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Passive activity loss carryover and rental property depreciation

1. I have a rental property that generates passive activity losses each year.  Last year I had negative adjusted gross income.  This year I will also have adjusted gross income.  Yet Turbotax seems to be deducting the full amount of allowed passive activity losses ($25000 / year) from my taxable income each year.  This causes much or all of my passive activity losses to be wasted, since I will not have any taxable income even without the passive activity loss deductions!

How can keep my passive activity losses by carrying them over, instead of wasting them on my nonexistent taxable income this year?

2. Related to 1, part of the passive activity losses stem from depreciation claimed on my rental property.  Is claiming depreciation optional?  I don't want to claim deprecation since 1) it is wasted on my nonexistent taxable income and 2) it lowers the tax basis of my property.
    In general, you can deduct passive activity losses only from passive activity income (a limit on loss deductions). You carry any excess loss forward to the following year or years until used, or until deducted in the year you dispose of your entire interest in the activity in a fully taxable transaction so you won't lose the loss as it's only against the related income.

    Depreciation. You must take depreciation. If you don't the IRS assumes you did as you were allowed and will decrease your basis based upon what you should have taken for depreciation.Special $25,000 allowance.   If you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.

      If you are married, filing a separate return, and lived apart from your spouse for the entire tax year, your special allowance cannot be more than $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you cannot use the special allowance to reduce your nonpassive income or tax on nonpassive income.

      The maximum special allowance is reduced if your modified adjusted gross income exceeds certain amounts. See Phaseout rule,



    So the answer is to say NO that you didn't materially participate..... of course only if you really didnt.
    • This issue is part of my current question. (See "Suspended Losses from rental not carried forward; used to reduce AGI below zero".)

      I agree with "maglib" about passive losses only offsetting passive income unless you can use the $25K exception, and about the nasty "allowed or allowable" depreciation rule. But I'm not sure what "So the answer is to say NO that you didn't materially participate..... of course only if you really didnt" is suggesting.

      Looks to me like "material" participation is a much tougher test than "active" participation. (See www dot anchin dot com slash PR-021810 dot htm) And, it is explicitly disallowed for real estate activities, unless you meet the "real estate professional" test which is yet a different set of requirements. I suspect both you and I belong in the active but not material category.

      I'm in an LLC partnership as a non-material participant, and TurboTax does seem to properly handle passive losses from that K1, and save them for carryover years, though it doesn't put them on the explicit "Carryover to 2011" sheet. Maybe if I was not an active participant in my rentals, it would do the same for them. But I certainly don't want to confuse the IRS by suddenly declaring I'm not "active", when I've been active for years and might need to be again next year!

      So I think I understand what's supposed to happen. My current question is down to whether I need to manually override what TurboTax has done this year, so my AGI ends up as zero instead of negative, or whether it doesn't matter and I can just manually insert the proper carryover amounts next year. Will the IRS remember that those losses were wasted pushing my income below zero in 2010?

      The "we ignore these issues" page says TurboTax 2010 totally doesn't deal with NOL Net Operating Loss, anyone who hits that must deal with it manually. It doesn't mention our "suspended losses", but I suspect they are in the same category. Don't they realize how badly the economy sucks at this point?

      Loren
    • Duh! I just had a serious insight...  We don't want to reduce our AGI to exactly zero! We only want to reduce it enough that our deductions and exemptions will lead to zero tax! So we'd like to save even more of our 2010 losses for future years. I'm not finding any clues about whether that is allowable for passive losses.

      There was a question here "Can I defer carryover suspended loss to a future year?", but the answer was based on capital loss rather than passive income loss, and I can't see that the author ever re-posted the question. I suspect the guy who answered didn't know the answer for suspended loss, or he would have just replied instead of suggesting a re-post.

      I'm going to go ask the IRS...  

      Loren
    Not sure how much this is going to help at this point, but here goes:

    "Passive losses allowed in excess of passive income due to the special $25,000 rental real estate allowance can become part of the taxpayer's NOL, which is carried back 3 years or forward 15 years."

    http://www.irs.gov/businesses/small/article/0,,id=146339,00.html
    • Thanks, "tagteam2008". I'd seen one "becomes an NOL" search result something like that before, but it didn't seem very authoritative so I ignored it. Interesting to see it on the IRS page.

