor indirectly controls it (or a member ofwhose family controls it),

5) A corporation and an individual whoowns directly or indirectly more than 10%of the value of the outstanding stock ofthe corporation,

6) A trust fiduciary and a corporation ofwhich more than 10% in value of theoutstanding stock is owned directly orindirectly by or for the trust or by or forthe grantor of the trust,

7) The grantor and fiduciary, or the fiduciaryand beneficiary, of any trust,

8) A corporation and a partnership if thesame persons own over 10% in valueof the outstanding stock of the corpo-ration and more than 10% of the capitalinterest or the profits interest in thepartnership,

9) Two S corporations if the same personsown more than 10% in value of the out-standing stock of each corporation,

10) An S corporation and a regular corpo-ration if the same persons own morethan 10% in value of the outstandingstock of each corporation,

11) A partnership and a person who ownsdirectly or indirectly more than 10% ofthe capital or profits of the partnership,

12) Two partnerships if the same personsdirectly or indirectly own more than 10%of the capital or profits of each,

13) Two persons who are engaged in busi-ness under common control, and

14) An executor of an estate and a benefi-ciary of that estate.

To determine the direct or indirect owner-ship of the outstanding stock of a corporation,apply the following rules.

1) Stock owned directly or indirectly by orfor a corporation, partnership, estate, ortrust is considered owned proportion-ately by or for its shareholders, partners,or beneficiaries.

2) Stock owned directly or indirectly by orfor an individual's family is consideredowned by the individual. The family ofan individual includes only brothers andsisters, half-brothers and half-sisters, a

spouse, ancestors, and lineal descend-ants.

3) Any stock in a corporation owned by anindividual (other than by applying rule(2)) is considered owned directly or indi-rectly by the individual's partner.

4) When applying rule (1), (2), or (3), stockconsidered owned by a person underrule (1) is treated as actually owned bythat person. But, if a person construc-tively owns stock because of rule (2) or(3), he or she does not own the stock forpurposes of applying either rule (2) or (3)to make another person the constructiveowner of the same stock.

Effect of government price support pro-grams. A government target price program(such as provided by the Agriculture andConsumer Protection Act of 1973) or othergovernment price support programs for aproduct that you grow does not, withoutagreements limiting your costs, reduce theamount you have at risk.

Effect of increasing amounts at risk insubsequent years. Any loss that is allow-able in a particular year reduces your at-riskinvestment (but not below zero) as of the be-ginning of the next tax year and in all suc-ceeding tax years for that activity. If you havea loss that is more than your at-risk amount,the loss disallowed will not be allowed in lateryears unless you increase your at-riskamount. Losses that are suspended becausethey are greater than your investment that isat risk are treated as a deduction for the ac-tivity in the following year. Consequently, ifyour amount at risk increases in later years,you may deduct previously suspended lossesto the extent that the increases in youramount at risk exceed your losses in lateryears. However, your deduction of sus-pended losses may be limited by the passiveloss rules.

Amounts Not At Risk You are not considered at risk for amountsprotected against loss through nonrecoursefinancing, guarantees, stop loss agreements,or other similar arrangements.

Nonrecourse financing. Nonrecourse fi-nancing is financing for which you are notpersonally liable. If you borrow money tocontribute to an activity and the lender's onlyrecourse is to your interest in the activity orthe property used in the activity, the loan isa nonrecourse loan.

You are not considered at risk for yourshare of any nonrecourse loan used to fi-nance an activity or to acquire property usedin the activity unless the loan is secured byproperty not used in the activity.

However, you are considered at risk forqualified nonrecourse financing securedby real property used in the holding of realproperty.

Qualified nonrecourse financing is financ-ing for which no one is personally liable forrepayment and that is:

1) Borrowed by you in connection with theactivity of holding real property,

2) Secured by real property used in theactivity,

3) Not convertible from a debt obligation toan ownership interest, and

4) Loaned or guaranteed by any federal,state, or local government, or borrowedby you from a qualified person.

Other types of property used as secu-rity. The rules in the next two paragraphsapply to any financing incurred after August3, 1998. You can also choose to apply theserules to financing you obtained before August4, 1998. If you do that, you must reduce theamounts at risk as a result of applying theserules to years ending before August 4, 1998,to the extent they increase the losses allowedfor those years.

In determining whether qualifiednonrecourse financing is secured only by realproperty used in the activity of holding realproperty, disregard property that is incidentalto the activity of holding real property. Alsodisregard other property if the total gross fairmarket value of that property is less than 10%of the total gross fair market value of all theproperty securing the financing.

For this purpose, treat yourself as owningdirectly your proportional share of the assetsin any partnership in which you own, directlyor indirectly, an equity interest.

Qualified person. A qualified person ac-tively and regularly engages in the businessof lending money. The most common exam-ple is a bank.

A qualified person is not:

1) A person related to you in one of theways listed under Related persons, ear-lier. However, a person related to youmay be a qualified person if thenonrecourse financing is commerciallyreasonable and on the same terms asloans involving unrelated persons.

