US Internal Revenue Service: p925--1997

8/14/2019 US Internal Revenue Service: p925--1997

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ContentsPassive Activity Limits ...................... 2

Who Must Use These Rules? ........ 2Grouping Your Activities ................. 2Passive Activities ............................ 3Activities That Are Not Passive

Activities ................................... 5Passive Activity Income .................. 6Passive Activity Deductions ............ 7Recharacterization of Passive

Income ..................................... 7Significant Participation Passive

Activities ................................... 7Dispositions ..................................... 8How to Report Your Passive Activity

Loss ......................................... 9

At-Risk Limits ..................................... 19Activities Covered by the At-Risk

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

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

Index .................................................... 22

IntroductionThis publication discusses two sets of rulesthat may limit the losses that you can deducton your tax return from any trade, business,or income-producing activity. The first part ofthe publication contains the passive activityrules. The second part discusses the at-riskrules. However, when you figure your allow-able losses from any activity, you must applythe at-risk rules before the passive activityrules.

Useful ItemsYou may want to see:

Publication

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

541 Partnerships

Form (and Instructions)

4952 Investment Interest Expense De-duction

6198 At-Risk Limitations

8582 Passive Activity Loss Limitations

8582CR Passive Activity Credit Limita-

tions 8810 Corporate Passive Activity Loss

and Credit Limitations

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

Departmentof theTreasury

InternalRevenueService

Publication 925Cat. No. 64265X

Passive ActivityandAt-Risk Rules

For use in preparing

1997 Returns

Get f orms and other informat ion faster and easier by:COMPUTER

World Wide Web www.irs.ustreas.gov FTP ftp.irs.ustreas.gov IRIS at FedWorld (703) 321-8020

FAX From your FAX machine, dial (703) 368-9694See How To Get More Information in this publication.


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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 amount at riskin the activity. The at-riskrules are explained in the second part of thispublication. After you figure your amount at

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.

CAUTION

!However, you must apply the rules inthis part separately to your income orloss from a passive activity held

through a publicly traded partnership(PTP). You can offset losses from passiveactivities of a PTP only against income or gainfrom passive activities of the same PTP. For

more information on how to apply the passiveactivity loss rules to PTPs, see PubliclyTraded Partnerships (PTPs) in the in-structions for Form 8582.

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.

You must apply the limit on passive activ-ity credits separately to your credits from apassive activity held through a publiclytraded partnership (PTP). You can offset

credits from passive activities of a PTP onlyagainst the tax on the net passive incomefrom the same PTP. For more information onhow to apply the limit on passive activitycredits to PTPs, see Publicly Traded Part-nerships (PTPs) in the instructions for Form8582CR.

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 interest

in a passive activity.See the instructions for Form 8582CR for

more information.

Who Must Use TheseRules?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 testing

period is performing personal services.The testing period for any tax year is theprevious tax year. If the corporation has

just 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 employeeowners substantially per-form the services in (2). This requirementis met if more than 20% of the corpo-ration's compensation cost for its activ-ities 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, law, engi-neering, architecture, accounting, actuarialscience, performing 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 as an in-

dependent contractor, on any day of thetesting period, and

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 its

outstanding stock is directly or indirectlyowned by five or fewer individuals. In-dividual includes certain trusts and pri-vate foundations.

Net active income offset. A closelyheld corporation can offset net active incomewith its passive activity loss. It can also offsetthe tax attributable to its net active incomewith its passive activity credits. However, aclosely held corporation cannot offset itsportfolio income (defined later under PassiveActivity Income) 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.

Grouping Your ActivitiesYou can treat one or more trade or businessactivities or rental activities as a single activityif those activities form an appropriate eco-nomic unitfor measuring gain or loss underthe passive activity rules.

Appropriate Economic UnitsGenerally, 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) Purchase 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 in

Philadelphia. 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 predominant partof DEF's business is transporting goods forABC. DEF is the only trucking business inwhich Betty is involved. Following the rulesof this section, Betty treats ABC's wholesaleactivity and DEF's trucking activity as a singleactivity.

