Passive activity credits and recharacterized income.

Author:Hesse, Christopher W.
 
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* Tax credits attributable to passive activities may be suspended under the passive activity credit rules.

* Even though income from a passive activity is recharacterized as nonpassive, credits from the activity may be treated as passive activity credits.

* By changing the level of participation in an activity, a taxpayer may be able to accelerate the use of passive activity credits caused by the recharacterization of income as nonpassive.

The Internal Revenue Code includes various tax incentives to encourage certain economic and social behavior. Depending on the investor's participation level, however, the promised tax benefits might not arise. Passthrough owners that do not materially participate in a trade or business may find their tax credits suspended under the passive activity rules. This concern is particularly acute when the passthrough owner significantly participates in the business activity but does not materially participate.

Material participation: Under the regulations, a person is treated as materially participating in an activity for the tax year if:

  1. The individual participates in the activity for more than 500 hours during the year;

  2. The individual's participation in the activity for the tax year constitutes substantially all of the participation in that activity of all individuals (including individuals who are not owners of interests in the activity) for the year;

  3. The individual participates in the activity for more than 100 hours during the tax year, and the individual's participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who did not own interests in the activity) for the year;

  4. The activity is a significant participation activity (within the meaning of Temp. Regs. Sec. 1.469-5T(c)) for the tax year, and the individual's aggregate participation in all significant participation activities during that year exceeds 500 hours;

  5. The individual materially participated in the activity (determined without regard to this paragraph (5)) for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year;

  6. The activity is a personal service activity (within the meaning of Temp. Regs. Sec. 1.469-5T(d)), and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or

  7. Based on all the facts and circumstances (taking into account the rules in Temp. Regs. Sec. 1.469-5T(b)), the individual participates in the activity on a regular, continuous, and substantial basis during the year. (1)

Significant participation: An individual significantly participates in an activity if he or she participates for more than 100 hours during the year (2) and does not otherwise materially participate. (3) The individual who significantly participates without achieving more than 500 hours in all significantly participating activities is a person involved with a significant participation passive activity. (4) In this case, the amount of gross income that exceeds the passive activity deductions from all significant participation passive activities is recharacterized as income that is not from a passive activity...

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