2) A person from which you acquired theproperty or a person related to that per-son.

3) A person who receives a fee due to yourinvestment in the real property or a per-son related to that person.

Other loss limiting arrangements. Anycapital you have contributed to an activity isnot at risk if you are protected against eco-nomic loss by an agreement or arrangementfor compensation or reimbursement. For ex-ample, you are not at risk if you will be reim-bursed for part or all of any loss because ofa binding agreement between yourself andanother person.

Example 1. Some commercial feedlotsreimburse investors against any loss sus-tained on sales of the fed livestock above astated dollar amount per head. Under such“stop loss” orders, the investor is at risk onlyfor the portion of the investor's capital forwhich the investor is not entitled to a re-imbursement.

Example 2. You are personally liable fora mortgage, but you separately obtain insur-ance to compensate you for any paymentsyou must actually make because of yourpersonal liability. You are considered at riskonly to the extent of the uninsured portion ofthe personal liability to which you are ex-posed. You can include in the amount youhave at risk the amount of any premium whichyou paid from your personal assets for theinsurance. However, if you obtain casualtyinsurance or insurance protecting yourselfagainst tort liability, it does not affect theamount you are otherwise considered to haveat risk.

Reductions ofAmounts At Risk The amount you have at risk in any activity isreduced by any losses allowed in previousyears under the at-risk rules. It may also bereduced because of distributions you receivedfrom the activity, debts changed from re-course to nonrecourse, or the initiation of astop-loss or similar agreement. If the amountat risk is reduced below zero, your previouslyallowed losses are subject to recapture, asexplained next.

Recapture Rule If the amount you have at risk in any activityat the end of any tax year is less than zero,you must recapture at least part of your pre-viously allowed losses. You do this by addingto your income from the activity for that yearthe smaller of the following amounts:

1) The negative at-risk amount (treated asa positive amount), or

2) The total amount of losses deducted inprevious tax years beginning after 1978,minus any amounts you previouslyadded to your income from that activityunder this recapture rule.

Do not use the recapture income to re-duce any net loss from the activity for the taxyear. Instead, treat the recaptured amount asa deduction for the activity in the next taxyear.

Pre-1979 activity. If the amount you had atrisk in an activity at the end of your tax yearthat began in 1978 was less than zero, youapply the preceding rule for the recapture oflosses by substituting that negative amountfor zero. For example, if your at-risk amountfor that tax year was minus $50, you will re-capture losses only when your at-risk amountgoes below minus $50.

How To Get MoreInformationYou can order free publications and forms,ask tax questions, and get more informationfrom the IRS in several ways. By selecting themethod that is best for you, you will havequick and easy access to tax help.

Free tax services. To find out what servicesare available, get Publication 910, Guide toFree Tax Services. It contains a list of free taxpublications and an index of tax topics. It alsodescribes other free tax information services,including tax education and assistance pro-grams and a list of TeleTax topics.

Personal computer. With your per-sonal computer and modem, you canaccess the IRS on the Internet at

www.irs.gov . While visiting our web site, youcan select:

• Frequently Asked Tax Questions (locatedunder Taxpayer Help & Ed) to find an-swers to questions you may have.

• Forms & Pubs to download forms andpublications or search for forms andpublications by topic or keyword.

• Fill-in Forms (located under Forms &Pubs) to enter information while the formis displayed and then print the completedform.

• Tax Info For You to view Internal Reve-nue Bulletins published in the last fewyears.

• Tax Regs in English to search regulationsand the Internal Revenue Code (underUnited States Code (USC)).

• Digital Dispatch and IRS Local News Net(both located under Tax Info For Busi-ness) to receive our electronic newslet-ters on hot tax issues and news.

• Small Business Corner (located underTax Info For Business) to get informationon starting and operating a small busi-ness.

You can also reach us with your computerusing File Transfer Protocol at ftp.irs.gov.

TaxFax Service. Using the phoneattached to your fax machine, you canreceive forms and instructions by

calling 703–368–9694. Follow the directionsfrom the prompts. When you order forms,enter the catalog number for the form youneed. The items you request will be faxed toyou.

Phone. Many services are availableby phone.

• Ordering forms, instructions, and publi-cations. Call 1–800–829–3676 to ordercurrent and prior year forms, instructions,and publications.

• Asking tax questions. Call the IRS withyour tax questions at 1–800–829–1040.

• TTY/TDD equipment. If you have accessto TTY/TDD equipment, call 1–800–829–4059 to ask tax questions or to orderforms and publications.

• TeleTax topics. Call 1–800–829–4477 tolisten to pre-recorded messages coveringvarious tax topics.

Evaluating the quality of our telephoneservices. To ensure that IRS representativesgive accurate, courteous, and professionalanswers, we evaluate the quality of our tele-phone services in several ways.