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 IRS may have when you first group your

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activities and when you add or dispose of anyactivities in your groupings.

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 with a trade or business activity. How-ever, you can group them together if the ac-tivities form an appropriate economic unitand:

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 property for use in the trade orbusiness activity may be grouped withthe trade or business activity.

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 a building. Wilma is Plum Tower's

only 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) ownHealthy 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).

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,and

With activities conducted through otherentities.

CAUTION!

You may not treat activities grouped

together 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 and Signif-icant Participation Passive Activities underRecharacterization 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 prior year deductions andcredits disallowed under the passive ac-tivity rules that is allocable to the part ofthe 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.

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

Treatment of former passive activities. Aformer passive activity is an activity that is nota passive activity in the current tax year, but

was a passive activity in any earlier tax year.If you have net income from a former passiveactivity in the current year and a prior yearunallowed loss from that activity, you canoffset 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 can offset the allocable part of yourcurrent year tax liability with any prior yearunallowed passive activity credits from a for-mer passive activity. The allocable part ofyour current year tax liability refers to that partof this year's tax liability that is allocable to thecurrent year net income from the former pas-sive activity. You figure this after you reduceyour net income from the activity by any prior

year unallowed loss from that activity (but notbelow zero).

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

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

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

3) Involves research or experimental ex-penditures that are deductible under

Code section 174 (or that would bedeductible if you chose to deduct ratherthan capitalize them).

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

You generally report trade or businessactivities on Schedule C, on Schedule CEZ,on Schedule F, or in Part II or III of ScheduleE.

Rental ActivitiesA rental activity is a passive activity even ifyou materially participated in that activity,unless you materially participated as a real

estate 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 figure

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the 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), is 30 daysor less and you provide significant per-sonal services with the rentals. Signif-icant personal services include only ser-vices performed by individuals. They donot 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 life,and

c) Services that are similar to thosecommonly provided with long-term

rentals of real estate, for example,cleaning 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, and

c) Your gross rental income from the

property 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 of your partnership, Scorporation, or a joint venture.

TIP

If 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. Similarly, you can offsetcredits from the activity against the tax on upto $25,000 of nonpassive income after takinginto account any losses allowed under thisexception.

If you are married, filing a separate return,and lived apart from your spouse for the entiretax year, your offset amount cannot exceed$12,500. However, if you lived with yourspouse at any time during the year and arefiling a separate return, you cannot use thisspecial offset to reduce your nonpassive in-come or tax on nonpassive income.

The offset amount is reduced if yourmodified adjusted gross income exceedscertain 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 rental

real 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 less strin-gent requirement 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 in

rental 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 partic-ipation requirement for the activity for the taxyear the decedent died.

Limited partners cannot actively partic-ipate in the partnership's rental real estateactivities.

You do not actively participate in a rentalreal estate activity unless your interest in theactivity (including your spouse's interest) wasat least 10% by value of all interests in theactivity 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. This special $25,000 off-set ($12,500 for married individuals filingseparate returns and living apart at all timesduring the year) is reduced by 50% of theamount of your modified adjusted gross in-come that is more than $100,000 ($50,000 ifyou are married filing separately). If yourmodified adjusted gross income is $150,000or more ($75,000 or more if you are marriedfiling separately), you generally cannot use

the special offset.Modified adjusted gross income for this

purpose 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 U.S. Savings Bonds used to payqualified higher education expenses,

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

5) Any passive activity loss, or any rentalreal estate loss allowed because youmaterially participated in the rental ac-tivity as a real estate professional (asdiscussed later under Activities That AreNot Passive Activities),

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

7) The deduction for half the self-employment tax.

