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2011 Tax File

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2011 Tax File

2011 tax file 1. 2011 tax file   Deducting Business Expenses Table of Contents What's New Introduction Topics - This chapter discusses: Useful Items - You may want to see: What Can I Deduct?Cost of Goods Sold Capital Expenses Capital versus Deductible Expenses Personal versus Business Expenses How Much Can I Deduct?Not-for-profit limits. 2011 tax file At-risk limits. 2011 tax file Passive activities. 2011 tax file Net operating loss. 2011 tax file When Can I Deduct an Expense?Economic performance. 2011 tax file Not-for-Profit ActivitiesGross Income Limit on Deductions What's New Optional safe harbor method to determine the business use of a home deduction. 2011 tax file  Beginning in 2013, you can use the optional safe harbor method to determine the deduction for the business use of your home. 2011 tax file See Optional safe harbor method under Business use of your home , later. 2011 tax file Introduction This chapter covers the general rules for deducting business expenses. 2011 tax file Business expenses are the costs of carrying on a trade or business, and they are usually deductible if the business is operated to make a profit. 2011 tax file Topics - This chapter discusses: What you can deduct How much you can deduct When you can deduct Not-for-profit activities Useful Items - You may want to see: Publication 334 Tax Guide for Small Business 463 Travel, Entertainment, Gift, and Car Expenses 525 Taxable and Nontaxable Income 529 Miscellaneous Deductions 536 Net Operating Losses (NOLs) for Individuals, Estates, and Trusts 538 Accounting Periods and Methods 542 Corporations 547 Casualties, Disasters, and Thefts 587 Business Use of Your Home 925 Passive Activity and At-Risk Rules 936 Home Mortgage Interest Deduction 946 How To Depreciate Property Form (and Instructions) Sch A (Form 1040) Itemized Deductions 5213 Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit See chapter 12 for information about getting publications and forms. 2011 tax file What Can I Deduct? To be deductible, a business expense must be both ordinary and necessary. 2011 tax file An ordinary expense is one that is common and accepted in your industry. 2011 tax file A necessary expense is one that is helpful and appropriate for your trade or business. 2011 tax file An expense does not have to be indispensable to be considered necessary. 2011 tax file Even though an expense may be ordinary and necessary, you may not be allowed to deduct the expense in the year you paid or incurred it. 2011 tax file In some cases you may not be allowed to deduct the expense at all. 2011 tax file Therefore, it is important to distinguish usual business expenses from expenses that include the following. 2011 tax file The expenses used to figure cost of goods sold, Capital expenses, and Personal expenses. 2011 tax file Cost of Goods Sold If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. 2011 tax file Some of your business expenses may be included in figuring cost of goods sold. 2011 tax file Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. 2011 tax file If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense. 2011 tax file The following are types of expenses that go into figuring cost of goods sold. 2011 tax file The cost of products or raw materials, including freight. 2011 tax file Storage. 2011 tax file Direct labor (including contributions to pension or annuity plans) for workers who produce the products. 2011 tax file Factory overhead. 2011 tax file Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. 2011 tax file Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs. 2011 tax file This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million. 2011 tax file For more information, see the following sources. 2011 tax file Cost of goods sold—chapter 6 of Publication 334. 2011 tax file Inventories—Publication 538. 2011 tax file Uniform capitalization rules—Publication 538 and section 263A of the Internal Revenue Code and the related regulations. 2011 tax file Capital Expenses You must capitalize, rather than deduct, some costs. 2011 tax file These costs are a part of your investment in your business and are called “capital expenses. 2011 tax file ” Capital expenses are considered assets in your business. 2011 tax file In general, you capitalize three types of costs. 2011 tax file Business start-up costs (See Tip below). 2011 tax file Business assets. 2011 tax file Improvements. 2011 tax file You can elect to deduct or amortize certain business start-up costs. 2011 tax file See chapters 7 and 8. 2011 tax file Cost recovery. 2011 tax file   Although you generally cannot take a current deduction for a capital expense, you may be able to recover the amount you spend through depreciation, amortization, or depletion. 2011 tax file These recovery methods allow you to deduct part of your cost each year. 2011 tax file In this way, you are able to recover your capital expense. 2011 tax file See Amortization (chapter 8) and Depletion (chapter 9) in this publication. 2011 tax file A taxpayer can elect to deduct a portion of the costs of certain depreciable property as a section 179 deduction. 2011 tax file A greater portion of these costs can be deducted if the property is qualified disaster assistance property. 2011 tax file See Publication 946 for details. 2011 tax file Going Into Business The costs of getting started in business, before you actually begin business operations, are capital expenses. 2011 tax file These costs may include expenses for advertising, travel, or wages for training employees. 2011 tax file If you go into business. 2011 tax file   When you go into business, treat all costs you had to get your business started as capital expenses. 2011 tax file   Usually you recover costs for a particular asset through depreciation. 2011 tax file Generally, you cannot recover other costs until you sell the business or otherwise go out of business. 2011 tax file However, you can choose to amortize certain costs for setting up your business. 2011 tax file See Starting a Business in chapter 8 for more information on business start-up costs. 2011 tax file If your attempt to go into business is unsuccessful. 2011 tax file   If you are an individual and your attempt to go into business is not successful, the expenses you had in trying to establish yourself in business fall into two categories. 2011 tax file The costs you had before making a decision to acquire or begin a specific business. 2011 tax file These costs are personal and nondeductible. 2011 tax file They include any costs incurred during a general search for, or preliminary investigation of, a business or investment possibility. 2011 tax file The costs you had in your attempt to acquire or begin a specific business. 2011 tax file These costs are capital expenses and you can deduct them as a capital loss. 2011 tax file   If you are a corporation and your attempt to go into a new trade or business is not successful, you may be able to deduct all investigatory costs as a loss. 2011 tax file   The costs of any assets acquired during your unsuccessful attempt to go into business are a part of your basis in the assets. 2011 tax file You cannot take a deduction for these costs. 2011 tax file You will recover the costs of these assets when you dispose of them. 2011 tax file Business Assets There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. 2011 tax file You must fully capitalize the cost of these assets, including freight and installation charges. 2011 tax file Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules. 2011 tax file See Regulations section 1. 2011 tax file 263A-2 for information on these rules. 2011 tax file Improvements Improvements are generally major expenditures. 2011 tax file Some examples are: new electric wiring, a new roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements. 2011 tax file The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. 2011 tax file Beginning in 2014, you must capitalize as improvements costs that are for the betterment of a unit of property, restore the unit of property, or adapt the unit of property to a new or different use. 2011 tax file Temporary regulations allow you to capitalize costs meeting the above criteria for tax years beginning after 2011. 2011 tax file However, you can currently deduct repairs that keep your property in a normal efficient operating condition as a business expense. 2011 tax file Treat as repairs amounts paid to replace parts of a machine that only keep it in a normal operating condition. 2011 tax file Restoration plan. 2011 tax file   Capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration plan to make it suitable for your business. 2011 tax file This applies even if some of the work would by itself be classified as repairs. 2011 tax file Capital versus Deductible Expenses To help you distinguish between capital and deductible expenses, different examples are given below. 2011 tax file Motor vehicles. 2011 tax file   You usually capitalize the cost of a motor vehicle you use in your business. 2011 tax file You can recover its cost through annual deductions for depreciation. 2011 tax file   There are dollar limits on the depreciation you can claim each year on passenger automobiles used in your business. 2011 tax file See Publication 463. 2011 tax file   Generally, repairs you make to your business vehicle are currently deductible. 2011 tax file However, amounts you pay to recondition and overhaul a business vehicle are capital expenses and are recovered through depreciation. 2011 tax file Roads and driveways. 2011 tax file    The cost of building a private road on your business property and the cost of replacing a gravel driveway with a concrete one are capital expenses you may be able to depreciate. 2011 tax file The cost of maintaining a private road on your business property is a deductible expense. 2011 tax file Tools. 2011 tax file   Unless the uniform capitalization rules apply, amounts spent for tools used in your business are deductible expenses if the tools have a life expectancy of less than 1 year or their cost is minor. 2011 tax file Machinery parts. 2011 tax file   Unless the uniform capitalization rules apply, the cost of replacing short-lived parts of a machine to keep it in good working condition, but not add to its life, is a deductible expense. 2011 tax file Heating equipment. 2011 tax file   The cost of changing from one heating system to another is a capital expense. 2011 tax file Personal versus Business Expenses Generally, you cannot deduct personal, living, or family expenses. 2011 tax file However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. 2011 tax file You can deduct the business part. 2011 tax file For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you generally can deduct 70% of the interest as a business expense. 2011 tax file The remaining 30% is personal interest and generally is not deductible. 2011 tax file See chapter 4 for information on deducting interest and the allocation rules. 2011 tax file Business use of your home. 2011 tax file   If you use part of your home for business, you may be able to deduct expenses for the business use of your home. 2011 tax file These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. 2011 tax file   To qualify to claim expenses for the business use of your home, you must meet both of the following tests. 2011 tax file The business part of your home must be used exclusively and regularly for your trade or business. 2011 tax file The business part of your home must be: Your principal place of business, or A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business, or A separate structure (not attached to your home) used in connection with your trade or business. 2011 tax file   You generally do not have to meet the exclusive use test for the part of your home that you regularly use either for the storage of inventory or product samples, or as a daycare facility. 2011 tax file   Your home office qualifies as your principal place of business if you meet the following requirements. 2011 tax file You use the office exclusively and regularly for administrative or management activities of your trade or business. 2011 tax file You have no other fixed location where you conduct substantial administrative or management activities of your trade or business. 2011 tax file   If you have more than one business location, determine your principal place of business based on the following factors. 