• A second IRS representative sometimesmonitors live telephone calls. That persononly evaluates the IRS assistor and doesnot keep a record of any taxpayer's nameor tax identification number.

• We sometimes record telephone calls toevaluate IRS assistors objectively. Wehold these recordings no longer than oneweek and use them only to measure thequality of assistance.

• We value our customers' opinions.Throughout this year, we will be survey-ing our customers for their opinions onour service.

Walk-in. You can walk in to manypost offices, libraries, and IRS officesto pick up certain forms, instructions,

and publications. Also, some libraries and IRSoffices have:

• An extensive collection of products avail-able to print from a CD-ROM or photo-copy from reproducible proofs.

• The Internal Revenue Code, regulations,Internal Revenue Bulletins, and Cumula-tive Bulletins available for research pur-poses.

Mail. You can send your order forforms, instructions, and publicationsto the Distribution Center nearest to

you and receive a response within 10 work-days after your request is received. Find theaddress that applies to your part of thecountry.

• Western part of U.S.:Western Area Distribution CenterRancho Cordova, CA 95743–0001

• Central part of U.S.:Central Area Distribution CenterP.O. Box 8903Bloomington, IL 61702–8903

• Eastern part of U.S. and foreign ad-dresses:Eastern Area Distribution CenterP.O. Box 85074Richmond, VA 23261–5074

CD-ROM. You can order IRS Publi-cation 1796, Federal Tax Products onCD-ROM, and obtain:

• Current tax forms, instructions, and pub-lications.

• Prior-year tax forms, instructions, andpublications.

• Popular tax forms which may be filled inelectronically, printed out for submission,and saved for recordkeeping.

• Internal Revenue Bulletins.

The CD-ROM can be purchased fromNational Technical Information Service (NTIS)by calling 1–877–233–6767 or on the Internetat www.irs.gov/cdorders. The first releaseis available in mid-December and the finalrelease is available in late January.

IRS Publication 3207, Small BusinessResource Guide, is an interactive CD-ROMthat contains information important to smallbusinesses. It is available in mid-February.You can get one free copy by calling 1–800–829–3676.

Index

AActivity ................................. 2, 4, 6

Appropriate economic unit ..... 6 Nonpassive ............................. 4

Trade or business .................. 2Amounts not at risk ................... 21Appropriate economic unit .......... 6Assistance (See More information)

At-risk activities ................... 19, 20 Aggregation of ...................... 20 Separation of ........................ 20

At-risk amounts ................... 20, 21 At-risk limits ......................... 19, 21

CClosely held corporation ........ 2, 19

Corporation: Closely held ........................ 2, 5 Personal service ................. 2, 5

DDeductions, passive activity ........ 6

Disabled farmer ........................... 5 Disclosure requirement ............... 6 Dispositions ............................. 7, 9

Death ...................................... 9 Gift .......................................... 9 Installment sale ...................... 9 Partial ..................................... 7

F Farmer ......................................... 5

Form: 6198 ..................................... 19

Former passive activity ............... 2Free tax services ....................... 21

GGrouping passive activities ......... 6

HHelp (See More information)

IIncome, passive activity .............. 5

L Limited entrepreneur ................... 7 Limited partners ........................... 5

Losses, closely held corporations 2

M Material participation ............... 4, 5

Modified adjusted gross income . 3 More information ....................... 21

N Nonrecourse loan ...................... 21

P Participation ................................. 4

Passive activity ............ 2, 3, 4, 6, 9 Comprehensive example ....... 9 Credits .................................... 2 Disposition .............................. 9 Former .................................... 2 Grouping ................................. 6 Limits ...................................... 2 Material participation .............. 4 Rental ..................................... 3 Rules .................................. 2, 6

Who must use these rules ..... 2Passive activity deductions ......... 6Passive activity income ............... 5Passive income, recharacterization

of ............................................ 7Personal services defined ........... 2Publications (See More information)Publicly traded partnership ...... 2, 7

RReal estate professional .............. 5Recapture rule under at-risk

limits ..................................... 21Recharacterization of passive in-

come ....................................... 7Reductions of amounts at risk .. 21

Related persons ........................ 20 Rental activity .......................... 3, 5

$25,000 offset ........................ 3 Active participation ................. 3 Exceptions .............................. 3

Phaseout rule ......................... 3Real estate professional ........ 5 Retired farmer ............................. 5

S Separate activity ........................ 20

Significant participation passive ac-tivities ..................................... 7

Surviving spouse of farmer ......... 5

TTax help (See More information) Trade or business activities .... 2, 5

Definition of ............................ 2 Real property .......................... 5

TTY/TDD information ................ 21

W Worksheet 1 .............................. 10 Worksheet 2 .............................. 10 Worksheet 3 .............................. 11 Worksheet 4 .............................. 11 Worksheet 5 .............................. 11 Worksheet 6 .............................. 11 Worksheet A ................................ 7 Worksheet B ................................ 8

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passive activity passive activity limits and at-risk rules · net passive income. passive activity...

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