      But it does say "can", not "must"...  I've asked the IRS specifically if one must apply the full amount of a PAL in the year it was first allowed. Will report the result...  

      Loren
    form 8582 will limit the $25k loss allowed to your AGI.  I understand you want to limit it even further and I don't see any ruling on that.  Good Question but at least you can limit it to the extent of AGI.
      IRS eMail reply:
      -----
      You are not required to claim the special allowance for active participation in rental real estate activities. You can treat those as any other passive activity that applies the losses only against passive income. If you do not want to claim those losses, you will need to leave Part II of Form 8582, Passive Activity Loss Limitations, blank. In any case, you can not carry forward unallowed passive activity losses to the next year unless those are reflected on Form 8582 and its worksheets.
      -----

      In TT, you can open Form 8582, right click each entry in Part II, select Override, and delete it. For California, you can do the same in Form 3801, Part II (except the line 6 entry of federal AGI won't delete).

      Verify that the program recalculates the Form 8582 Part IV (US), and Form 3801 Part III (CA), Total Losses Allowed, and shows the expected Unallowed Loss amounts in Form 8582 p2 Wks 5, and in Form 3801 Wks 5.

      If you don't choose to do this, and allow TT to show a negative AGI, then you need to manually claim a NOL for the negative amount of your AGI. TT won't help you with this, and you waste the future benefit of the passive loss that reduced your AGI below your other deductions and exemptions.
      -----
      If you decide to claim those losses and that gives you a negative adjusted gross income, you may have a net operating loss (NOL). If you have a net operating loss, you have more options on how to handle the loss. Generally, if you have an NOL for a tax year, you must carry back the entire amount of the NOL to the 2 tax years before the NOL year and then carry forward any remaining NOL for up to 20 years after the NOL year. You can, however, choose not to carry back an NOL and only carry it forward.
      -----

      I guess a question remains if you need to use part of your passive loss to avoid tax this year. Seems like if you can choose not to use any of the $25K allowance, you could choose to use only part of it, but who knows.


      And, to the depreciation part of the original question, you are not required to claim depreciation, but due to the "allowed or allowable" rule, there is no benefit to be had by avoiding the claim.
      • Turns out there is a gotcha when you override values - you can't e-file!
        -----
        Article ID: GEN12335
        Uncommon tax situations may require a tax calculation that deviates from the standard. TurboTax Desktop software allows you to to override a tax calculation, if necessary. Overriding is not an option in TurboTax Online.

        If you override a TurboTax calculation, keep in mind the following:

        The TurboTax Accuracy Guarantee is invalidated.
        You must print and mail your return because TurboTax won't let you e-file a tax return with overridden values.
        -----

        They also say, "When you run the final review, TurboTax will warn you of overridden values", but that isn't true, at least this year. It lets you e-file, right up through the final, "irrevocable" e-file button press, and then comes back with "we need some more information..." Then it steps through each line you've overridden and asks you to delete the overrides.

        After I stepped through all of my overrides _without_ restoring them to the default values that would waste thousands of dollars of passive losses, the program went back to the "final" e-file button, without any suggestion of what would happen if I pressed it. Would it circle around again and ask me again to undo my overrides, or would it try to file the overridden return?

        So while I sit here waiting for 50+ pages to print, and hoping I don't run out of ink when the nearest store is two hours' drive from here, I get to think about why the program isn't smart enough to know the $25K passive loss allowance for rentals is optional. Obviously a few of us noticed we were wasting losses; I wonder how many people just accepted the default numbers.

        So much for the heavily advertised "best result" guarantee...
      • Thank you guys so much for posting this thread because I had the exact same question.  I want to be able to use part of the $25,000 but not all of it and I'm not sure if you can.  Just checking in this year to see if anyone found more guidance?
      • @KellyKelly2:
        I haven't heard from the IRS since filing my overridden return ten months ago. I guess that isn't conclusive, but I'm calling it good!

        But I declined the whole of my "Special Allowance".

        With the benefit of my further research, it seems clear that at least if you have more than one passive activity, you absolutely can't just tweak or zero out a particular loss-making activity.

