Passive Activity — Instruction 1065

In general, section 469 limits the amount of losses, deductions, and credits that partners can claim from passive activities. The passive activity limitations don’t apply to the partnership. Instead, they apply to each partner’s share of any income or loss and credit attributable to a passive activity. Because the treatment of each partner’s share of partnership income or loss and credit depends on the nature of the activity that generated it, the partnership must report income or loss and credits separately for each activity.

The following instructions and the instructions for Schedules K and K-1, later, explain the applicable passive activity limitation rules and specify the type of information the partnership must provide to its partners for each activity. If the partnership had more than one activity, it must report information for each activity on an attached statement to Schedules K and K-1.

Generally, passive activities include (a) activities that involve the conduct of a trade or business if the partner doesn’t materially participate in the activity, and (b) all rental activities (defined later) regardless of the partner’s participation. For exceptions, see Activities That Aren’t Passive Activities, later.

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The level of each partner’s participation in an activity must be determined by the partner.

The passive activity rules provide that losses and credits from passive activities can generally be applied only against income and tax from passive activities. Thus, passive losses and credits can’t be applied against income from salaries, wages, professional fees, or a business in which the partner materially participates; against portfolio income (defined later); or against the tax related to any of these types of income.

Special provisions apply to certain activities. First, the passive activity limitations must be applied separately for a net loss from passive activities held through a PTP. Second, special rules require that net income from certain activities that would otherwise be treated as passive income must be recharacterized as nonpassive income for purposes of the passive activity limitations.

To allow each partner to correctly apply the passive activity limitations, the partnership must report income or loss and credits separately by activity for each of the following.

Trade or business activities.
Rental real estate activities.
Rental activities other than real estate.
Portfolio income.

Activities That Aren’t Passive Activities The following aren’t passive activities.

Trade or business activities in which the partner materially participated for the tax year.
Any rental real estate activity in which the partner materially participated if the partner met both of the following conditions for the tax year.

a. More than half of the personal services the partner

performed in trades or businesses were performed in real property trades or businesses in which the partner materially participated.

b. The partner performed more than 750 hours of services

in real property trades or businesses in which the partner materially participated.

Note: For a partner that is a closely held C corporation (defined in section 465(a)(1)(B)), the above conditions are treated as met if more than 50% of the corporation’s gross receipts are from real property trades or businesses in which the corporation materially participated.

For purposes of this rule, each interest in rental real estate is a separate activity, unless the partner elects to treat all interests in rental real estate as one activity.

If the partner is married filing jointly, either the partner or the partner’s spouse must separately meet both of the above conditions, without taking into account services performed by the other spouse.

A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Services the partner performed as an employee aren’t treated as performed in a real property trade or business unless the partner owned more than 5% of the stock (or more than 5% of the capital or profits interest) in the employer.

An interest in an oil or gas well drilled or operated under a working interest if at any time during the tax year the partner held the working interest directly or through an entity that didn’t limit the partner’s liability (for example, an interest as a general partner). This exception applies regardless of whether the partner materially participated for the tax year.
The rental of a dwelling unit used by a partner for personal purposes during the year for more than the greater of 14 days or 10% of the number of days that the residence was rented at fair rental value.
An activity of trading personal property for the account of owners of interests in the activity. For purposes of this rule, “personal property” means property that is actively traded, such as stocks, bonds, and other securities. See Temporary Regulations section 1.469-1T(e)(6).

Trade or Business Activities A trade or business activity is an activity (other than a rental activity or an activity treated as incidental to an activity of holding property for investment) that:

Involves the conduct of a trade or business (within the meaning of section 162),
Is conducted in anticipation of starting a trade or business, or
Involves research or experimental expenditures deductible under section 174 or 174A (or that would be if you chose to deduct rather than capitalize them).

If the partner doesn’t materially participate in the activity, a trade or business activity conducted through a partnership is generally a passive activity of the partner.

