PAL rules: definition of activity.

• Author: Schmalz, John G.
• Position: Passive activity losses

The PAL rules have been the subject of IRS interest since their enactment in 1986. Last year, the Service released audit guidelines addressing the rules as part of its Market Segment Specialization Program, to highlight common passive activity audit issues and recommend techniques to resolve them. Final Regs. Sec. 1.469-4 is part of a continuing attempt to clarify a very technical area that is often misunderstood, in part because the Code does not provide details and prior regulations were difficult to follow.

Under the basic rules, PALs and credits may only reduce income from other passive activities; excess passive losses are suspended. However, if an individual sells an entire passive activity interest, any suspended losses are freed up and may offset income generated by the sale or be used to offset nonpassive income. Passive activities generally are defined as rental activities and other trade, business or investment activities in which an individual does not materially participate.

Defining some of these basic terms is more difficult. Material participation is determined using several alternative tests that quantify the amount of an owner's participation in an activity. Generally, one or more trade or business or rental activities may be treated as a single activity if together they are an appropriate economic unit. Determining an individual's separate and grouped activities is the first step in figuring how passive losses may be used.

One key point is the ability to use suspended losses on the partial disposition of an activity. The final regulations are more stringent than those proposed earlier, which permitted use of suspended losses on dispositions of a substantial part of an activity. In contrast, final Regs. Sec. 1.469-4(g) requires disposition of substantially all of an activity. This test by definition is harder to satisfy. Another problem is that the IRS has not explained how to determine what constitutes "substantially all." The disposed part may be treated as a separate activity, but only if the amount of deductions and credits and the gross income allocable to that part for the tax year can be established with reasonable certainty.

Regs. Sec. 1.469-4(c)(2)...