Claiming passive activity credits.

• Author: Ellentuck, Albert B.

Credits arising from passive activities are allowable only to the extent a shareholder's regular tax liability is attributable to passive activities for the year. The tax attributable to passive activities is the difference between the:

1. Shareholder's regular tax liability under Sec. 26(b) based on all income (disregarding credits), and

2. Regular tax liability (disregarding credits) if taxable income were reduced by net passive activity income; see Temp. Regs. Sec. 1.469-3T(a) and (d).

Example

Albert's Schedule K-1 from Alco, an S corporation, shows a $15,000 alcohol fuels credit. Albert does not materially participate in Alco, and the $15,000 is the only credit to which he is entitled. Disregarding the credit, Albert's regular tax liability would be $60,000. If the tax were computed without considering passive activity income, Albert's tax would be $50,000.Thus, Albert can take up to $10,000 in passive credits. The unused balance of the credit ($5,000) carries forward as a passive activity credit to apply against tax on passive activity income in future years.

In the following year, Albert's regular tax liability is $75,000, while his tax computed without considering passive activity income is $65,000. The $5,000 alcohol fuels credit carryover is the only credit to which he is entitled. Because the tax attributable to passive activity income exceeds $5,000, the entire credit carryover can be used in the following year.

The credits subject to the passive activity credit rules include the general business credits. Under Temp. Kegs. Sec. 1.469-3T(b), the passive activity credit rules apply if the credits are attributable to a passive activity.

Caution: The credits for Federal tax on fuels and for the purchase of a diesel-powered vehicle (claimed on Form 4136, Credit for Federal Tax Paid on Fuels) are not passive activity credits.

Using Passive Activity Credits from Rental Real Estate

Sec. 469(i) allows up to $25,000 of nonpassive income to be offset per year with the deduction equivalent of the passive activity credits attributable to a rental real estate activity in which the taxpayer actively participates. Under Sec. 469(j)(5), a deduction equivalent is the amount of deduction it takes to reduce the regular tax liability by an amount equal to the credit. For example, if a taxpayer is in the 28% bracket, $100 of credit carries a deduction equivalent of $357 ($100/.28); that is, it would take a $357 deduction to reduce the tax by $100. For...