Each partner must determine if the partner materially participated in an activity. As a result, while the partnership’s ordinary business income (loss) is reported on page 1 of Form 1065, the specific income and deductions from each separate trade or business activity must be reported on attached statements to Form 1065. Similarly, while each partner’s distributive share of the partnership’s ordinary business income (loss) is reported in box 1 of Schedule K-1, each partner’s distributive share of the income and deductions from each trade or business activity must be reported on attached statements to each Schedule K-1. See Passive Activity Reporting Requirements, later, for more information.

Rental Activities Generally, except as noted below, if the gross income from an activity consists of amounts paid principally for the use of real or personal tangible property held by the partnership, the activity is a rental activity.

There are several exceptions to this general rule. Under these exceptions, an activity involving the use of real or personal tangible property isn’t a rental activity if any of the following apply.

The average period of customer use (defined below) for such property is 7 days or less.
The average period of customer use for such property is 30 days or less and significant personal services (defined below) are provided by or on behalf of the partnership.
Extraordinary personal services (defined below) are provided by or on behalf of the partnership.
The rental of such property is treated as incidental to a nonrental activity of the partnership under Temporary Regulations section 1.469-1T(e)(3)(vi) and Regulations section 1.469-1(e)(3)(vi)(D).
The partnership customarily makes the property available during defined business hours for nonexclusive use by various customers.
The partnership provides property for use in a nonrental activity of a partnership or joint venture in its capacity as an owner of an interest in such partnership or joint venture. Whether the partnership provides property used in an activity of another partnership or of a joint venture in the partnership’s capacity as an owner of an interest in the partnership or joint venture is determined on the basis of all the facts and circumstances.

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In addition, a guaranteed payment described in section 707(c) is never income from a rental activity.

Average period of customer use. Figure the average period of customer use for a class of property by dividing the total number of days in all rental periods by the number of rentals during the tax year. If the activity involves renting more than one class of property, multiply the average period of customer use of each class by the ratio of the gross rental income from that class to the activity’s total gross rental income. The activity’s average period of customer use equals the sum of these class-by-class average periods weighted by gross income. See Regulations section 1.469-1(e)(3)(iii).

Significant personal services. Personal services include only services performed by individuals. To determine if personal services are significant personal services, consider all the relevant facts and circumstances. Relevant facts and circumstances include:

How often the services are provided,
The type and amount of labor required to perform the services, and
The value of the services in relation to the amount charged for use of the property.

The following services aren’t considered in determining whether personal services are significant.

Services necessary to permit the lawful use of the rental property.
Services performed in connection with improvements or repairs to the rental property that extend the useful life of the property substantially beyond the average rental period.
Services provided in connection with the use of any improved real property that are similar to those commonly provided in connection with long-term rentals of high-grade commercial or residential property. Examples include cleaning and maintenance of common areas, routine repairs, trash collection, elevator service, and security at entrances.

Extraordinary personal services. Services provided in connection with making rental property available for customer use are extraordinary personal services only if the services are performed by individuals and the customers’ use of the rental property is incidental to their receipt of the services.

For example, a patient’s use of a hospital room is generally incidental to the care received from the hospital’s medical staff. Similarly, a student’s use of a dormitory room in a boarding school is incidental to the personal services provided by the school’s teaching staff.

Rental activity incidental to a nonrental activity. An activity isn’t a rental activity if the rental of the property is incidental to a nonrental activity, such as the activity of holding property for investment, a trade or business activity, or the activity of dealing in property.

Rental of property is incidental to an activity of holding property for investment if both of the following apply.

The main purpose for holding the property is to realize a gain from the appreciation of the property.
The gross rental income from such property for the tax year is less than 2% of the smaller of the property’s unadjusted basis or its FMV.

Rental of property is incidental to a trade or business activity if all of the following apply.

The partnership owns an interest in the trade or business at all times during the year.
The rental property was mainly used in the trade or business activity during the tax year or during at least 2 of the 5 preceding tax years.
The gross rental income from the property for the tax year is less than 2% of the smaller of the property’s unadjusted basis or its FMV.

The sale or exchange of property that is also rented during the tax year (in which the gain or loss is recognized) is treated as incidental to the activity of dealing in property if, at the time of the sale or exchange, the property was held primarily for sale to customers in the ordinary course of the partnership’s trade or business.