2011 tax file The relative importance of the activities performed at each location. 2011 tax file If the relative importance factor does not determine your principal place of business, consider the time spent at each location. 2011 tax file Optional safe harbor method. 2011 tax file   Beginning in 2013, individual taxpayers can use the optional safe harbor method to determine the amount of deductible expenses attributable to certain business use of a residence during the tax year. 2011 tax file This method is an alternative to the calculation, allocation, and substantiation of actual expenses. 2011 tax file   The deduction under the optional method is limited to $1,500 per year based on $5 a square foot for up to 300 square feet. 2011 tax file Under this method, you claim your allowable mortgage interest, real estate taxes, and casualty losses on the home as itemized deductions on Schedule A (Form 1040). 2011 tax file You are not required to allocate these deductions between personal and business use, as is required under the regular method. 2011 tax file If you use the optional method, you cannot depreciate the portion of your home used in a trade or business. 2011 tax file   Business expenses unrelated to the home, such as advertising, supplies, and wages paid to employees, are still fully deductible. 2011 tax file All of the requirements discussed earlier under Business use of your home still apply. 2011 tax file   For more information on the deduction for business use of your home, including the optional safe harbor method, see Publication 587. 2011 tax file    If you were entitled to deduct depreciation on the part of your home used for business, you cannot exclude the part of the gain from the sale of your home that equals any depreciation you deducted (or could have deducted) for periods after May 6, 1997. 2011 tax file Business use of your car. 2011 tax file   If you use your car exclusively in your business, you can deduct car expenses. 2011 tax file If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage. 2011 tax file Generally, commuting expenses between your home and your business location, within the area of your tax home, are not deductible. 2011 tax file   You can deduct actual car expenses, which include depreciation (or lease payments), gas and oil, tires, repairs, tune-ups, insurance, and registration fees. 2011 tax file Or, instead of figuring the business part of these actual expenses, you may be able to use the standard mileage rate to figure your deduction. 2011 tax file Beginning in 2013, the standard mileage rate is 56. 2011 tax file 5 cents per mile. 2011 tax file   If you are self-employed, you can also deduct the business part of interest on your car loan, state and local personal property tax on the car, parking fees, and tolls, whether or not you claim the standard mileage rate. 2011 tax file   For more information on car expenses and the rules for using the standard mileage rate, see Publication 463. 2011 tax file How Much Can I Deduct? Generally, you can deduct the full amount of a business expense if it meets the criteria of ordinary and necessary and it is not a capital expense. 2011 tax file Recovery of amount deducted (tax benefit rule). 2011 tax file   If you recover part of an expense in the same tax year in which you would have claimed a deduction, reduce your current year expense by the amount of the recovery. 2011 tax file If you have a recovery in a later year, include the recovered amount in income in that year. 2011 tax file However, if part of the deduction for the expense did not reduce your tax, you do not have to include that part of the recovered amount in income. 2011 tax file   For more information on recoveries and the tax benefit rule, see Publication 525. 2011 tax file Payments in kind. 2011 tax file   If you provide services to pay a business expense, the amount you can deduct is limited to your out-of-pocket costs. 2011 tax file You cannot deduct the cost of your own labor. 2011 tax file   Similarly, if you pay a business expense in goods or other property, you can deduct only what the property costs you. 2011 tax file If these costs are included in the cost of goods sold, do not deduct them again as a business expense. 2011 tax file Limits on losses. 2011 tax file   If your deductions for an investment or business activity are more than the income it brings in, you have a loss. 2011 tax file There may be limits on how much of the loss you can deduct. 2011 tax file Not-for-profit limits. 2011 tax file   If you carry on your business activity without the intention of making a profit, you cannot use a loss from it to offset other income. 2011 tax file See Not-for-Profit Activities , later. 2011 tax file At-risk limits. 2011 tax file   Generally, a deductible loss from a trade or business or other income-producing activity is limited to the investment you have “at risk” in the activity. 2011 tax file You are at risk in any activity for the following. 2011 tax file The money and adjusted basis of property you contribute to the activity. 2011 tax file Amounts you borrow for use in the activity if: You are personally liable for repayment, or You pledge property (other than property used in the activity) as security for the loan. 2011 tax file For more information, see Publication 925. 2011 tax file Passive activities. 2011 tax file   Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate, or a rental activity. 2011 tax file In general, deductions for losses from passive activities only offset income from passive activities. 2011 tax file You cannot use any excess deductions to offset other income. 2011 tax file In addition, passive activity credits can only offset the tax on net passive income. 2011 tax file Any excess loss or credits are carried over to later years. 2011 tax file Suspended passive losses are fully deductible in the year you completely dispose of the activity. 2011 tax file For more information, see Publication 925. 2011 tax file Net operating loss. 2011 tax file   If your deductions are more than your income for the year, you may have a “net operating loss. 2011 tax file ” You can use a net operating loss to lower your taxes in other years. 2011 tax file See Publication 536 for more information. 2011 tax file   See Publication 542 for information about net operating losses of corporations. 2011 tax file When Can I Deduct an Expense? When you can deduct an expense depends on your accounting method. 2011 tax file An accounting method is a set of rules used to determine when and how income and expenses are reported. 2011 tax file The two basic methods are the cash method and the accrual method. 2011 tax file Whichever method you choose must clearly reflect income. 2011 tax file For more information on accounting methods, see Publication 538. 2011 tax file Cash method. 2011 tax file   Under the cash method of accounting, you generally deduct business expenses in the tax year you pay them. 2011 tax file Accrual method. 2011 tax file   Under an accrual method of accounting, you generally deduct business expenses when both of the following apply. 2011 tax file The all-events test has been met. 2011 tax file The test is met when: All events have occurred that fix the fact of liability, and The liability can be determined with reasonable accuracy. 2011 tax file Economic performance has occurred. 2011 tax file Economic performance. 2011 tax file   You generally cannot deduct or capitalize a business expense until economic performance occurs. 2011 tax file If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the property is used. 2011 tax file If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. 2011 tax file Example. 2011 tax file Your tax year is the calendar year. 2011 tax file In December 2013, the Field Plumbing Company did some repair work at your place of business and sent you a bill for $600. 2011 tax file You paid it by check in January 2014. 2011 tax file If you use the accrual method of accounting, deduct the $600 on your tax return for 2013 because all events have occurred to “fix” the fact of liability (in this case the work was completed), the liability can be determined, and economic performance occurred in that year. 2011 tax file If you use the cash method of accounting, deduct the expense on your 2014 return. 2011 tax file Prepayment. 2011 tax file   You generally cannot deduct expenses in advance, even if you pay them in advance. 2011 tax file This rule applies to both the cash and accrual methods. 2011 tax file It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year. 2011 tax file Example. 2011 tax file In 2013, you sign a 10-year lease and immediately pay your rent for the first 3 years. 2011 tax file Even though you paid the rent for 2013, 2014, and 2015, you can only deduct the rent for 2013 on your 2013 tax return. 2011 tax file You can deduct the rent for 2014 and 2015 on your tax returns for those years. 2011 tax file Contested liability. 2011 tax file   Under the cash method, you can deduct a contested liability only in the year you pay the liability. 2011 tax file Under the accrual method, you can deduct contested liabilities such as taxes (except foreign or U. 2011 tax file S. 2011 tax file possession income, war profits, and excess profits taxes) either in the tax year you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. 2011 tax file However, to take the deduction in the year of payment or transfer, you must meet certain conditions. 2011 tax file See Regulations section 1. 2011 tax file 461-2. 2011 tax file Related person. 2011 tax file   Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not yet paid them. 2011 tax file However, if you and the person you owe are related and that person uses the cash method of accounting, you must pay the expense before you can deduct it. 2011 tax file Your deduction is allowed when the amount is includible in income by the related cash method payee. 2011 tax file See Related Persons in Publication 538. 2011 tax file Not-for-Profit Activities If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. 2011 tax file Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit. 2011 tax file The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. 2011 tax file It does not apply to corporations other than S corporations. 2011 tax file In determining whether you are carrying on an activity for profit, several factors are taken into account. 2011 tax file No one factor alone is decisive. 2011 tax file Among the factors to consider are whether: You carry on the activity in a businesslike manner, The time and effort you put into the activity indicate you intend to make it profitable, You depend on the income for your livelihood, Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business), You change your methods of operation in an attempt to improve profitability, You (or your advisors) have the knowledge needed to carry on the activity as a successful business, You were successful in making a profit in similar activities in the past, The activity makes a profit in some years, and You can expect to make a future profit from the appreciation of the assets used in the activity. 2011 tax file Presumption of profit. 2011 tax file   An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. 2011 tax file Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. 2011 tax file The activity must be substantially the same for each year within this period. 2011 tax file You have a profit when the gross income from an activity exceeds the deductions. 2011 tax file   If a taxpayer dies before the end of the 5-year (or 7-year) period, the “test” period ends on the date of the taxpayer's death. 2011 tax file   If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. 2011 tax file This means the limits discussed here will not apply. 2011 tax file You can take all your business deductions from the activity, even for the years that you have a loss. 2011 tax file You can rely on this presumption unless the IRS later shows it to be invalid. 2011 tax file Using the presumption later. 2011 tax file   If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test. 2011 tax file   You can elect to do this by filing Form 5213. 2011 tax file Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity. 2011 tax file   The benefit gained by making this election is that the IRS will not immediately question whether your activity is engaged in for profit. 2011 tax file Accordingly, it will not restrict your deductions. 