Passive activity credit flowchart.

• Author: Koehler, Kevin

Many individual taxpayers invest in passive activities. Often, these activities generate tax credits. Understanding the limitations on the use of passive activity credits is a key element in providing sound tax advice to clients. Clients are typically excited by the prospects of tax credits but fail to realize the limitations--and are sometimes surprised to learn they receive no current-year tax benefit.

The Sec. 469 rules regarding the use of passive activity credits are complex. The 2014 version of Form 8582-CR, Passive Activity Credit Limitations, has 16 pages of instructions and nine worksheets to determine the allowable passive activity credit. Most allowable credits must also meet the Sec. 38 general business limitations. The flowchart below provides a quick way to visualize the requirements the credits must meet and the limitations imposed on them before they can be deducted against current-year tax.

The first type of credits the flowchart lists, "Other passive activity credits," includes common business credits, such as the work opportunity credit, credit for increasing research activities, and the credit for employer Federal Insurance Contributions Act (FICA) taxes paid on certain tips. These credits are limited to the tax equivalency of net passive income. Tax equivalency is the amount of income tax attributable to the net passive income. If net passive activities produce a loss, the credits are suspended and carried forward to the next tax year.

The tax-equivalency computation, fortunately, is straightforward. It is the difference between the tax on taxable income with and without the net passive income. Taxable income does not have to be refigured for those items based on a percentage of adjusted gross income (AGI). In other words, one should ignore the effect of phaseouts and look strictly at tax brackets.

For example, assume married taxpayers filing jointly have $20,000 of passive credits, $50,000 of net passive income, and $350,000 of taxable income in 2015. The first step is to calculate the income tax on $350,000 of taxable income ($91,029) and then, excluding the $50,000 of passive income, on $300,000 of taxable income ($74,529). The $16,500 difference ($91,029-$74,529) in income tax is the tax-equivalent amount on the $50,000 of passive income and is the allowable credit. The remaining $3,500 ($20,000-$16,500) of credits are carried forward.

The second type of credits in the flowchart are credits coming from publicly...