Example. During 1997 John was unmar-ried and was not a real estate professional.For 1997 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 1997 return, he may deductonly $15,000 of his passive activity loss. Hemust carry over the remaining $16,000 pas-sive activity loss to 1998. 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 $25,000offset starts when your modified adjusted

Adjusted gross income, modified as re-quired ....................................................... $120,000Minus amount not subject to phaseout ... 100,000

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

Required reduction to offset amount ....... $10,000

Maximum offset ....................................... $25,000

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

Adjusted offset amount ............................ $15,000

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

Salary ......................................................... $42,300 Deduction allowable/ Adjusted offsetamount (see above) ................................. 15,000Dividends ................................................... 300

Interest ....................................................... 1,400 Amount that must be carried forward ...... $16,000Rental loss ................................................. (4,000)

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gross income exceeds $200,000 ($100,000 ifyou are a married individual filing a separatereturn and living apart at all times during theyear).

There is no phaseout of the $25,000 offsetfor low-income housing credits for propertyplaced in service after 1989. If you hold anindirect interest in the property through apartnership, S corporation, or other pass-through entity, this special exception will notapply unless you also acquired your interestin the pass-through entity after 1989.

You apply the $25,000 offset first to pas-sive activity losses, then to credits other thanthe rehabilitation and low-income housingcredits, then to rehabilitation credits and low-income housing credits for property placed inservice before 1990. You apply any remainingoffset to low-income housing credits forproperty placed in service after 1989.

Activities That Are NotPassive ActivitiesThe following are notpassive activities.

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

2) A working interest in an oil or gas well.

You must hold your working interest di-rectly or through an entity that does notlimit your liability (such as a generalpartner interest in a partnership). It doesnot matter whether you materially par-ticipated in the activity for the tax year.However, if your liability was limited forpart of the year (for example, you con-verted your general partner interest to alimited partner interest during the year)and you had a net loss from the well forthe year, some of your income and de-ductions from the working interest maybe treated as passive activity gross in-come and passive activity deductions.See Temporary Regulations section1.4691T(e)(4)(ii).

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

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

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

CAUTION!

You should not enter Income and

losses from these activities on Form8582, but on the forms or schedules

you would normally use.

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

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

2) Your participation was substantially allof the participation in the activity of all

individuals 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 partic-ipation 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. When determining whether youmaterially participated in tax years be-ginning before 1987 (other than a tax

year of a partnership, S corporation, es-tate, or trust ending after 1986), youmaterially participated only if you partic-ipated for more than 500 hours duringthe tax year.

6) The activity is a personal service activityin which you materially participated forany 3 (whether or not consecutive) pre-ceding tax years. To determine materialparticipation in tax years beginning be-fore 1987 (other than a tax year of apartnership, S corporation, estate, ortrust ending after 1986), you materiallyparticipated only if you participated formore than 500 hours during the tax year.An activity is a personal service activity

if it involves the performance of personalservices in the fields of health, law, en-gineering, architecture, accounting,actuarial science, performing arts, con-sulting, or any other trade or business inwhich capital is not a material 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 you

materially 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 when you perform the workis treated as participation in the 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:

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

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. If you are marriedfor the tax year, your participation in an ac-tivity includes your spouse's participation.This applies even if your spouse did not ownany interest in the activity and you and yourspouse do not file a joint return for the year.

Proof of participation. You can use anyreasonable method to prove your participationin an activity for the year. You do not have tomaintain contemporaneous daily time reports,logs, or similar documents if you can establishyour participation some other way. For ex-ample, you can show the services you per-formed and the approximate number of hoursspent by using an appointment book, calen-

dar, or narrative summary.

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 only

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if 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 ProfessionalGenerally, rental activities are passive activ-ities even if you materially participated inthem. However, if you qualified as a real es-tate professional, rental real estate activitiesin which you materially participated are notpassive activities. For this purpose, each in-terest you have in a rental real estate activityis a separate activity, unless you choose totreat all interest 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 1997, report income or losses fromrental real estate activities in which youmaterially participated as nonpassive income

or 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, and

2) You performed more than 750 hours of

services 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:

Develops,

Redevelops,

Constructs,

Reconstructs,

Acquires,

Converts,

Rents,

Operates,

Manages,

Leases, or

Brokers

real property.Closely held corporations. A closely

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

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

Passive activity income does not includethe following items.