2011 tax file Rather, you will gain time to earn a profit in the required number of years. 2011 tax file If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. 2011 tax file If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year with a loss in the 5-year (or 7-year) period. 2011 tax file   Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. 2011 tax file The period is extended only for deductions of the activity and any related deductions that might be affected. 2011 tax file    You must file Form 5213 within 3 years after the due date of your return (determined without extensions) for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable to the activity. 2011 tax file Gross Income Gross income from a not-for-profit activity includes the total of all gains from the sale, exchange, or other disposition of property, and all other gross receipts derived from the activity. 2011 tax file Gross income from the activity also includes capital gains and rents received for the use of property which is held in connection with the activity. 2011 tax file You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts. 2011 tax file However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of accounting. 2011 tax file Limit on Deductions If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the three categories. 2011 tax file If you are an individual, these deductions may be taken only if you itemize. 2011 tax file These deductions may be taken on Schedule A (Form 1040). 2011 tax file Category 1. 2011 tax file   Deductions you can take for personal as well as for business activities are allowed in full. 2011 tax file For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. 2011 tax file Deduct them on the appropriate lines of Schedule A (Form 1040). 2011 tax file For tax years beginning after December 31, 2008, you can deduct a casualty loss on property you own for personal use only to the extent it is more than $500 and exceeds 10% of your adjusted gross income (AGI). 2011 tax file The 10% AGI limitation does not apply to net disaster losses resulting from federally declared disasters in 2008 and 2009, and individuals are allowed to claim the net disaster losses even if they do not itemize their deductions. 2011 tax file The reduction amount returns to $100 for tax years beginning after December 31, 2009. 2011 tax file See Publication 547 for more information on casualty losses. 2011 tax file For the limits that apply to home mortgage interest, see Publication 936. 2011 tax file Category 2. 2011 tax file   Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than your deductions under the first category. 2011 tax file Most business deductions, such as those for advertising, insurance premiums, interest, utilities, and wages, belong in this category. 2011 tax file Category 3. 2011 tax file   Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity exceeds the deductions you take under the first two categories. 2011 tax file Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. 2011 tax file Where more than one asset is involved, allocate depreciation and these other deductions proportionally. 2011 tax file    Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). 2011 tax file They are subject to the 2%-of-adjusted-gross-income limit. 2011 tax file See Publication 529 for information on this limit. 2011 tax file Example. 2011 tax file Adriana is engaged in a not-for-profit activity. 2011 tax file The income and expenses of the activity are as follows. 2011 tax file Gross income $3,200 Subtract:     Real estate taxes $700   Home mortgage interest 900   Insurance 400   Utilities 700   Maintenance 200   Depreciation on an automobile 600   Depreciation on a machine 200 3,700 Loss $(500)   Adriana must limit her deductions to $3,200, the gross income she earned from the activity. 2011 tax file The limit is reached in category (3), as follows. 2011 tax file Limit on deduction $3,200 Category 1: Taxes and interest $1,600   Category 2: Insurance, utilities, and maintenance 1,300 2,900 Available for Category 3 $ 300   The $800 of depreciation is allocated between the automobile and machine as follows. 2011 tax file $600 $800 x $300 = $225 depreciation for the automobile             $200 $800 x $300 = $75 depreciation for the machine The basis of each asset is reduced accordingly. 2011 tax file Adriana includes the $3,200 of gross income on line 21 (other income) of Form 1040. 2011 tax file The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040). 2011 tax file Adriana deducts the remaining $1,600 ($1,300 for category (2) and $300 for category (3)) as other miscellaneous deductions on Schedule A (Form 1040) subject to the 2%-of-adjusted-gross-income limit. 2011 tax file Partnerships and S corporations. 2011 tax file   If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. 2011 tax file They are reflected in the individual shareholder's or partner's distributive shares. 2011 tax file More than one activity. 2011 tax file   If you have several undertakings, each may be a separate activity or several undertakings may be combined. 2011 tax file The following are the most significant facts and circumstances in making this determination. 2011 tax file The degree of organizational and economic interrelationship of various undertakings. 2011 tax file The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business or investment setting. 2011 tax file The similarity of the undertakings. 2011 tax file   The IRS will generally accept your characterization if it is supported by facts and circumstances. 2011 tax file    If you are carrying on two or more different activities, keep the deductions and income from each one separate. 2011 tax file Figure separately whether each is a not-for-profit activity. 2011 tax file Then figure the limit on deductions and losses separately for each activity that is not for profit. 2011 tax file Prev  Up  Next   Home   More Online Publications
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Where to File Tax Returns - Addresses Listed by Return Type

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Page Last Reviewed or Updated: 09-Dec-2013

The 2011 Tax File

2011 tax file Publication 925 - Main Content Table of Contents Passive Activity LimitsWho Must Use These Rules? Passive Activity Loss Passive Activity Credit Publicly Traded Partnership Excess Farm Loss Passive Activities Activities That Are Not Passive Activities Passive Activity Income and Deductions Grouping Your Activities Recharacterization of Passive Income Dispositions How To Report Your Passive Activity Loss Comprehensive ExampleGeneral Information At-Risk LimitsWho Is Affected? Activities Covered by the At-Risk Rules At-Risk Amounts Amounts Not At Risk Reductions of Amounts At Risk Recapture Rule How To Get Tax HelpLow Income Taxpayer Clinics Passive Activity Limits Who Must Use These Rules? The passive activity rules apply to: Individuals, Estates, Trusts (other than grantor trusts), Personal service corporations, and Closely held corporations. 2011 tax file Even though the rules do not apply to grantor trusts, partnerships, and S corporations directly, they do apply to the owners of these entities. 2011 tax file For information about personal service corporations and closely held corporations, including definitions and how the passive activity rules apply to these corporations, see Form 8810 and its instructions. 2011 tax file Before applying the passive activity limits, you must first determine the amount of the deductions disallowed under the basis, excess farm loss, or at-risk rules. 2011 tax file See Passive Activity Deductions, later. 2011 tax file Passive Activity Loss Generally, the passive activity loss for the tax year is not allowed. 2011 tax file However, there is a special allowance under which some or all of your passive activity loss may be allowed. 2011 tax file See Special $25,000 allowance , later. 2011 tax file Definition of passive activity loss. 2011 tax file    Generally, your passive activity loss for the tax year is the excess of your passive activity deductions over your passive activity gross income. 2011 tax file See Passive Activity Income and Deductions , later. 2011 tax file   For a closely held corporation, the passive activity loss is the excess of passive activity deductions over the sum of passive activity gross income and net active income. 2011 tax file For details on net active income, see the Instructions for Form 8810. 2011 tax file For the definition of passive activity gross income, see Passive Activity Income , later. 2011 tax file For the definition of passive activity deductions, see Passive Activity Deductions , later. 2011 tax file Identification of Disallowed Passive Activity Deductions If all or a part of your passive activity loss is disallowed for the tax year, you may need to allocate the disallowed passive activity loss among different passive activities and among different deductions within a passive activity. 2011 tax file Allocation of disallowed passive activity loss among activities. 2011 tax file   If all or any part of your passive activity loss is disallowed for the tax year, a ratable portion of the loss (if any) from each of your passive activities is disallowed. 2011 tax file The ratable portion of a loss from an activity is computed by multiplying the passive activity loss that is disallowed for the tax year by the fraction obtained by dividing: The loss from the activity for the tax year; by The sum of the losses for the tax year from all activities having losses for the tax year. 2011 tax file Use Worksheet 5 of Form 8582 to figure the ratable portion of the loss from each activity that is disallowed. 2011 tax file Loss from an activity. 2011 tax file   The term “loss from an activity” means: The amount by which the passive activity deductions (defined later) from the activity for the tax year exceed the passive activity gross income (defined later) from the activity for the tax year; reduced by Any part of such amount that is allowed under the Special $25,000 Allowance , later. 2011 tax file   If your passive activity gross income from significant participation passive activities (defined later) for the tax year is more than your passive activity deductions from those activities for the tax year, those activities shall be treated, solely for purposes of figuring your loss from the activity, as a single activity that does not have a loss for such taxable year. 2011 tax file See Significant Participation Passive Activities , later. 2011 tax file Example. 2011 tax file John Pine holds interests in three passive activities, A, B, and C. 2011 tax file The gross income and deductions from these activities for the taxable year are as follows:   A B C Total Gross income $7,000 $4,000 $12,000 $23,000 Deductions (16,000) (20,000) (8,000) (44,000)           Net income (loss) ($9,000) ($16,000) $4,000 ($21,000)   John Pine’s $21,000 passive activity loss for the taxable year is disallowed. 2011 tax file Therefore, a ratable portion of the losses from activities A and B is disallowed. 2011 tax file He figures the disallowed portion of each loss as follows: A: $21,000 x $9,000/$25,000 $7,560 B: $21,000 x $16,000/$25,000 13,440     Total $21,000 Allocation within loss activities. 2011 tax file   If all or any part of your loss from an activity is disallowed under Allocation of disallowed passive activity loss among activities for the tax year, a ratable portion of each of your passive activity deductions (defined later), other than an excluded deduction (defined below) from such activity is disallowed. 2011 tax file The ratable portion of a passive activity deduction is the amount of the disallowed portion of the loss from the activity for the tax year multiplied by the fraction obtained by dividing: The amount of such deduction; by The sum of all of your passive activity deductions (other than excluded deductions) from that activity from the tax year. 2011 tax file Excluded deductions. 2011 tax file    “Excluded deduction” means any passive activity deduction that is taken into account in computing your net income from an item of property for a taxable year in which an amount of the taxpayer's gross income from such item of property is treated as not from a passive activity. 2011 tax file See Recharacterization of Passive Income , later. 2011 tax file Separately identified deductions. 2011 tax file   In identifying the deductions from an activity that are disallowed, you do not need to account separately for a deduction unless such deduction may, if separately taken into account, result in an income tax liability for any tax year different from that which would result were such deduction not taken into account separately. 