See Temporary Regulations section 1.469-1T(e)(3) and Regulations section 1.469-1(e)(3) for more information on the definition of rental activities for purposes of the passive activity limitations.

Reporting of rental activities. In reporting the partnership’s income or losses and credits from rental activities, the partnership must separately report rental real estate activities and rental activities other than rental real estate activities.

Partners who actively participate in a rental real estate activity may be able to deduct part or all of their rental real estate losses (and the deduction equivalent of rental real estate credits) against income (or tax) from nonpassive activities. The combined amount of rental real estate losses and the deduction equivalent of rental real estate credits from all sources (including rental real estate activities not held through the partnership) that may be claimed is limited to $25,000. This $25,000 amount is generally reduced for high-income partners.

Report rental real estate activity income (loss) on Form 8825 and Schedule K, line 2, and in box 2 of Schedule K-1, rather than on page 1 of Form 1065. Report credits related to rental real estate activities on Schedule K, lines 15c and 15d (box 15, codes E and F, of Schedule K-1), and low-income housing credits on Schedule K, lines 15a and 15b (box 15, codes C and D, of Schedule K-1).

See Line 3. Other Net Rental Income (Loss) , later, for reporting other net rental income (loss) other than rental real estate.

Portfolio Income Generally, portfolio income includes all gross income, other than income derived in the ordinary course of a trade or business, that is attributable to interest; dividends; royalties; income from a real estate investment trust (REIT), a regulated investment company (RIC), a REMIC, a common trust fund, a CFC, a QEF, or a cooperative; income from the disposition of property that produces income of a type defined as portfolio income; and income from the disposition of property held for investment. See Self-Charged Interest, later, for an exception.

Solely for purposes of the preceding paragraph, gross income derived in the ordinary course of a trade or business includes (and portfolio income, therefore, doesn’t include) the following types of income.

Interest income on loans and investments made in the ordinary course of a trade or business of lending money.
Interest on accounts receivable arising from the performance of services or the sale of property in the ordinary course of a trade or business of performing such services or selling such property, but only if credit is customarily offered to customers of the business.
Income from investments made in the ordinary course of a trade or business of furnishing insurance or annuity contracts or reinsuring risks underwritten by insurance companies.
Income or gain derived in the ordinary course of an activity of trading or dealing in any property if such activity constitutes a trade or business (unless the dealer held the property for investment at any time before such income or gain is recognized).

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Royalties derived by the taxpayer in the ordinary course of a trade or business of licensing intangible property.
Amounts included in the gross income of a patron of a cooperative by reason of any payment or allocation to the patron based on patronage as a result of a trade or business of the patron.
Other income identified by the IRS as income derived by the taxpayer in the ordinary course of a trade or business.

See Temporary Regulations section 1.469-2T(c)(3) for more information on portfolio income.

Report portfolio income and related deductions on Schedule K rather than on page 1 of Form 1065.

Self-Charged Interest

Certain self-charged interest income and deductions may be treated as passive activity gross income and passive activity deductions if the loan proceeds are used in a passive activity. Generally, self-charged interest income and deductions result from loans between the partnership and its partners and also include loans between the partnership and another partnership if each owner in the borrowing entity has the same proportional ownership interest in the lending entity.

The self-charged interest rules don’t apply to a partner’s interest in a partnership if the partnership makes an election under Regulations section 1.469-7(g) to avoid the application of these rules. To make the election, the partnership must attach to its original or amended partnership return a statement that includes the name, address, and EIN of the partnership and a declaration that the election is being made under Regulations section 1.469-7(g). The election will apply to the tax year in which it was made and all subsequent tax years. Once made, the election may only be revoked with the consent of the IRS.

For more details on the self-charged interest rules, see Regulations section 1.469-7.

Grouping Activities Generally, one or more trade or business or rental activities may be treated as a single activity if the activities make up an appropriate economic unit for measurement of gain or loss under the passive activity rules. Whether activities make up an appropriate economic unit depends on all the relevant facts and circumstances. The factors given the greatest weight in determining whether activities make up an appropriate economic unit are:

Similarities and differences in types of trades or businesses,
The extent of common control,
The extent of common ownership,
Geographical location, and
Reliance between or among the activities.

