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Need Some Deductions for 2011?

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10 Oddball Tax Deductions

11 Most Overlooked Tax Deductions

Updated for 2011

Passive Activity Rules

Passive Activity and At-Risk Rules

Background:

There are two rules that limit the amount of a business loss you may deduct from your other sources of income in any given tax year.

  1. Passive Activity Rules
  2. At-Risk Rules

Passive activity rules:

Passive activity rules target investors who do not materially participate in the businesses they invest in. Such investors simply expect a return on their investment.

A business you merely invest in but do not materially participate in is a passive activity for tax purposes. In addition, rental activities are considered passive activities regardless of your participation in the activity.

See the Special $25,000 Allowance for Real Estate Nonprofessionals.

Passive activity rules prevent investors from deducting passive activity losses from their nonpassive sources of income.

In other words, passive activity losses may only be deducted from passive activity income.

For example, a loss from a passive activity may not be deducted from salary income from a job.

If passive activity losses exceed passive activity income, the excess must be carried over to future tax years and may be deducted from passive activity income at that time.

The passive activity rules (Section 469, Passive Activity Losses and Credits Limited) were enacted into law with the passage of the Tax Reform Act of 1986.

At-risk rules:

The Tax Reform Act of 1986 also extended the at-risk rules to property placed in service after 1986.

At-risk rules deal with your investment in a business not your participation.

The amount of a business loss you may deduct from other sources of income is limited to the amount of your investment in the business.

For example, assume you invested $10,000 in your S-corporation and that you're the only stockholder/employee.

If the S-corporation suffers a $20,000 loss in a tax year, your maximum loss deduction is limited to $10,000, the amount your investment (the amount you stand to lose).

The $10,000 may be deducted from your other sources of income (e.g., wages, salary, interest, dividends).

The remaining $10,000 loss is called a suspended loss and must be carried over to the following year.

Historical Note

During the 1980s a variety of speculative and questionable tax shelters were created offering passive investors the lure of significant tax incentives in the form of tax deductions (write-offs).

These tax shelters were generally set up as limited partnerships and were involved in highly leveraged real estate activities that tended to attract high-income taxpayers.

Losses and deductions would be passed through these entities to its investors who could then deduct their share of the losses and deductions from their other sources of income.

Over time, an investor stood to save more money in taxes, via the tax deductions, than the amount he/she actually invested in the activity!

In other words, rather than real economic incentives such as the profitability and economic substance of the activity being the motivating factor for investors to put up their money, it was the lure of tax write-offs, touted by promoters, that was the primary incentive to invest in such activities.

Congress concluded that since these tax shelters were not designed to produce real economic benefit but only as vehicles to generate tax savings, the tax incentives had to be limited.

The at-risk rules address the amount of your investment in an activity. The passive activity rules address the amount of your participation in an activity.

Generally, if you participate at least 500 hours per year (10 hours per week) in your business, you're not subject to the passive activity rules

At-risk rules limit the amount you can deduct for a business loss in a tax year up to the amount of your investment in an activity (the amount you stand to lose).

Passive activity rules restrict the deduction of passive activity losses only from passive activity income.

The new rules are intended to have the effect of directing capital investment into viable, economic activities where profit is the motivating factor not merely tax savings.

Next:

Passive Activity: Who Do Passive Activity Rules Apply To; Investors; Purpose of Passive Activity Rules: What is a Passive Activity? Tax Forms You May Need to File

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