2011 tax file   Use Form 8582, Worksheet 7, for any activity if you have passive activity deductions for that activity that must be separately identified. 2011 tax file   Deductions that must be accounted for separately include (but are not limited to) the following deductions. 2011 tax file Deductions that arise in a rental real estate activity in tax years in which you actively participate in such activity. 2011 tax file See Active participation , later. 2011 tax file Deductions that arise in a rental real estate activity in tax years in which you do not actively participate in such activity. 2011 tax file See Active participation , later. 2011 tax file Losses from sales or exchanges of capital assets. 2011 tax file Section 1231 losses. 2011 tax file See Section 1231 Gains and Losses in Publication 544, Sales and Other Disposition of Assets, for more information. 2011 tax file Carryover of Disallowed Deductions In the case of an activity with respect to which any deductions or credits are disallowed for a taxable year (the loss activity), the disallowed deductions are allocated among your activities for the next tax year in a manner that reasonably reflects the extent to which each activity continues the loss activity. 2011 tax file The disallowed deductions or credits allocated to an activity under the preceding sentence are treated as deductions or credits from the activity for the next tax year. 2011 tax file For more information, see Regulations section 1. 2011 tax file 469-1(f)(4). 2011 tax file Passive Activity Credit Generally, the passive activity credit for the tax year is disallowed. 2011 tax file The passive activity credit is the amount by which the sum of all your credits subject to the passive activity rules exceed your regular tax liability allocable to all passive activities for the tax year. 2011 tax file Credits that are included in figuring the general business credit are subject to the passive activity rules. 2011 tax file See the Instructions for Form 8582-CR for more information. 2011 tax file Publicly Traded Partnership You must apply the rules in this part separately to your income or loss from a passive activity held through a publicly traded partnership (PTP). 2011 tax file You also must apply the limit on passive activity credits separately to your credits from a passive activity held through a PTP. 2011 tax file You can offset deductions from passive activities of a PTP only against income or gain from passive activities of the same PTP. 2011 tax file Likewise, you can offset credits from passive activities of a PTP only against the tax on the net passive income from the same PTP. 2011 tax file This separate treatment rule also applies to a regulated investment company holding an interest in a PTP for the items attributable to that interest. 2011 tax file For more information on how to apply the passive activity loss rules to PTPs, and on how to apply the limit on passive activity credits to PTPs, see Publicly Traded Partnerships (PTPs) in the Instructions for Forms 8582 and 8582-CR, respectively. 2011 tax file Excess Farm Loss If you receive an applicable subsidy for any tax year and you have an excess farm loss for the tax year, special rules apply. 2011 tax file These rules do not apply to C corporations. 2011 tax file For information, see the Instructions for Schedule F (Form 1040), Profit or Loss From Farming. 2011 tax file Passive Activities There are two kinds of passive activities. 2011 tax file Trade or business activities in which you do not materially participate during the year. 2011 tax file Rental activities, even if you do materially participate in them, unless you are a real estate professional. 2011 tax file Material participation in a trade or business is discussed later, under Activities That Are Not Passive Activities . 2011 tax file Treatment of former passive activities. 2011 tax file   A former passive activity is an activity that was a passive activity in any earlier tax year, but is not a passive activity in the current tax year. 2011 tax file You can deduct a prior year's unallowed loss from the activity up to the amount of your current year net income from the activity. 2011 tax file Treat any remaining prior year unallowed loss like you treat any other passive loss. 2011 tax file   In addition, any prior year unallowed passive activity credits from a former passive activity offset the allocable part of your current year tax liability. 2011 tax file The allocable part of your current year tax liability is that part of this year's tax liability that is allocable to the current year net income from the former passive activity. 2011 tax file You figure this after you reduce your net income from the activity by any prior year unallowed loss from that activity (but not below zero). 2011 tax file Trade or Business Activities A trade or business activity is an activity that: Involves the conduct of a trade or business (that is, deductions would be allowable under section 162 of the Internal Revenue Code if other limitations, such as the passive activity rules, did not apply), Is conducted in anticipation of starting a trade or business, or Involves research or experimental expenditures that are deductible under Internal Revenue Code section 174 (or that would be deductible if you chose to deduct rather than capitalize them). 2011 tax file A trade or business activity does not include a rental activity or the rental of property that is incidental to an activity of holding the property for investment. 2011 tax file You generally report trade or business activities on Schedule C, C-EZ, F, or in Part II or III of Schedule E. 2011 tax file Rental Activities A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional. 2011 tax file See Real Estate Professional under Activities That Are Not Passive Activities, later. 2011 tax file An activity is a rental activity if tangible property (real or personal) is used by customers or held for use by customers, and the gross income (or expected gross income) from the activity represents amounts paid (or to be paid) mainly for the use of the property. 2011 tax file It does not matter whether the use is under a lease, a service contract, or some other arrangement. 2011 tax file Exceptions. 2011 tax file   Your activity is not a rental activity if any of the following apply. 2011 tax file The average period of customer use of the property is 7 days or less. 2011 tax file You figure the average period of customer use by dividing the total number of days in all rental periods by the number of rentals during the tax year. 2011 tax file If the activity involves renting more than one class of property, multiply the average period of customer use of each class by a fraction. 2011 tax file The numerator of the fraction is the gross rental income from that class of property and the denominator is the activity's total gross rental income. 2011 tax file The activity's average period of customer use will equal the sum of the amounts for each class. 2011 tax file The average period of customer use of the property, as figured in (1) above, is 30 days or less and you provide significant personal services with the rentals. 2011 tax file Significant personal services include only services performed by individuals. 2011 tax file To determine if personal services are significant, all relevant facts and circumstances are taken into consideration, including the frequency of the services, the type and amount of labor required to perform the services, and the value of the services relative to the amount charged for use of the property. 2011 tax file Significant personal services do not include the following. 2011 tax file Services needed to permit the lawful use of the property, Services to repair or improve property that would extend its useful life for a period substantially longer than the average rental, and Services that are similar to those commonly provided with long-term rentals of real estate, such as cleaning and maintenance of common areas or routine repairs. 2011 tax file You provide extraordinary personal services in making the rental property available for customer use. 2011 tax file Services are extraordinary personal services if they are performed by individuals and the customers' use of the property is incidental to their receipt of the services. 2011 tax file The rental is incidental to a nonrental activity. 2011 tax file The rental of property is incidental to an activity of holding property for investment if the main purpose of holding the property is to realize a gain from its appreciation and the gross rental income from the property is less than 2% of the smaller of the property's unadjusted basis or fair market value. 2011 tax file The unadjusted basis of property is its cost not reduced by depreciation or any other basis adjustment. 2011 tax file The rental of property is incidental to a trade or business activity if all of the following apply. 2011 tax file You own an interest in the trade or business activity during the year. 2011 tax file The rental property was used mainly in that trade or business activity during the current year, or during at least 2 of the 5 preceding tax years. 2011 tax file Your gross rental income from the property is less than 2% of the smaller of its unadjusted basis or fair market value. 2011 tax file Lodging provided to an employee or the employee's spouse or dependents is incidental to the activity or activities in which the employee performs services if the lodging is furnished for the employer's convenience. 2011 tax file You customarily make the rental property available during defined business hours for nonexclusive use by various customers. 2011 tax file You provide the property for use in a nonrental activity in your capacity as an owner of an interest in the partnership, S corporation, or joint venture conducting that activity. 2011 tax file    If you meet any of the exceptions listed above, see the instructions for Form 8582 for information about how to report any income or loss from the activity. 2011 tax file Special $25,000 allowance. 2011 tax file   If you or your spouse actively participated in a passive rental real estate activity, the amount of the passive activity loss that is disallowed is decreased and you therefore can deduct up to $25,000 of loss from the activity from your nonpassive income. 2011 tax file This special allowance is an exception to the general rule disallowing the passive activity loss. 2011 tax file 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. 2011 tax file   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. 2011 tax file 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. 2011 tax file   The maximum special allowance is reduced if your modified adjusted gross income exceeds certain amounts. 2011 tax file See Phaseout rule , later. 2011 tax file Example. 2011 tax file Kate, a single taxpayer, has $70,000 in wages, $15,000 income from a limited partnership, a $26,000 loss from rental real estate activities in which she actively participated, and is not subject to the modified adjusted gross income phaseout rule. 2011 tax file She can use $15,000 of her $26,000 loss to offset her $15,000 passive income from the partnership. 2011 tax file She actively participated in her rental real estate activities, so she can use the remaining $11,000 rental real estate loss to offset $11,000 of her nonpassive income (wages). 2011 tax file Commercial revitalization deduction (CRD). 2011 tax file   The special allowance must first be applied to losses from rental real estate activities figured without the CRD. 2011 tax file Any remaining part of the special allowance is available for the CRD from the rental real estate activities and is not subject to the active participation rules or the phaseout based on modified adjusted gross income. 2011 tax file You cannot claim a CRD for a building placed in service after December 31, 2009. 2011 tax file Active participation. 2011 tax file   Active participation is not the same as material participation (defined later). 2011 tax file Active participation is a less stringent standard than material participation. 2011 tax file For example, you may be treated as actively participating if you make management decisions in a significant and bona fide sense. 