Example. The partnership has a significant ownership interest in a bakery and a movie theater in Baltimore and a bakery and a movie theater in Philadelphia. Depending on the relevant facts and circumstances, there may be more than one reasonable method for grouping the partnership’s activities. For instance, the following groupings may or may not be permissible.

A single activity.
A movie theater activity and a bakery activity.
A Baltimore activity and a Philadelphia activity.
Four separate activities.

Once the partnership chooses a grouping under these rules, it must continue using that grouping in later tax years unless a material change in the facts and circumstances makes it clearly inappropriate.

The IRS may regroup the partnership’s activities if the partnership’s grouping fails to reflect one or more appropriate

economic units and one of the primary purposes of the grouping is to avoid the passive activity limitations.

Limitation on grouping certain activities. The following activities may not be grouped together.

A rental activity with a trade or business activity unless the activities being grouped together make up an appropriate economic unit and:

a. The rental activity is insubstantial relative to the trade or

business activity or vice versa, or

b. Each owner of the trade or business activity has the

same proportionate ownership interest in the rental activity. If so, the portion of the rental activity involving the rental of property to be used in the trade or business activity can be grouped with the trade or business activity.

An activity involving the rental of real property with an activity involving the rental of personal property (except personal property provided in connection with the real property or vice versa).
Any activity with another activity in a different type of business and in which the partnership holds an interest as a limited partner or as a limited entrepreneur (as defined in section 461(k)(4)) if that other activity engages in holding, producing, or distributing motion picture films or videotapes; farming; leasing section 1245 property; or exploring for or exploiting oil and gas resources or geothermal deposits.

Activities conducted through other partnerships. Once a partnership determines its activities under these rules, the partnership as a partner can use these rules to group those activities with:

Each other,
Activities conducted directly by the partnership, or
Activities conducted through other partnerships.

A partner can’t treat as separate activities those activities grouped together by a partnership.

If you group your activities under these rules for section 469 purposes, check the appropriate box in item K below the name and address block on page 1 of Form 1065.

Recharacterization of Passive Income Under Temporary Regulations section 1.469-2T(f) and Regulations section 1.469-2(f), net passive income from certain passive activities must be treated as nonpassive income. Net passive income is the excess of an activity’s passive activity gross income over its passive activity deductions (current-year deductions and prior-year unallowed losses).

Any net passive income recharacterized as nonpassive income is treated as investment income for purposes of figuring investment interest expense limitations if it’s from (a) an activity of renting substantially nondepreciable property from an equity-financed lending activity, or (b) an activity related to an interest in a pass-through entity that licenses intangible property.

The amount of income from the activities in the first three paragraphs below that any partner will be required to recharacterize as nonpassive income may be limited under Temporary Regulations section 1.469-2T(f)(8). Because the partnership won’t have information regarding all of a partner’s activities, it must identify all partnership activities meeting the definitions under Certain nondepreciable rental property activities and Passive equity-financed lending activities below as activities that may be subject to recharacterization.

Income from the following six sources is subject to recharacterization.

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Significant participation passive activities. A significant participation passive activity is any trade or business activity in which the partner participated for more than 100 hours during the tax year but didn’t materially participate. Because each partner must determine the partner’s level of participation, the partnership won’t be able to identify significant participation passive activities.

Certain nondepreciable rental property activities. Net passive income from a rental activity is nonpassive income if less than 30% of the unadjusted basis of the property used or held for use by customers in the activity is subject to depreciation under section 167.

Passive equity-financed lending activities. If the partnership has net income from a passive equity-financed lending activity, the smaller of the net passive income or the equity-financed interest income from the activity is nonpassive income.

Rental of property incidental to a development activity. Net rental activity income is the excess of passive activity gross income from renting or disposing of property over passive activity deductions (current-year deductions and prior-year unallowed losses) that are reasonably allocable to the rented property. Net rental activity income is nonpassive income for a partner if all of the following apply.

