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Free efile federal 1. Free efile federal   Overview of Depreciation Table of Contents Introduction Useful Items - You may want to see: What Property Can Be Depreciated?Property You Own Property Used in Your Business or Income-Producing Activity Property Having a Determinable Useful Life Property Lasting More Than One Year What Property Cannot Be Depreciated?Land Excepted Property When Does Depreciation Begin and End?Placed in Service Idle Property Cost or Other Basis Fully Recovered Retired From Service What Method Can You Use To Depreciate Your Property?Property You Placed in Service Before 1987 Property Owned or Used in 1986 Intangible Property Corporate or Partnership Property Acquired in a Nontaxable Transfer Election To Exclude Property From MACRS What Is the Basis of Your Depreciable Property?Cost as Basis Other Basis Adjusted Basis How Do You Treat Repairs and Improvements? Do You Have To File Form 4562? How Do You Correct Depreciation Deductions?Filing an Amended Return Changing Your Accounting Method Introduction Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. Free efile federal It is an allowance for the wear and tear, deterioration, or obsolescence of the property. Free efile federal This chapter discusses the general rules for depreciating property and answers the following questions. Free efile federal What property can be depreciated? What property cannot be depreciated? When does depreciation begin and end? What method can you use to depreciate your property? What is the basis of your depreciable property? How do you treat repairs and improvements? Do you have to file Form 4562? How do you correct depreciation deductions? Useful Items - You may want to see: Publication 534 Depreciating Property Placed in Service Before 1987 535 Business Expenses 538 Accounting Periods and Methods 551 Basis of Assets Form (and Instructions) Sch C (Form 1040) Profit or Loss From Business Sch C-EZ (Form 1040) Net Profit From Business 2106 Employee Business Expenses 2106-EZ Unreimbursed Employee Business Expenses 3115 Application for Change in Accounting Method 4562 Depreciation and Amortization See chapter 6 for information about getting publications and forms. Free efile federal What Property Can Be Depreciated? You can depreciate most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment. Free efile federal You also can depreciate certain intangible property, such as patents, copyrights, and computer software. Free efile federal To be depreciable, the property must meet all the following requirements. Free efile federal It must be property you own. Free efile federal It must be used in your business or income-producing activity. Free efile federal It must have a determinable useful life. Free efile federal It must be expected to last more than one year. Free efile federal The following discussions provide information about these requirements. Free efile federal Property You Own To claim depreciation, you usually must be the owner of the property. Free efile federal You are considered as owning property even if it is subject to a debt. Free efile federal Example 1. Free efile federal You made a down payment to purchase rental property and assumed the previous owner's mortgage. Free efile federal You own the property and you can depreciate it. Free efile federal Example 2. Free efile federal You bought a new van that you will use only for your courier business. Free efile federal You will be making payments on the van over the next 5 years. Free efile federal You own the van and you can depreciate it. Free efile federal Leased property. Free efile federal   You can depreciate leased property only if you retain the incidents of ownership in the property (explained below). Free efile federal This means you bear the burden of exhaustion of the capital investment in the property. Free efile federal Therefore, if you lease property from someone to use in your trade or business or for the production of income, you generally cannot depreciate its cost because you do not retain the incidents of ownership. Free efile federal You can, however, depreciate any capital improvements you make to the property. Free efile federal See How Do You Treat Repairs and Improvements later in this chapter and Additions and Improvements under Which Recovery Period Applies in chapter 4. Free efile federal   If you lease property to someone, you generally can depreciate its cost even if the lessee (the person leasing from you) has agreed to preserve, replace, renew, and maintain the property. Free efile federal However, if the lease provides that the lessee is to maintain the property and return to you the same property or its equivalent in value at the expiration of the lease in as good condition and value as when leased, you cannot depreciate the cost of the property. Free efile federal Incidents of ownership. Free efile federal   Incidents of ownership in property include the following. Free efile federal The legal title to the property. Free efile federal The legal obligation to pay for the property. Free efile federal The responsibility to pay maintenance and operating expenses. Free efile federal The duty to pay any taxes on the property. Free efile federal The risk of loss if the property is destroyed, condemned, or diminished in value through obsolescence or exhaustion. Free efile federal Life tenant. Free efile federal   Generally, if you hold business or investment property as a life tenant, you can depreciate it as if you were the absolute owner of the property. Free efile federal However, see Certain term interests in property under Excepted Property, later. Free efile federal Cooperative apartments. Free efile federal   If you are a tenant-stockholder in a cooperative housing corporation and use your cooperative apartment in your business or for the production of income, you can depreciate your stock in the corporation, even though