2011 tax file Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions. 2011 tax file   Only individuals can actively participate in rental real estate activities. 2011 tax file However, a decedent's estate is treated as actively participating for its tax years ending less than 2 years after the decedent's death, if the decedent would have satisfied the active participation requirement for the activity for the tax year the decedent died. 2011 tax file   A decedent's qualified revocable trust can also be treated as actively participating if both the trustee and the executor (if any) of the estate choose to treat the trust as part of the estate. 2011 tax file The choice applies to tax years ending after the decedent's death and before: 2 years after the decedent's death if no estate tax return is required, or 6 months after the estate tax liability is finally determined if an estate tax return is required. 2011 tax file   The choice is irrevocable and cannot be made later than the due date for the estate's first income tax return (including any extensions). 2011 tax file   Limited partners are not treated as actively participating in a partnership's rental real estate activities. 2011 tax file   You are not treated as actively participating in a rental real estate activity unless your interest in the activity (including your spouse's interest) was at least 10% (by value) of all interests in the activity throughout the year. 2011 tax file   Active participation is not required to take the low-income housing credit, the rehabilitation investment credit, or CRD from rental real estate activities. 2011 tax file Example. 2011 tax file Mike, a single taxpayer, had the following income and loss during the tax year: Salary $42,300 Dividends 300 Interest 1,400 Rental loss (4,000) The rental loss came from a house Mike owned. 2011 tax file He advertised and rented the house to the current tenant himself. 2011 tax file He also collected the rents and did the repairs or hired someone to do them. 2011 tax file Even though the rental loss is a loss from a passive activity, Mike can use the entire $4,000 loss to offset his other income because he actively participated. 2011 tax file Phaseout rule. 2011 tax file   The maximum special allowance of $25,000 ($12,500 for married individuals filing separate returns and living apart at all times during the year) is reduced by 50% of the amount of your modified adjusted gross income that is more than $100,000 ($50,000 if you are married filing separately). 2011 tax file If your modified adjusted gross income is $150,000 or more ($75,000 or more if you are married filing separately), you generally cannot use the special allowance. 2011 tax file    Modified adjusted gross income for this purpose is your adjusted gross income figured without the following. 2011 tax file Taxable social security and tier 1 railroad retirement benefits. 2011 tax file Deductible contributions to individual retirement accounts (IRAs) and section 501(c)(18) pension plans. 2011 tax file The exclusion from income of interest from qualified U. 2011 tax file S. 2011 tax file savings bonds used to pay qualified higher education expenses. 2011 tax file The exclusion from income of amounts received from an employer's adoption assistance program. 2011 tax file Passive activity income or loss included on Form 8582. 2011 tax file Any rental real estate loss allowed because you materially participated in the rental activity as a Real Estate Professional (as discussed later, under Activities That Are Not Passive Activities). 2011 tax file Any overall loss from a publicly traded partnership (see Publicly Traded Partnerships (PTPs) in the instructions for Form 8582). 2011 tax file The deduction for the employer-equivalent portion of self-employment tax. 2011 tax file The deduction for domestic production activities. 2011 tax file The deduction allowed for interest on student loans. 2011 tax file The deduction for qualified tuition and related expenses. 2011 tax file Example. 2011 tax file During 2013, John was unmarried and was not a real estate professional. 2011 tax file For 2013, he had $120,000 in salary and a $31,000 loss from his rental real estate activities in which he actively participated. 2011 tax file His modified adjusted gross income is $120,000. 2011 tax file When he files his 2013 return, he can deduct only $15,000 of his passive activity loss. 2011 tax file He must carry over the remaining $16,000 passive activity loss to 2014. 2011 tax file He figures his deduction and carryover as follows: Adjusted gross income, modified as required $120,000       Minus amount not subject to phaseout 100,000 Amount subject to phaseout rule $20,000 Multiply by 50% × 50% Required reduction to special allowance $10,000 Maximum special allowance $25,000 Minus required reduction (see above) 10,000 Adjusted special allowance $15,000 Passive loss from rental real estate $31,000 Deduction allowable/Adjusted  special allowance (see above) 15,000       Amount that must be carried forward $16,000 Exceptions to the phaseout rules. 2011 tax file   A higher phaseout range applies to rehabilitation investment credits from rental real estate activities. 2011 tax file For those credits, the phaseout of the $25,000 special allowance starts when your modified adjusted gross income exceeds $200,000 ($100,000 if you are a married individual filing a separate return and living apart at all times during the year). 2011 tax file   There is no phaseout of the $25,000 special allowance for low-income housing credits or for the CRD. 2011 tax file Ordering rules. 2011 tax file   If you have more than one of the exceptions to the phaseout rules in the same tax year, you must apply the $25,000 phaseout against your passive activity losses and credits in the following order. 2011 tax file The portion of passive activity losses not attributable to the CRD. 2011 tax file The portion of passive activity losses attributable to the CRD. 2011 tax file The portion of passive activity credits attributable to credits other than the rehabilitation and low-income housing credits. 2011 tax file The portion of passive activity credits attributable to the rehabilitation credit. 2011 tax file The portion of passive activity credits attributable to the low-income housing credit. 2011 tax file Activities That Are Not Passive Activities The following are not passive activities. 2011 tax file Trade or business activities in which you materially participated for the tax year. 2011 tax file A working interest in an oil or gas well which you hold directly or through an entity that does not limit your liability (such as a general partner interest in a partnership). 2011 tax file It does not matter whether you materially participated in the activity for the tax year. 2011 tax file However, if your liability was limited for part of the year (for example, you converted your general partner interest to a limited partner interest during the year) and you had a net loss from the well for the year, some of your income and deductions from the working interest may be treated as passive activity gross income and passive activity deductions. 2011 tax file  See Temporary Regulations section 1. 2011 tax file 469-1T(e)(4)(ii). 2011 tax file The rental of a dwelling unit that you also used for personal purposes during the year for more than the greater of 14 days or 10% of the number of days during the year that the home was rented at a fair rental. 2011 tax file An activity of trading personal property for the account of those who own interests in the activity. 2011 tax file See Temporary Regulations section 1. 2011 tax file 469-1T(e)(6). 2011 tax file Rental real estate activities in which you materially participated as a real estate professional. 2011 tax file See Real Estate Professional , later. 2011 tax file You should not enter income and losses from these activities on Form 8582. 2011 tax file Instead, enter them on the forms or schedules you would normally use. 2011 tax file Material Participation A trade or business activity is not a passive activity if you materially participated in the activity. 2011 tax file Material participation tests. 2011 tax file    You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests. 2011 tax file You participated in the activity for more than 500 hours. 2011 tax file Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity. 2011 tax file You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year. 2011 tax file The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. 2011 tax file A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test. 2011 tax file See Significant Participation Passive Activities , under Recharacterization of Passive Income, later. 2011 tax file You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years. 2011 tax file The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. 2011 tax file An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor. 2011 tax file Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year. 2011 tax file   You did not materially participate in the activity under test (7) if you participated in the activity for 100 hours or less during the year. 2011 tax file Your participation in managing the activity does not count in determining whether you materially participated under this test if: Any person other than you received compensation for managing the activity, or Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services). 2011 tax file Participation. 2011 tax file   In general, any work you do in connection with an activity in which you own an interest is treated as participation in the activity. 2011 tax file Work not usually performed by owners. 2011 tax file   You do not treat the work you do in connection with an activity as participation in the activity if both of the following are true. 2011 tax file The work is not work that is customarily done by the owner of that type of activity. 2011 tax file One of your main reasons for doing the work is to avoid the disallowance of any loss or credit from the activity under the passive activity rules. 2011 tax file Participation as an investor. 2011 tax file   You do not treat the work you do in your capacity as an investor in an activity as participation unless you are directly involved in the day-to-day management or operations of the activity. 2011 tax file Work you do as an investor includes: Studying and reviewing financial statements or reports on operations of the activity, Preparing or compiling summaries or analyses of the finances or operations of the activity for your own use, and Monitoring the finances or operations of the activity in a nonmanagerial capacity. 2011 tax file Spouse's participation. 2011 tax file   Your participation in an activity includes your spouse's participation. 2011 tax file This applies even if your spouse did not own any interest in the activity and you and your spouse do not file a joint return for the year. 2011 tax file Proof of participation. 2011 tax file You can use any reasonable method to prove your participation in an activity for the year. 2011 tax file You do not have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way. 2011 tax file For example, you can show the services you performed and the approximate number of hours spent by using an appointment book, calendar, or narrative summary. 2011 tax file Limited partners. 2011 tax file   If you owned an activity as a limited partner, you generally are not treated as materially participating in the activity. 2011 tax file However, you are treated as materially participating in the activity if you met test (1), (5), or (6) under Material participation tests , discussed earlier, for the tax year. 2011 tax file   You are not treated as a limited partner, however, if you also were a general partner in the partnership at all times during the partnership's tax year ending with or within your tax year (or, if shorter, during that part of the partnership's tax year in which you directly or indirectly owned your limited partner interest). 2011 tax file Retired or disabled farmer and surviving spouse of a farmer. 2011 tax file   If you are a retired or disabled farmer, you are treated as materially participating in a farming activity if you materially participated for 5 or more of the 8 years before your retirement or disability. 2011 tax file Similarly, if you are a surviving spouse of a farmer, you are treated as materially participating in a farming activity if the real property used in the activity meets the estate tax rules for special valuation of farm property passed from a qualifying decedent, and you actively manage the farm. 2011 tax file Corporations. 