1) Income from an activity that is not apassive activity. These activities are dis-cussed earlier under Activities That AreNot 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. The interest from loans be-tween partnerships and their partners orS corporations and their shareholders isconsidered self-charged. Some self-charged interest income may be rechar-acterized as passive income.

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 Activities

That Are Not Passive Activities. This alsoapplies to income from other oil and gasproperty the basis of which is determinedwholly or partly by the basis of theproperty in the preceding sentence.

7) Any income from intangible property ifyour personal efforts significantly con-tributed to 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) Income from the reimbursement of aprior year casualty or theft loss if the in-come is included in gross income andthe loss deduction was not a passiveactivity deduction.

13) Alaska Permanent Fund dividends.

14) Cancellation of debt income, if at the

time 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 rule

may apply if you previously used the propertyin a different activity.Exception for more than one use in the

preceding 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 lessthan the smaller of:

1) $10,000, or

2) 10% of the total of fair market value ofyour interest in the property and the fairmarket value of all other property usedin that activity immediately before thedisposition.

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 your interest in the property innonpassive 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 agree

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to 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 in

another 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, and

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 includelosses from dispositions of property used ina passive activity at the time of the dispositionand losses from a disposition of less thanyour entire interest in a passive activity.

Passive activity deductions do notincludethe 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 not

passive 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 losses

similar in cause and severity recur regu-larly in the activity.

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

Recharacterization ofPassive IncomeNet income from the following passive activ-ities may have to be recharacterized and ex-cluded from passive activity income.

Significant participation passive activities,

Rental of nondepreciable property,

Equity-financed lending activities, Rental of property incidental to develop-

ment activities,

Rental of property to nonpassive activ-ities, and

Licensing of intangible property bypass-through entities.

If you are engaged in or have an interest inone of these activities during the tax year(either directly or through a partnership or 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 in this discussion, if the activity is a sig-nificant participation passive activity and youalso have net loss from a different significantparticipation passive activity.

Limit on recharacterized passive income.The total amount that you treat as nonpassive

income 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 Participation PassiveActivitiesA 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, 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 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 exceeds 500, do notcomplete Worksheet A or B. None of the ac-tivities are passive activities because yousatisfy test 4 for material participation. SeeMaterial Participation under Activities ThatAre Not Passive Activities, earlier. Report allthe income and losses from these activitieson the forms and schedules you normally use.Do not include the income and losses on

Form 8582.Column (b). Enter the net loss, if any,

from the activity. Net loss from an activitymeans either:

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

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

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

activity over any prior year unallowed lossesfrom the activity.Column (d). Combine amounts in the

Totals row for columns (b) and (c) and enterthe total net income or net loss in column (d).If column (d) is a net loss, skip Worksheet B.Include the income and losses in Worksheet2 of Form 8582.

If the total for column (d) is net income andyou must complete Form 8582 because youhave other passive activities to report, com-plete Worksheet B. However, you do not haveto complete Form 8582 if column (d) is netincome and you have only significant partic-ipation 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). Enter the ratio for each of theactivities in column (b). The total of the ratiosshould equal 1.00.

Column (c). Multiply the total of column(d) of Worksheet A by each of the ratios incolumn (b). Enter the results in column (c).

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Worksheet A. Significant Participation Passive Activities

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

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

Totals

Column (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 the

result in column (d). This column shows therecomputed current year passive net incomefor significant participation passive activitiesthat had some of its income recharacterizedas nonpassive income.

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 percent of the unad-

justed basis of all property ($400,000) usedin the rental activity. Calvin's net passive in-come from the activity (which is figured withthe gain from the disposition, including gainfrom the improvements) is treated as non-passive income.

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

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

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

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

2) You started to rent the item of propertyless than 12 months before the date ofdisposition.

3) You materially participated or signif-

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

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

Rental of Property to aNonpassive ActivityIf you rent property to a trade or businessactivity in which you materially participated,

net rental income from the property is treatedas nonpassive income. This rule does notapply to net income from renting propertyunder a written binding contract entered intobefore February 19, 1988. It also does notapply to property just described under Rentalof property incidental to a development activ-ity.

