Lane, a single taxpayer, received $160,000 in salary, $15,000 in income from an S Corporation in which Lane does not materially participate, and a $35,000 passive loss from a real estate rental activity in which Lane materially participated. Lane's modified adjusted gross income was $165,000.

What amount of the real estate rental activity loss was deductible?

a. $0

b. $15,000

c. $25,000

d. $35,000

Solution:

Rule: Passive activity is any activity in which the taxpayer does not materially participate. A net passive activity loss generally may not be deducted against other types of income (e.g., wages, other ordinary or active income, portfolio income (interest and dividends), or capital gains). In other words, passive losses may generally only offset passive income for a tax year-the remaining net loss is generally "suspended" and carried forward to a year when it may be used to offset passive income (or when the final disposition of the property occurs). However, there is an exception to this general rule. Taxpayers who own more than 10% of the rental activity, have modified AGI under $100,000, and have active participation (managing the property qualifies), may deduct up to $25,000 annually of net passive losses attributable to real estate. There is a phase-out provision for modified AGI from $100,000 - $150,000, and the deduction is completely phased-out for modified AGI in excess of $150,000.

Choice "b" is correct. Per the above rule, unless an exception exists (and it does not in this case, as Lane's modified adjusted gross income is in excess of $150,000), passive losses may only offset passive income for a tax year (i.e., no "net loss" may exist). In this case, Lane has a $20,000 net loss from passive activity [$15,000 S Corporation income (passive, in this case because the facts state Lane does not materially participate) minus the $35,000 rental real estate loss]. Thus, only $15,000 of the passive loss from real estate rental activity may be used to offset the $15,000 income from the S Corporation. The remaining $20,000 passive activity loss is carried forward to be used in future years.

Choice "a" is incorrect. Per the above rule, passive losses may generally only offset passive income for a tax year. Lane has passive income of $15,000 in the year; thus, passive loss up to $15,000 may be deducted from passive income.

Choice "c" is incorrect. This answer option is an attempt to confuse the candidate into using the "mom and pop" exception, which applies when taxpayers who actively participate, own more than 10% of the rental activity, and have modified AGI under $100,000 are able to deduct up to $25,000 annually of net passive losses attributable to real estate. There is a phase-out provision for modified AGI from $100,000 - $150,000, and the deduction is completely phased-out for modified AGI in excess of $150,000. In this case, the facts state that Lane's modified adjusted gross income is $165,000; thus, Lane does not qualify to use the exception.

Choice "d" is incorrect. This answer option assumes that the full amount of the rental real estate loss is deductible against the passive income from the S Corporation, and, thus, against Lane's other taxable income. As indicated in the rule above, unless an exception applies (it does not in this case), a net passive activity loss may not be deducted against other types of income (e.g., wages, other ordinary or active income, portfolio income (interest and dividends), or capital gains).

Thus, the full $35,000 rental real estate loss is not deductible in the year by Lane.