2011 tax file   A closely held corporation or a personal service corporation is treated as materially participating in an activity only if one or more shareholders holding more than 50% by value of the outstanding stock of the corporation materially participate in the activity. 2011 tax file   A closely held corporation can also satisfy the material participation standard by meeting the first two requirements for the qualifying business exception from the at-risk limits. 2011 tax file See Special exception for qualified corporations under Activities Covered by the At-Risk Rules, later. 2011 tax file Real Estate Professional Generally, rental activities are passive activities even if you materially participated in them. 2011 tax file However, if you qualified as a real estate professional, rental real estate activities in which you materially participated are not passive activities. 2011 tax file For this purpose, each interest you have in a rental real estate activity is a separate activity, unless you choose to treat all interests in rental real estate activities as one activity. 2011 tax file See the Instructions for Schedule E (Form 1040), Supplemental Income and Loss, for information about making this choice. 2011 tax file If you qualified as a real estate professional for 2013, report income or losses from rental real estate activities in which you materially participated as nonpassive income or losses, and complete line 43 of Schedule E (Form 1040). 2011 tax file If you also have an unallowed loss from these activities from an earlier year when you did not qualify, see Treatment of former passive activities under Passive Activities, earlier. 2011 tax file Qualifications. 2011 tax file   You qualified as a real estate professional for the year if you met both of the following requirements. 2011 tax file More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated. 2011 tax file You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated. 2011 tax file   Do not count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer. 2011 tax file You were a 5% owner if you owned (or are considered to have owned) more than 5% of your employer's outstanding stock, outstanding voting stock, or capital or profits interest. 2011 tax file   If you file a joint return, do not count your spouse's personal services to determine whether you met the preceding requirements. 2011 tax file However, you can count your spouse's participation in an activity in determining if you materially participated. 2011 tax file Real property trades or businesses. 2011 tax file   A real property trade or business is a trade or business that does any of the following with real property. 2011 tax file Develops or redevelops it. 2011 tax file Constructs or reconstructs it. 2011 tax file Acquires it. 2011 tax file Converts it. 2011 tax file Rents or leases it. 2011 tax file Operates or manages it. 2011 tax file Brokers it. 2011 tax file Closely held corporations. 2011 tax file   A closely held corporation can qualify as a real estate professional if more than 50% of the gross receipts for its tax year came from real property trades or businesses in which it materially participated. 2011 tax file Passive Activity Income and Deductions In figuring your net income or loss from a passive activity, take into account only passive activity income and passive activity deductions. 2011 tax file Self-charged interest. 2011 tax file   Certain self-charged interest income or deductions may be treated as passive activity gross income or passive activity deductions if the loan proceeds are used in a passive activity. 2011 tax file   Generally, self-charged interest income and deductions result from loans between you and a partnership or S corporation in which you had a direct or indirect ownership interest. 2011 tax file This includes both loans you made to the partnership or S corporation and loans the partnership or S corporation made to you. 2011 tax file   It also includes loans from one partnership or S corporation to another partnership or S corporation if each owner in the borrowing entity has the same proportional ownership interest in the lending entity. 2011 tax file    Exception. 2011 tax file The self-charged interest rules do not apply to your interest in a partnership or S corporation if the entity made an election under Regulations section 1. 2011 tax file 469-7(g) to avoid the application of these rules. 2011 tax file For more details on the self-charged interest rules, see Regulations section 1. 2011 tax file 469-7. 2011 tax file Passive Activity Income Passive activity income includes all income from passive activities and generally includes gain from disposition of an interest in a passive activity or property used in a passive activity. 2011 tax file Passive activity income does not include the following items. 2011 tax file Income from an activity that is not a passive activity. 2011 tax file These activities are discussed under Activities That Are Not Passive Activities , earlier. 2011 tax file Portfolio income. 2011 tax file This includes interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business. 2011 tax file It includes gain or loss from the disposition of property that produces these types of income or that is held for investment. 2011 tax file The exclusion for portfolio income does not apply to self-charged interest treated as passive activity income. 2011 tax file For more information on self-charged interest, see Self-charged interest , earlier. 2011 tax file Personal service income. 2011 tax file This includes salaries, wages, commissions, self-employment income from trade or business activities in which you materially participated, deferred compensation, taxable social security and other retirement benefits, and payments from partnerships to partners for personal services. 2011 tax file Income from positive section 481 adjustments allocated to activities other than passive activities. 2011 tax file (Section 481 adjustments are adjustments that must be made due to changes in your accounting method. 2011 tax file ) Income or gain from investments of working capital. 2011 tax file Income from an oil or gas property if you treated any loss from a working interest in the property for any tax year beginning after 1986 as a nonpassive loss, as discussed in item (2) under Activities That Are Not Passive Activities , earlier. 2011 tax file This also applies to income from other oil and gas property the basis of which is determined wholly or partly by the basis of the property in the preceding sentence. 2011 tax file Any income from intangible property, such as a patent, copyright, or literary, musical, or artistic composition, if your personal efforts significantly contributed to the creation of the property. 2011 tax file Any other income that must be treated as nonpassive income. 2011 tax file See Recharacterization of Passive Income , later. 2011 tax file Overall gain from any interest in a publicly traded partnership. 2011 tax file See Publicly Traded Partnerships (PTPs) in the instructions for Form 8582. 2011 tax file State, local, and foreign income tax refunds. 2011 tax file Income from a covenant not to compete. 2011 tax file Reimbursement of a casualty or theft loss included in gross income to recover all or part of a prior year loss deduction, if the loss deduction was not a passive activity deduction. 2011 tax file Alaska Permanent Fund dividends. 2011 tax file Cancellation of debt income, if at the time the debt is discharged the debt is not allocated to passive activities under the interest expense allocation rules. 2011 tax file See chapter 4 of Publication 535, Business Expenses, for information about the rules for allocating interest. 2011 tax file Disposition of property interests. 2011 tax file   Gain on the disposition of an interest in property generally is passive activity income if, at the time of the disposition, the property was used in an activity that was a passive activity in the year of disposition. 2011 tax file The gain generally is not passive activity income if, at the time of disposition, the property was used in an activity that was not a passive activity in the year of disposition. 2011 tax file An exception to this general rule may apply if you previously used the property in a different activity. 2011 tax file Exception for more than one use in the preceding 12 months. 2011 tax file   If you used the property in more than one activity during the 12-month period before its disposition, you must allocate the gain between the activities on a basis that reasonably reflects the property's use during that period. 2011 tax file Any gain allocated to a passive activity is passive activity income. 2011 tax file   For this purpose, an allocation of the gain solely to the activity in which the property was mainly used during that period reasonably reflects the property's use if the fair market value of your interest in the property is not more than the lesser of: $10,000, or 10% of the total of the fair market value of your interest in the property and the fair market value of all other property used in that activity immediately before the disposition. 2011 tax file Exception for substantially appreciated property. 2011 tax file   The gain is passive activity income if the fair market value of the property at disposition was more than 120% of its adjusted basis and either of the following conditions applies. 2011 tax file You used the property in a passive activity for 20% of the time you held your interest in the property. 2011 tax file You used the property in a passive activity for the entire 24-month period before its disposition. 2011 tax file If neither condition applies, the gain is not passive activity income. 2011 tax file However, it is treated as portfolio income only if you held the property for investment for more than half of the time you held it in nonpassive activities. 2011 tax file   For this purpose, treat property you held through a corporation (other than an S corporation) or other entity whose owners receive only portfolio income as property held in a nonpassive activity and as property held for investment. 2011 tax file Also, treat the date you agree to transfer your interest for a fixed or determinable amount as the disposition date. 2011 tax file   If you used the property in more than one activity during the 12-month period before its disposition, this exception applies only to the part of the gain allocated to a passive activity under the rules described in the preceding discussion. 2011 tax file Disposition of property converted to inventory. 2011 tax file   If you disposed of property that you had converted to inventory from its use in another activity (for example, you sold condominium units you previously held for use in a rental activity), a special rule may apply. 2011 tax file Under this rule, you disregard the property's use as inventory and treat it as if it were still used in that other activity at the time of disposition. 2011 tax file This rule applies only if you meet all of the following conditions. 2011 tax file At the time of disposition, you held your interest in the property in a dealing activity (an activity that involves holding the property or similar property mainly for sale to customers in the ordinary course of a trade or business). 2011 tax file Your other activities included a nondealing activity (an activity that does not involve holding similar property for sale to customers in the ordinary course of a trade or business) in which you used the property for more than 80% of the period you held it. 2011 tax file You did not acquire or hold your interest in the property for the main purpose of selling it to customers in the ordinary course of a trade or business. 2011 tax file Passive Activity Deductions Generally, a deduction is a passive activity deduction for a taxable year if and only if such deduction either: Arises in connection with the conduct of an activity that is a passive activity for the tax year; or Is treated as a deduction from an activity for the tax year because it was disallowed by the passive activity rules in the preceding year and carried forward to the tax year. 2011 tax file For purposes of item (1), above, an item of deduction arises in the taxable year in which the item would be allowable as a deduction under the taxpayer's method of accounting if taxable income for all taxable years were determined without regard to the passive activity rules and without regard to the basis, excess farm loss, and at-risk limits. 