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 trust

created 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 years

exceeded 25% of the fair market valueof your interest in the intangible propertyat the time you acquired your interest inthe entity.

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

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

gain or loss is recognized. Furthermore, theperson acquiring the interest from you mustnot be related 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,the excess of:

1) Any loss from the activity for the tax year(including losses carried over from prior

years 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),will not be treated as a loss from a pas-sive activity.

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.

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Worksheet B. Significant Participation Activities(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 1.00

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 $9,000 capital loss, whichis not subject to the passive activity loss limit.He will treat it as any other capital loss car-ryover.

Installment sale of an entire interest. If you

sell 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 gain remaining to be recognizedas of the beginning of the year.

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) of the remaining losses are al-lowed.

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 for the year of disposition. This

includes 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 anyinterest in a passive activity, the accumulatedunused passive activity losses allocable to theinterest cannot be deducted in any tax year.Instead, the basis of the transferred interestmust be increased by the amount of theselosses.

Dispositions by death. If a passive activityinterest is transferred because the owner

dies, accumulated unused losses are allowed(to a certain extent) as a deduction againstthe decedent's income in the year of disposi-tion. The decedent's losses are allowed onlyto the extent they exceed the amount bywhich the transferee's basis in the passiveactivity has been increased under the rulesfor determining the basis of property acquiredfrom a decedent. For example, if the basis ofan interest in a passive activity in the handsof a transferee is increased by $6,000 andunused passive activity losses of $8,000 wereallocable to the interest at the date of death,then the decedent's deduction for the tax yearwould 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. However, to treat thedisposition of substantially all of an activityas a separate activity, you must show withreasonable certainty:

1) The amount of prior year deductions andcredits disallowed under the passive ac-tivity rules that is allocable to the sub-stantial part of the disposed activity, 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 disposed activity.

How To Report YourPassive Activity LossReporting your passive activities may require

more 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 8582CR, Passive Activity CreditLimitations.

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

The following example shows how to re-port your passive activities. In this example,in addition to Form 1040, Charles and Lily useForm 8582 (to figure allowed passive activitydeductions), Schedule E (to report rental ac-tivities and partnership activities), Form 4797(to figure the gain and allowable loss fromassets sold that were used in the activities),and Schedule D (to report the sale of part-nership interests).

General InformationCharles and Lily are married, file a joint re-turn, and have combined wages of $132,000in 1997. They own interests in the followingactivities. They are at risk for all of their in-vestment in the activities. They did not mate-rially participate in any of the business activ-ities. They actively participated in the rentalreal estate activities in 1997 and all prioryears. Charles and Lily are not real estateprofessionals.

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

Minus: adjusted basis ................................ 42,000Capital loss ................................................ $12,000

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

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

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

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

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

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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 1997. Their records alsoshow a gain of $2,776 in 1997 from thesale of section 1231 assets used in theactivity. That section 1231 gain is re-ported in Part I of Form 4797. In 1996they completed the Worksheets in theinstructions for Form 8582 and calcu-lated that $6,667 of Activity A's ScheduleE loss for 1996 was disallowed by thepassive activity rules. That loss is carriedover to 1997 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 1997. In 1996 they completedthe Worksheets in the instructions forForm 8582 and calculated that $8,225of Activity B's Schedule E loss for 1996was disallowed by the passive activityrules. That loss is carried over to 1997as a prior year unallowed Schedule Eloss.

3) Partnership #1 holds a trade or businessactivity and is not a publicly traded part-nership (PTP). Partnership #1 reports a$4,000 distributive share of its 1997profits to Charles and Lily on line 1 ofSchedule K1, Form 1065. They reportthat profit on Schedule E. In 1996 theycompleted the Worksheets in the in-structions for Form 8582 and calculatedthat $2,600 of their distributive share ofPartnership #1's 1996 loss was disal-lowed by the passive activity rules. Thatloss is carried over to 1997 as a prioryear unallowed Schedule E loss.