The partnership recognizes gain from the sale, exchange, or other disposition of the rental property during the tax year.
The use of the item of property in the rental activity started less than 12 months before the date of disposition. The use of an item of rental property begins on the first day that (a) the partnership owns an interest in the property, (b) substantially all of the property is either rented or held out for rent and ready to be rented, and (c) no significant value-enhancing services remain to be performed.
The partner materially or significantly participated for any tax year in an activity that involved performing services to enhance the value of the property (or any other item of property if the basis of the property disposed of is determined in whole or in part by reference to the basis of that item of property).

Because the partnership can’t determine a partner’s level of participation, the partnership must identify net income from property described earlier under Rental Activities (without regard to the partner’s level of participation) as income that may be subject to recharacterization.

Rental of property to a nonpassive activity. If a taxpayer rents property to a trade or business activity in which the taxpayer materially participates, the taxpayer’s net rental activity income from the property is nonpassive income.

Acquisition of an interest in a pass-through entity that li- censes intangible property. Generally, net royalty income from intangible property is nonpassive income if the taxpayer acquired an interest in the pass-through entity after the pass-through entity created the intangible property or performed substantial services or incurred substantial costs in developing or marketing the intangible property. Net royalty income is the excess of passive activity gross income from licensing or transferring any right in intangible property over passive activity deductions (current-year deductions and prior-year unallowed losses) that are reasonably allocable to the intangible property.

See Temporary Regulations section 1.469-2T(f)(7)(iii) for exceptions to this rule.

Passive Activity Reporting Requirements To allow partners to correctly apply the passive activity loss and credit limitation rules, the partnership must do the following.

If the partnership carries on more than one activity, provide an attached statement for each activity conducted through the partnership that identifies the type of activity conducted (trade or business, rental real estate, or rental activity other than rental real estate). See Grouping Activities, earlier.
On the attached statement for each activity, provide a statement, using the same box numbers as shown on Schedule K-1, detailing the net income (loss), credits, and all items required to be separately stated under section 702(a) from each trade or business activity, from each rental real estate activity, from each rental activity other than a rental real estate activity, and from investments. If the partnership grouped separate activities, the attachments must identify each group. The attached group activity description must be sufficient for a partner to determine if its other activities qualify to be grouped with any groups provided by the partnership.
Identify the net income (loss) and credits from each oil or gas well drilled or operated under a working interest that any partner (other than a partner whose only interest in the partnership during the year is as a limited partner) holds through the partnership. Further, if any partner had an interest as a general partner in the partnership during less than the entire year, the partnership must identify both the disqualified deductions from each well that the partner must treat as passive activity deductions, and the ratable portion of the gross income from each well that the partner must treat as passive activity gross income.
Identify the net income (loss) and the partner’s share of partnership interest expense from each activity of renting a dwelling unit that any partner uses for personal purposes during the year for more than the greater of 14 days or 10% of the number of days that the residence is rented at fair rental value.
Identify the net income (loss) and the partner’s share of partnership interest expense from each activity of trading personal property conducted through the partnership.
For any gain (loss) from the disposition of an interest in an activity or of an interest in property used in an activity (including dispositions before 1987 from which gain is being recognized after 1986):

a. Identify the activity in which the property was used at

the time of disposition;

b. If the property was used in more than one activity during

the 12 months preceding the disposition, identify the activities in which the property was used and the adjusted basis allocated to each activity; and

c. For gains only, if the property was substantially

appreciated at the time of the disposition and the applicable holding period specified in Regulations section 1.469-2(c)(2)(iii)(A) wasn’t satisfied, identify the amount of the nonpassive gain and indicate whether the gain is investment income under Regulations section 1.469-2(c)(2)(iii)(F).

Specify the amount of gross portfolio income, the interest expense properly allocable to portfolio income, and expenses other than interest expense that are clearly and directly allocable to portfolio income.
Identify separately any of the following types of payments to partners.

a. Payments to a partner for services other than in the

partner’s capacity as a partner under section 707(a).

b. Guaranteed payments to a partner for services under

section 707(c).

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c. Guaranteed payments for use of capital.

d. If section 736(a)(2) payments are made for unrealized

receivables or for goodwill, the amount of the payments and the activities to which the payments are attributable.

e. If section 736(b) payments are made, the amount of the

payments and the activities to which the payments are attributable.