2011 tax file See Coordination with other limitations on deductions that apply before the passive activity rules , later. 2011 tax file Passive activity deductions generally include losses from dispositions of property used in a passive activity at the time of the disposition and losses from a disposition of less than your entire interest in a passive activity. 2011 tax file Exceptions. 2011 tax file   Passive activity deductions do not include the following items. 2011 tax file Deductions for expenses (other than interest expense) that are clearly and directly allocable to portfolio income. 2011 tax file Qualified home mortgage interest, capitalized interest expenses, and other interest expenses (other than self-charged interest) properly allocable to passive activities. 2011 tax file For more information on self-charged interest, see Self-charged interest under Passive Activity Income and Deductions, earlier. 2011 tax file Losses from dispositions of property that produce portfolio income or property held for investment. 2011 tax file State, local, and foreign income taxes. 2011 tax file Miscellaneous itemized deductions that may be disallowed because of the 2%-of-adjusted-gross-income limit. 2011 tax file Charitable contribution deductions. 2011 tax file Net operating loss deductions. 2011 tax file Percentage depletion carryovers for oil and gas wells. 2011 tax file Capital loss carrybacks and carryovers. 2011 tax file Items of deduction from a passive activity that are disallowed under the limits on deductions that apply before the passive activity rules. 2011 tax file See Coordination with other limitations on deductions that apply before the passive activity rules , later. 2011 tax file Deductions and losses that would have been allowed for tax years beginning before 1987 but for basis or at-risk limits. 2011 tax file Net negative section 481 adjustments allocated to activities other than passive activities. 2011 tax file (Section 481 adjustments are adjustments required due to changes in accounting methods. 2011 tax file ) Casualty and theft losses, unless losses similar in cause and severity recur regularly in the activity. 2011 tax file The deduction for the employer-equivalent portion of self-employment tax. 2011 tax file Coordination with other limitations on deductions that apply before the passive activity rules. 2011 tax file   An item of deduction from a passive activity that is disallowed for a tax year under the basis or at-risk limitations is not a passive activity deduction for the tax year. 2011 tax file The following sections provide rules for figuring the extent to which items of deduction from a passive activity are disallowed for a tax year under the basis or at-risk limitations. 2011 tax file Proration of deductions disallowed under basis limitations. 2011 tax file   If any amount of your distributive share of a partnership's loss for the tax year is disallowed under the basis limitation, a ratable portion of your distributive share of each item of deduction or loss of the partnership is disallowed for the tax year. 2011 tax file For this purpose, the ratable portion of an item of deduction or loss is the amount of such item multiplied by the fraction obtained by dividing: The amount of your distributive share of partnership loss that is disallowed for the taxable year; by The sum of your distributive shares of all items of deduction and loss of the partnership for the tax year. 2011 tax file   If any amount of your pro rata share of an S corporation's loss for the tax year is disallowed under the basis limitation, a ratable portion of your pro rata share of each item of deduction or loss of the S corporation is disallowed for the tax year. 2011 tax file For this purpose, the ratable portion of an item of deduction or loss is the amount of such item multiplied by the fraction obtained by dividing: The amount of your share of S corporation loss that is disallowed for the tax year; by The sum of your pro rata shares of all items of deduction and loss of the corporation for the tax year. 2011 tax file Proration of deductions disallowed under at-risk limitation. 2011 tax file   If any amount of your loss from an activity (as defined in Activities Covered by the At-Risk Rules , later) is disallowed under the at-risk rules for the tax year, a ratable portion of each item of deduction or loss from the activity is disallowed for the tax year. 2011 tax file For this purpose, the ratable portion of an item of deduction or loss is the amount of such item multiplied by the fraction obtained by dividing: The amount of the loss from the activity that is disallowed for the tax year; by The sum of all deductions from the activity for the taxable year. 2011 tax file Coordination of basis and at-risk limitations. 2011 tax file   The portion of any item of deduction or loss that is disallowed for the tax year under the basis limitations is not taken into account for the taxable year in determining the loss from an activity (as defined in Activities Covered by the At-Risk Rules , later) for purposes of applying the at-risk rules. 2011 tax file Separately identified items of deduction and loss. 2011 tax file   In identifying the items of deduction and loss from an activity that are not disallowed under the basis and at-risk limitations (and that therefore may be treated as passive activity deductions), you need not account separately for any item of deduction or loss unless such item may, if separately taken into account, result in an income tax liability different from that which would result were such item of deduction or loss taken into account separately. 2011 tax file   Items of deduction or loss that must be accounted for separately include (but are not limited to) items of deduction or loss that: Are attributable to separate activities. 2011 tax file See Grouping Your Activities , later. 2011 tax file Arise in a rental real estate activity in tax years in which you actively participate in such activity; Arise in a rental real estate activity in taxable years in which you do not actively participate in such activity; Arose in a taxable year beginning before 1987 and were not allowed for such taxable year under the basis or at-risk limitations; Are taken into account under section 613A(d) (relating to limitations on certain depletion deductions); Are taken into account under section 1211 (relating to the limitation on capital losses); Are taken into account under section 1231 (relating to property used in a trade or business and involuntary conversions). 2011 tax file See Section 1231 Gains and Losses in Publication 544 for more information. 2011 tax file Are attributable to pre-enactment interests in activities. 2011 tax file See Regulations section 1. 2011 tax file 469-11T(c). 2011 tax file Grouping Your Activities You can treat one or more trade or business activities, or rental activities, as a single activity if those activities form an appropriate economic unit for measuring gain or loss under the passive activity rules. 2011 tax file Grouping is important for a number of reasons. 2011 tax file If you group two activities into one larger activity, you need only show material participation in the activity as a whole. 2011 tax file But if the two activities are separate, you must show material participation in each one. 2011 tax file On the other hand, if you group two activities into one larger activity and you dispose of one of the two, then you have disposed of only part of your entire interest in the activity. 2011 tax file But if the two activities are separate and you dispose of one of them, then you have disposed of your entire interest in that activity. 2011 tax file Grouping can also be important in determining whether you meet the 10% ownership requirement for actively participating in a rental real estate activity. 2011 tax file Appropriate Economic Units Generally, to determine if activities form an appropriate economic unit, you must consider all the relevant facts and circumstances. 2011 tax file You can use any reasonable method of applying the relevant facts and circumstances in grouping activities. 2011 tax file The following factors have the greatest weight in determining whether activities form an appropriate economic unit. 2011 tax file All of the factors do not have to apply to treat more than one activity as a single activity. 2011 tax file The factors that you should consider are: The similarities and differences in the types of trades or businesses, The extent of common control, The extent of common ownership, The geographical location, and The interdependencies between or among activities, which may include the extent to which the activities: Buy or sell goods between or among themselves, Involve products or services that are generally provided together, Have the same customers, Have the same employees, or Use a single set of books and records to account for the activities. 2011 tax file Example 1. 2011 tax file John Jackson owns a bakery and a movie theater at a shopping mall in Baltimore and a bakery and movie theater in Philadelphia. 2011 tax file Based on all the relevant facts and circumstances, there may be more than one reasonable method for grouping John's activities. 2011 tax file For example, John may be able to group the movie theaters and the bakeries into: One activity, A movie theater activity and a bakery activity, A Baltimore activity and a Philadelphia activity, or Four separate activities. 2011 tax file Example 2. 2011 tax file Betty is a partner in ABC partnership, which sells nonfood items to grocery stores. 2011 tax file Betty is also a partner in DEF (a trucking business). 2011 tax file ABC and DEF are under common control. 2011 tax file The main part of DEF's business is transporting goods for ABC. 2011 tax file DEF is the only trucking business in which Betty is involved. 2011 tax file Based on the rules of this section, Betty treats ABC's wholesale activity and DEF's trucking activity as a single activity. 2011 tax file Consistency and disclosure requirement. 2011 tax file   Generally, when you group activities into appropriate economic units, you may not regroup those activities in a later tax year. 2011 tax file You must meet any disclosure requirements of the IRS when you first group your activities and when you add or dispose of any activities in your groupings. 2011 tax file   However, if the original grouping is clearly inappropriate or there is a material change in the facts and circumstances that makes the original grouping clearly inappropriate, you must regroup the activities and comply with any disclosure requirements of the IRS. 2011 tax file   See Disclosure Requirement , later. 2011 tax file Regrouping by the IRS. 2011 tax file   If any of the activities resulting from your grouping is not an appropriate economic unit and one of the primary purposes of your grouping (or failure to regroup) is to avoid the passive activity rules, the IRS may regroup your activities. 2011 tax file Rental activities. 2011 tax file   In general, you cannot group a rental activity with a trade or business activity. 2011 tax file However, you can group them together if the activities form an appropriate economic unit and: The rental activity is insubstantial in relation to the trade or business activity, The trade or business activity is insubstantial in relation to the rental activity, or Each owner of the trade or business activity has the same ownership interest in the rental activity, in which case the part of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity. 2011 tax file Example. 2011 tax file Herbert and Wilma are married and file a joint return. 2011 tax file Healthy Food, an S corporation, is a grocery store business. 2011 tax file Herbert is Healthy Food's only shareholder. 2011 tax file Plum Tower, an S corporation, owns and rents out the building. 2011 tax file Wilma is Plum Tower's only shareholder. 2011 tax file Plum Tower rents part of its building to Healthy Food. 2011 tax file Plum Tower's grocery store rental business and Healthy Food's grocery business are not insubstantial in relation to each other. 2011 tax file Herbert and Wilma file a joint return, so they are treated as one taxpayer for purposes of the passive activity rules. 2011 tax file The same owner (Herbert and Wilma) owns both Healthy Food and Plum Tower with the same ownership interest (100% in each). 