4) Partnership #2 is a PTP that holds atrade or business activity. In 1997

Charles and Lily disposed of their entireinterest in Partnership #2. They do notreport that gain on Form 8582 becausePartnership #2 is a PTP. They recognizea long-term capital gain of $15,300($25,300 selling price minus $10,000adjusted basis), which they report onSchedule D. The partnership reports a$1,200 distributive share of its 1997losses to them on line 1 of ScheduleK1, Form 1065. They report that losson Schedule E. In 1996 they followed theinstructions for Form 8582 and calcu-lated that $2,445 of their distributiveshare of Partnership #2's 1996 loss wasdisallowed by the passive activity rules.That loss is carried over and added tothe $1,200 Schedule E loss. See the

discussion of PTPs in the instructions forForm 8582.

5) Partnership #3 holds a single trade orbusiness activity and is not a PTP.Charles and Lily sold their entire interestin partnership #3 in November 1997.They recognize a $4,000 ($15,000 sell-ing price minus $11,000 adjusted basis)long-term capital gain, which they reporton Schedule D.

In 1996 they completed the Work-sheets in the Form 8582 instructions andcalculated that $3,000 of their distributiveshare of the partnership's loss for 1996was disallowed by the passive activity

rules. That loss is carried over to 1997as a prior year unallowed Schedule Eloss. Charles and Lily's distributive shareof partnership losses for 1997 reportedon line 1 of Schedule K1, Form 1065,is $6,000.

6) Partnership #4 is a limited partnershipthat holds a trade or business activity.Charles and Lily are limited partners whodid not meet any of the material partic-ipation tests. Their distributive share of1997 partnership loss, reported on line

1 of Schedule K1, Form 1065, is$2,400. In 1996 they completed theWorksheets in the Form 8582 in-structions and calculated that $1,500 oftheir distributive share of loss for 1996was disallowed by the passive activityrules. That loss is carried over to 1997as a prior year unallowed Schedule Eloss.

Step OneCompleting the TaxForms Before Figuring thePassive Activity Loss LimitsAs far as they can, Charles and Lily completethe forms they usually use to report incomeor expenses from their activities. They entertheir combined wages, $132,000, on Form1040. They complete line 8 of Schedule Dshowing long-term capital gains of $15,300from Partnership #2 and $4,000 from Part-nership #3. Because Partnership #2 is a PTP,it is not entered on Form 8582. Since thedisposition of Partnership #3 represents adisposition of an entire interest in an activitywith an overall loss of $5,000, that partnershipis also not entered on Form 8582. Theycombine the PTP $1,200 current year losswith its $2,445 prior year loss, and also com-bine the Partnership #3 $6,000 current yearloss with its $3,000 prior year loss, and enterthe two combined amounts in column (g) online 27 of Schedule E, Part II. They enter the$4,000 profit from Partnership #1 in column

(h). They complete Schedule E, Part I,through line 22. Since their rental activitiesare passive, they must complete Form 8582to figure the deductible losses to enter on line23.

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

Step TwoForm 8582and the WorksheetsCharles and Lily now complete Form 8582and the worksheets that apply to their passiveactivities. Because they are at risk for allamounts invested in their activities, they donot 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 activities).They enter all amounts from the activitieseven though they already reported the gainof $2,776 from Activity A on Form 4797, sinceall income or loss from these activities mustbe taken into account to figure the loss al-lowed.

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.

c) ($6,667) prior year unallowed lossin column (c) from their worksheetsused in 1996.

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.

b) ($8,225) prior year unallowed lossin column (c) from their 1996 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 Form

8582, 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

way they reported their rental activities onWorksheet 1. Then they enter the totals onForm 8582, 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 oneactivity 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. They enter:

1) Partnership #1 on line C in column (a).

2) P in column (b) since this entity is apartnership.

3) No entry in column (c) since it is not aforeign partnership.

4) The identification number in column (d).