Identify the ratable portion of any section 481 adjustment (whether a net positive or a net negative adjustment) allocable to each partnership activity.
Identify the amount of gross income from each oil or gas property of the partnership.
Identify any gross income from sources specifically excluded from passive activity gross income, including:

a. Income from intangible property if the partner is an

individual whose personal efforts significantly contributed to the creation of the property;

b. Income from state, local, or foreign income tax refunds;

and

c. Income from a covenant not to compete if the partner is

an individual who contributed the covenant to the partnership.

Identify any deductions that aren’t passive activity deductions.
If the partnership makes a full or partial disposition of its interest in another entity, identify the gain (loss) allocable to each activity conducted through the entity, and the gain allocable to a passive activity that would have been recharacterized as nonpassive gain had the partnership disposed of its interest in property used in the activity (because the property was substantially appreciated at the time of the disposition, and the gain represented more than 10% of the partner’s total gain from the disposition).
Identify the following items from activities that may be subject to the recharacterization rules. See Recharacterization of Passive Income , earlier.

a. Net income from an activity of renting substantially

nondepreciable property.

b. The smaller of equity-financed interest income or net

passive income from an equity-financed lending activity.

c. Net rental activity income from property developed (by

the partner or the partnership), rented, and sold within 12 months after the rental of the property commenced.

d. Net rental activity income from the rental of property by

the partnership to a trade or business activity in which the partner had an interest (either directly or indirectly).

e. Net royalty income from intangible property if the

partner acquired the partner’s interest in the partnership after the partnership created the intangible property or performed substantial services, or incurred substantial costs in developing or marketing the intangible property.

Identify separately the credits from each activity conducted by or through the partnership.
Identify the partner’s distributive share of the partnership’s self-charged interest income or expense (see Self-Charged Interest , earlier).

a. Loans between a partner and the partnership. Identify

the lending or borrowing partner’s share of the self-charged interest income or expense. If the partner made the loan to the partnership, also identify the activity in which the loan proceeds were used. If the

proceeds were used in more than one activity, allocate the interest to each activity based on the amount of the proceeds used in each activity.

b. Loans between the partnership and another partnership

or S corporation. If the partnership’s partners have the same proportional ownership interest in the partnership and the other partnership or S corporation, identify each partner’s share of the interest income or expense from the loan. If the partnership was the borrower, also identify the activity in which the loan proceeds were used. If the loan proceeds were used in more than one activity, allocate the interest to each activity based on the amount of the proceeds used in each activity.

Net Investment Income Tax (NIIT) Reporting Requirements The information described in this section should be given directly to the partner and shouldn’t be reported by the partnership to the IRS.

To allow partners to correctly figure the NIIT where a partner disposes of an interest in the partnership during the tax year, the partnership may be required to provide the partner with certain information. The NIIT is a tax imposed on an individual’s, trust’s, or estate’s net investment income. Net investment income includes the net gains or losses from the sale of an interest in the partnership. A partner who is actively involved in one or more of the partnership’s or lower-tier pass-through entities’ trades or businesses (other than trading in financial instruments or commodities) can reduce the amount of the gain or loss from the sale of the partnership or lower-tier pass-through entity interest included in its net investment income. However, to figure its net investment income, the active partner needs certain information from the partnership.

Generally, the partnership must provide certain information to the partner if the partnership knows, or has reason to know, the following.

The partner disposed of an interest in the partnership.
The partner materially participates (within the meaning of the passive activity loss rules (section 469)) in one or more of the trades or businesses (within the meaning of section

of the partnership or a lower-tier pass-through entity (other than trading in financial instruments or commodities).

The partner doesn’t qualify for the optional simplified reporting method for figuring its net investment income associated with the disposition of the interest. For more information, see the instructions for Form 8960, line 5c.

Information to be provided to partner. Generally, the partnership must provide the partner with its distributive share of the net gain and loss from the deemed sale for FMV of the partnership’s property, other than property that relates to the trades or businesses in which the partner materially participates, as determined under the passive activity loss rules applicable to the transfer of an interest in a pass-through entity. For more information, see the instructions for Form 8960, line 5c.