2011 tax file If the grouping forms an appropriate economic unit, as discussed earlier, Herbert and Wilma can group Plum Tower's grocery store rental and Healthy Food's grocery business into a single trade or business activity. 2011 tax file Grouping of real and personal property rentals. 2011 tax file   In general, you cannot treat an activity involving the rental of real property and an activity involving the rental of personal property as a single activity. 2011 tax file However, you can treat them as a single activity if you provide the personal property in connection with the real property or the real property in connection with the personal property. 2011 tax file Certain activities may not be grouped. 2011 tax file   In general, if you own an interest as a limited partner or a limited entrepreneur in one of the following activities, you may not group that activity with any other activity in another type of business. 2011 tax file Holding, producing, or distributing motion picture films or video tapes. 2011 tax file Farming. 2011 tax file Leasing any section 1245 property (as defined in section 1245(a)(3) of the Internal Revenue Code). 2011 tax file For a list of section 1245 property, see Section 1245 property under Activities Covered by the At-Risk Rules , later. 2011 tax file Exploring for, or exploiting, oil and gas resources. 2011 tax file Exploring for, or exploiting, geothermal deposits. 2011 tax file   If you own an interest as a limited partner or a limited entrepreneur in an activity described in the list above, you may group that activity with another activity in the same type of business if the grouping forms an appropriate economic unit as discussed earlier. 2011 tax file Limited entrepreneur. 2011 tax file   A limited entrepreneur is a person who: Has an interest in an enterprise other than as a limited partner, and Does not actively participate in the management of the enterprise. 2011 tax file Activities conducted through another entity. 2011 tax file   A personal service corporation, closely held corporation, partnership, or S corporation must group its activities using the rules discussed in this section. 2011 tax file Once the entity groups its activities, you, as the partner or shareholder of the entity, may group those activities (following the rules of this section): With each other, With activities conducted directly by you, or With activities conducted through other entities. 2011 tax file    You may not treat activities grouped together by the entity as separate activities. 2011 tax file Personal service and closely held corporations. 2011 tax file   You may group an activity conducted through a personal service or closely held corporation with your other activities only to determine whether you materially or significantly participated in those other activities. 2011 tax file See Material Participation , earlier, and Significant Participation Passive Activities , later. 2011 tax file Publicly traded partnership (PTP). 2011 tax file   You may not group activities conducted through a PTP with any other activity, including an activity conducted through another PTP. 2011 tax file Partial dispositions. 2011 tax file   If you dispose of substantially all of an activity during your tax year, you may treat the part disposed of as a separate activity. 2011 tax file However, you can do this only if you can show with reasonable certainty: The amount of deductions and credits disallowed in prior years under the passive activity rules that is allocable to the part of the activity disposed of, and The amount of gross income and any other deductions and credits for the current tax year that is allocable to the part of the activity disposed of. 2011 tax file Disclosure Requirement For tax years beginning after January 24, 2010, the following disclosure requirements for groupings apply. 2011 tax file You are required to report certain changes to your groupings that occur during the tax year to the IRS. 2011 tax file If you fail to report these changes, each trade or business activity or rental activity will be treated as a separate activity. 2011 tax file You will be considered to have made a timely disclosure if you filed all affected income tax returns consistent with the claimed grouping and make the required disclosure on the income tax return for the year in which you first discovered the failure to disclose. 2011 tax file If the IRS discovered the failure to disclose, you must have reasonable cause for not making the required disclosure. 2011 tax file New grouping. 2011 tax file   You must file a written statement with your original income tax return for the first tax year in which two or more activities are originally grouped into a single activity. 2011 tax file The statement must provide the names, addresses, and employer identification numbers (EINs), if applicable, for the activities being grouped as a single activity. 2011 tax file In addition, the statement must contain a declaration that the grouped activities make up an appropriate economic unit for the measurement of gain or loss under the passive activity rules. 2011 tax file Addition to an existing grouping. 2011 tax file   You must file a written statement with your original income tax return for the tax year in which you add a new activity to an existing group. 2011 tax file The statement must provide the name, address, and EIN, if applicable, for the activity that is being added and for the activities in the existing group. 2011 tax file In addition, the statement must contain a declaration that the activities make up an appropriate economic unit for the measurement of gain or loss under the passive activity rules. 2011 tax file Regrouping. 2011 tax file   You must file a written statement with your original income tax return for the tax year in which you regroup the activities. 2011 tax file The statement must provide the names, addresses, and EINs, if applicable, for the activities that are being regrouped. 2011 tax file If two or more activities are being regrouped into a single activity, the statement must contain a declaration that the regrouped activities make up an appropriate economic unit for the measurement of gain or loss under the passive activity rules. 2011 tax file In addition, the statement must contain an explanation of the material change in the facts and circumstances that made the original grouping clearly inappropriate. 2011 tax file Groupings by partnerships and S corporations. 2011 tax file   Partnerships and S corporations are not subject to the rules for new grouping, addition to an existing grouping, or regrouping. 2011 tax file Instead, they must comply with the disclosure instructions for grouping activities provided in their Form 1065, U. 2011 tax file S. 2011 tax file Return of Partnership Income, or Form 1120S, U. 2011 tax file S. 2011 tax file Income Tax Return for an S Corporation, whichever is applicable. 2011 tax file   The partner or shareholder is not required to make a separate disclosure of the groupings disclosed by the entity unless the partner or shareholder: Groups together any of the activities that the entity does not group together, Groups the entity's activities with activities conducted directly by the partner or shareholder, or Groups an entity's activities with activities conducted through another entity. 2011 tax file   A partner or shareholder may not treat activities grouped together by the entity as separate activities. 2011 tax file Recharacterization of Passive Income Net income from the following passive activities may have to be recharacterized and excluded from passive activity income. 2011 tax file Significant participation passive activities, Rental of property when less than 30% of the unadjusted basis of the property is subject to depreciation, Equity-financed lending activities, Rental of property incidental to development activities, Rental of property to nonpassive activities, and Licensing of intangible property by  pass-through entities. 2011 tax file If you are engaged in or have an interest in one of these activities during the tax year (either directly or through a partnership or an S corporation), combine the income and losses from the activity to determine if you have a net loss or net income from that activity. 2011 tax file If the result is a net loss, treat the income and losses the same as any other income or losses from that type of passive activity (trade or business activity or rental activity). 2011 tax file If the result is net income, do not enter any of the income or losses from the activity or property on Form 8582 or its worksheets. 2011 tax file Instead, enter income or losses on the form and schedules you normally use. 2011 tax file However, see Significant Participation Passive Activities , later, if the activity is a significant participation passive activity and you also have a net loss from a different significant participation passive activity. 2011 tax file Limit on recharacterized passive income. 2011 tax file   The total amount that you treat as nonpassive income under the rules described later in this discussion for significant participation passive activities, rental of nondepreciable property, and equity-financed lending activities cannot exceed the greatest amount that you treat as nonpassive income under any one of these rules. 2011 tax file Investment income and investment expense. 2011 tax file   To figure your investment interest expense limitation on Form 4952, treat as investment income any net passive income recharacterized as nonpassive income from rental of nondepreciable property, equity-financed lending activity, or licensing of intangible property by a pass-through entity. 2011 tax file Significant Participation Passive Activities A significant participation passive activity is any trade or business activity in which you participated for more than 100 hours during the tax year but did not materially participate. 2011 tax file If your gross income from all significant participation passive activities is more than your deductions from those activities, a part of your net income from each significant participation passive activity is treated as nonpassive income. 2011 tax file Corporations. 2011 tax file   An activity of a personal service corporation or closely held corporation is a significant participation passive activity if both of the following statements are true. 2011 tax file The corporation is not treated as materially participating in the activity for the year. 2011 tax file One or more individuals, each of whom is treated as significantly participating in the activity, directly or indirectly hold (in total) more than 50% (by value) of the corporation's outstanding stock. 2011 tax file Worksheet A. 2011 tax file   Complete Worksheet A. 2011 tax file Significant Participation Passive Activities , below, if you have income or losses from any significant participation activity. 2011 tax file Begin by entering the name of each activity in the left column. 2011 tax file Column (a). 2011 tax file   Enter the number of hours you participated in each activity and total the column. 2011 tax file   If the total is more than 500, do not complete Worksheet A or B. 2011 tax file None of the activities are passive activities because you satisfy test 4 for material participation. 2011 tax file (See Material participation tests , earlier. 2011 tax file ) Report all the income and losses from these activities on the forms and schedules you normally use. 2011 tax file Do not include the income and losses on Form 8582. 2011 tax file Column (b). 2011 tax file   Enter the net loss, if any, from the activity. 2011 tax file Net loss from an activity means either: The activity's current year net loss (if any) plus prior year unallowed losses (if any), or The excess of prior year unallowed losses over the current year net income (if any). 2011 tax file Enter -0- here if the prior year unallowed loss is the same as the current year net income. 2011 tax file Column (c). 2011 tax file   Enter net income (if any) from the activity. 2011 tax file Net income means the excess of the current year's net income from the activity over any prior year unallowed losses from the activity. 2011 tax file Column (d). 2011 tax file   Combine amounts in the Totals row for columns (b) and (c) and enter the total net income or net loss in the Totals row of column (d). 2011 tax file If column (d) is a net loss, skip Worksheet B, Significant Participation Activities With Net Income. 2011 tax file Include the income and losses in Worksheet 3 of Form 8582 (or Worksheet 2 in the Form 88