5) A check mark in column (e) since all oftheir investment is at risk.

6) ($2,600), which is the prior year unal-lowed Schedule E loss, in column (g).

7) $4,000, their distributive share of 1997profit, in column (h).

Page 10


11/23

Step ThreeCompletingForm 8582Charles and Lily fill out Part II, Form 8582,since they will need the figure on line 9 tocomplete Worksheet 3. They enter allamounts as though they were positive (with-out brackets around losses). They then com-plete Part III of Form 8582.

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 gain,$11,655, from the entire disposition ofPartnership #2, a PTP, plus their $5,000overall loss from the entire dispositionof partnership #3.

They reported on Schedule D 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 1997 loss of

$1,200 with its prior year loss of $2,445,and combined the Partnership #3 1997loss of $6,000 with its prior year loss of$3,000. Netting these amounts givesthem the PTP overall gain of $11,655and the Partnership #3 overall loss of$5,000 that were used in figuring modi-fied adjusted gross income.

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

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

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

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

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

Step FourCompletingWorksheet 3Charles and Lily must complete Worksheet 3since they have an overall loss in column (e)of Worksheet 1 and an amount on line 9 ofForm 8582. This worksheet allocates theamount on line 9 (their special allowance foractive participation rental real estate activ-ities) between Activity A and Activity 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 Totalline and enteringthe result in (b). These ratios, whenadded, must equal 1.00.

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

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

Step FiveCompletingWorksheet 4Worksheet 4 must be completed if 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 3.They have one activity showing a loss inWorksheet 2, column (e). They fill in thenames of the activities and the schedules or

forms each will be reported on 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 Totalline.

2) They divide each of the losses in column(a) by the amount on the column (a)Totalline, and enter each result in col-umn (b). These numbers must also addup to 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 incolumn (c). These amounts are the unallowedloss from each activity and must add up to

$35,543.

Step SixUsingWorksheets 5 and 6Charles and Lily now decide whether theymust use Worksheet 5, Worksheet 6, or bothto figure their allowed losses. If the loss from

an 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 the activities they entered onWorksheet 4 should go on Worksheet 5 sincethe losses are reported on Schedule E only.(Worksheet 6 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 1997 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 Lillyenter 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 by writing:

1) The name of the activity on line 27D,column (a),

2) P in column (b),

3) The employer identification number incolumn (d),

4) A check mark in column (e) since all theirinvestment is at-risk, and

5) ($148) in column (g).

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

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

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

Charles and Lily are now able to completetheir return, having limited their losses fromtheir passive activities as required.

Page 11


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Charles Eric

Lily Woods

6 925 Count ry Road

Anyt own, VA 2230 6

123 0 0 456 7

56 7 0 0 1234

2

2

132,0 0 0

22,076

(21,09 4)

132 ,98 2

132 ,98 2

Department of the TreasuryInternal Revenue Service

1040 U.S. Individual Income Tax ReturnOMB No. 1545-0074For the year Jan. 1Dec. 31, 1997, or other tax year beginning , 1997, ending , 19

Last nameYour first name and initial Your social security number

(Seeinstructionson page 10.)

LABEL

HERE

Last name Spousessocialsecurity numberIf a joint return, spouses first name and initial

Use the IRSlabel.Otherwise,

please printor type.

Home address (number and st reet). If you have a P.O. box, see page 10. Apt. no.For help in finding lineinstructions, see pages

2 and 3 in the booklet.City, town or post office, state, and ZIP code. If you have a foreign address, see page 10.

PresidentialElection Campaign(See page 10.)

Note: CheckingYes 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 10.)5

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

return, do not check box 6aExemptionsSpouseb

(4) No. of monthslived in your

home in 1997Dependents:c (2) Dependentssocial security number

(3) Dependentsrelationship to

you(1) First name Last name

If more than sixdependents,see page 10.

d Total number of exemptions claimed

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

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

Copy B of yourForms W-2,

W-2G, and1099-R here.