        If you have only a single activity, you couldn't run into the need to adjust loss amounts according to ownership percentages, so your overrides would be much simpler. TurboTax will certainly let you try manually claiming part of the allowance...  I'd bet nobody at the IRS has a clue whether it should be allowed or not.

        Loren
      Re: My solution from last year...  

      "In TT, you can open Form 8582, right click each entry in Part II, select Override, and delete it. For California, you can do the same in Form 3801, Part II (except the line 6 entry of federal AGI won't delete)."

      For 2011, you can't override anything in Form 8582! For California, you can still zero out Form 3801, Part II, line 4, and it will zero Line 9 for you. But for the Federal override, you must make the changes in the individual activity worksheets that had losses.

      You should see your previous year carryovers on the "Carryovers to 2011 Smart Worksheet". Just below that on the "Activity Summary Smart Worksheet", "Schedule E, Line I - Net profit (loss) allowed" seems to be the place to enter zeros, or however much you want to claim this year.

      Below that, the "Carryforward to 2012 Smart Worksheet" is not smart enough to respond to your overrides - you need to manually enter the sum of your previous and current carryovers at "Schedule E suspended loss". The changes do propagate to your 1040 automatically.

      They do _not_ propagate to Form 8582 Part IV (US), Total Losses Allowed, or to the Unallowed Loss amounts in Form 8582 p2 Wks 5, like they did last year. I have no idea if this is a problem...  But since the "Carryforward to 2012" looks right, I'm going to guess it will work.

      Seems like things get more difficult each year...  

      -----

      After more study, I'm doubting my guess above is correct. It does result in no current losses, and carryforwards to 2012. But the allowed versus carryforward amounts it calculated when I could override the 8582 allowance for 2010 were a complex result based on all of my rentals, both profitable and loss making, and on my K-1 partnership amounts.

      Can I really choose to make Sch E line 22 equal zero, like I suggested above, and carry forward all of the loss on the one rental property? Or must I reduce my override of the loss by the gain on the other rental and by the interaction with the K-1 partnership? That's not a simple calculation, and I believe its results would need to be overridden in many places.

      Why can't TurboTax just ask us if we want to take the special allowance or not?
        After consulting several times with the IRS, it is clear my first idea, zeroing out the loss of the loss-making real estate activity in its individual worksheets (as suggested by the TurboTax help popup) will not fly if one has multiple activities. The conclusion seems to be that the only way to handle this for 2011 is to tell TurboTax that my participation is not "active", despite it remaining as active as ever. The IRS can't seem to guarantee this is not going to cause problems later, but they suggest it is probably acceptable:

        ---
        There is no actual guidance in regards to not claiming the Special Allowance when you are actively participating in the rental activity. If you do not want to claim the Special Allowance, you must report that for that particular year you were not actively participating. This is a determination that you must make every year. What appears on your 2010 return will not affect your 2012 return. It will have no bearing in future years. The active participation is what determines if you are eligible to claim a loss. All of your questions revolve around this one topic and we do not have enough guidance to provide you with anything beyond what is already mentioned in this response.
        ---

        The alternatives seem far too complex and subject to confusion next year, so I guess I'll try it. It does have the advantage of not requiring overrides and thus preventing E-Filing.

        When I removed my overrides, the "final check" complained about not having Federal AGI entered in the California "Special Allowance" worksheet. It persisted until I opened the California form manually and clicked that box. Didn't enter anything...  But that seems to have made it happy - guess it triggered some re-calculation somewhere that noticed I was no longer "active".

        I'm going to take another day to review the results of this choice before sending it to the IRS. If I learn anything more, I'll share it here.

        Loren
        • I stumbled across this thread because I'm looking to do something similar.  I sold one rental property for a significant loss, which offset my income considerably.  A second rental property I own has more than $25K of carried forward PAL.  TurboTax decided to apply all $25K of the PAL special allowance this year resulting in more than $7,500 in unused deductions because my taxable income hit $0.  Stupid.  The easy fix for this was to tell TurboTax I didn't actively participate in the second rental property during 2012, thereby shutting off the entire special allowance and leaving the PAL untouched.  Not perfect, but it'll do.

          Thanks Loren for remaining active on this thread...it really helped!