99 Dividends. Attach Schedule B if required

1010 Taxable refunds, credits, or offsets of state and local income taxes (see page 12) 1111 Alimony received

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

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

1313 Capital gain or (loss). Attach Schedule D

1414 Other gains or (losses). Attach Form 4797

15a 15bTotal IRA distributions b Taxable amount (see page 13)15a

16b16aTotal pensions and annuities b Taxable amount (see page 13)16a

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

1919 Unemployment compensation

20b20a b Taxable amount (see page 14)20a Social security benefits

21

21

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

23IRA deduction (see page 16)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 17)

26

2727

Keogh and self-employed SEP and SIMPLE plans 2828

Penalty on early withdrawal of savings 2929

Alimony paid b Recipients SSN

31Add lines 23 through 30a

30a

Subtract line 31 from line 22. This is your adjusted gross income 31

AdjustedGrossIncome

32

If you did notget a W-2,see page 12.

Form

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

Cat. No. 11320B

Label

Form 1040 (1997)

IRS Use OnlyDo not write or staple in this space.

Head of household (with qualifying person). (See page 10.) If the qualifying person is a child but not your dependent ,

enter this childs name here.

Other income. List type and amountsee page 15

Moving expenses. Attach Form 3903 or 3903-F

24 24

(99)

For Privacy Act and Paperwork Reduction Act Notice, see page 38.

If line 32 is under$29,290 (under$9,770 if a childdid not live withyou), see EIC inst.on page 21.

No. of boxeschecked on6a and 6b

No. of your

children on 6cwho:

Dependents on 6cnot entered above

Add numbersentered onlines above

lived with you

did not live withyou due to divorceor separation(see page 11)

1997

32

30a

Page 12


13/23

Charles Eric and Lily Woods 123 0 0 456 7

Part nership #2(ent ire disposit ion of

pass ive act ivit y) 12-2-91 12-4-97 25,30 0 10 ,0 0 0 15,30 0Part nership # 3

(ent ire disposit ion ofpass ive act ivit y) 12-15-92 11-18 -97 15,0 0 0 11,0 0 0 4,0 00

2,776

22,076

*28% Rate Gain or Loss includes all gains and losses in Part II, column (f) from sales, exchanges, or conversions (includinginstallment payments received) either:

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

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

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

Your social security numberName(s) shown on Form 1040

Short-Term Capital Gains and LossesAssets Held One Year or Less(f) GAIN or (LOSS)

FOR ENTIRE YEAR.Subtract (e) from (d)

(e) Cost orother basis

(see page D-4)

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

(d) Sales price(see page D-3)

(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 Forms 2119 and 6252, and short-term gain or (loss)

from Forms 4684, 6781, and 88245

66

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

7

Short-term capital loss carryover. Enter the amount, if any, from line 9 of your1996 Capital Loss Carryover Worksheet

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

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

8

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

9

10 Total long-term sales price amounts.Add column (d) of lines 8 and 9 10

11Gain from Form 4797, Part I; long-term gain from Forms 2119, 2439, and6252; and long-term gain or (loss) from Forms 4684, 6781, and 8824

11

1212

13

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

14

Capital gain distributions

15 15

14

16

Long-term capital loss carryover. Enter in both columns (f) and (g) the amount,if any, from line 14 of your 1996 Capital Loss Carryover Worksheet ( )

Combine lines 8 through 14 in column (g)

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

For Paperwork Reduction Act Notice, see Form 1040 instructions. Schedule D (Form 1040) 1997Cat. No. 11338H

( )

44

Part I

Part II

7

13

(b) Dateacquired

(Mo., day, yr.)

2

9

(99)

1997

(f) GAIN or (LOSS)FOR ENTIRE YEAR.Subtract (e) from (d)

(e) Cost orother basis

(see page D-4)

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

(d) Sales price(see page D-3)

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

(b) Dateacquired

(Mo., day, yr.)

(g) 28% RATE GAINor (LOSS)

Before May 7, 1997, or A

Documents

US Internal Revenue Service: p925--1997