the corporation owns the apartment. Free efile federal   Figure your depreciation deduction as follows. Free efile federal Figure the depreciation for all the depreciable real property owned by the corporation in which you have a proprietary lease or right of tenancy. Free efile federal If you bought your cooperative stock after its first offering, figure the depreciable basis of this property as follows. Free efile federal Multiply your cost per share by the total number of outstanding shares, including any shares held by the corporation. Free efile federal Add to the amount figured in (a) any mortgage debt on the property on the date you bought the stock. Free efile federal Subtract from the amount figured in (b) any mortgage debt that is not for the depreciable real property, such as the part for the land. Free efile federal Subtract from the amount figured in (1) any depreciation for space owned by the corporation that can be rented but cannot be lived in by tenant-stockholders. Free efile federal Divide the number of your shares of stock by the total number of outstanding shares, including any shares held by the corporation. Free efile federal Multiply the result of (2) by the percentage you figured in (3). Free efile federal This is your depreciation on the stock. Free efile federal   Your depreciation deduction for the year cannot be more than the part of your adjusted basis in the stock of the corporation that is allocable to your business or income-producing property. Free efile federal You must also reduce your depreciation deduction if only a portion of the property is used in a business or for the production of income. Free efile federal Example. Free efile federal You figure your share of the cooperative housing corporation's depreciation to be $30,000. Free efile federal Your adjusted basis in the stock of the corporation is $50,000. Free efile federal You use one half of your apartment solely for business purposes. Free efile federal Your depreciation deduction for the stock for the year cannot be more than $25,000 (½ of $50,000). Free efile federal Change to business use. Free efile federal   If you change your cooperative apartment to business use, figure your allowable depreciation as explained earlier. Free efile federal The basis of all the depreciable real property owned by the cooperative housing corporation is the smaller of the following amounts. Free efile federal The fair market value of the property on the date you change your apartment to business use. Free efile federal This is considered to be the same as the corporation's adjusted basis minus straight line depreciation, unless this value is unrealistic. Free efile federal The corporation's adjusted basis in the property on that date. Free efile federal Do not subtract depreciation when figuring the corporation's adjusted basis. Free efile federal   If you bought the stock after its first offering, the corporation's adjusted basis in the property is the amount figured in (1), above. Free efile federal The fair market value of the property is considered to be the same as the corporation's adjusted basis figured in this way minus straight line depreciation, unless the value is unrealistic. Free efile federal   For a discussion of fair market value and adjusted basis, see Publication 551. Free efile federal Property Used in Your Business or Income-Producing Activity To claim depreciation on property, you must use it in your business or income-producing activity. Free efile federal If you use property to produce income (investment use), the income must be taxable. Free efile federal You cannot depreciate property that you use solely for personal activities. Free efile federal Partial business or investment use. Free efile federal   If you use property for business or investment purposes and for personal purposes, you can deduct depreciation based only on the business or investment use. Free efile federal For example, you cannot deduct depreciation on a car used only for commuting, personal shopping trips, family vacations, driving children to and from school, or similar activities. Free efile federal    You must keep records showing the business, investment, and personal use of your property. Free efile federal For more information on the records you must keep for listed property, such as a car, see What Records Must Be Kept in chapter 5. Free efile federal    Although you can combine business and investment use of property when figuring depreciation deductions, do not treat investment use as qualified business use when determining whether the business-use requirement for listed property is met. Free efile federal For information about qualified business use of listed property, see What Is the Business-Use Requirement in chapter 5. Free efile federal Office in the home. Free efile federal   If you use part of your home as an office, you may be able to deduct depreciation on that part based on its business use. Free efile federal For information about depreciating your home office, see Publication 587. Free efile federal Inventory. Free efile federal   You cannot depreciate inventory because it is not held for use in your business. Free efile federal Inventory is any property you hold primarily for sale to customers in the ordinary course of your business. Free efile federal   If you are a rent-to-own dealer, you may be able to treat certain property held in your business as depreciable property rather than as inventory. Free efile federal See Rent-to-own dealer under Which Property Class Applies Under GDS in chapter 4. Free efile federal   In some cases, it is not clear whether property is held for sale (inventory) or for use in your business. Free efile federal If it is unclear, examine carefully all the facts in the operation of the particular business. Free efile federal The following example shows how a careful examination of the facts in two similar situations results in different conclusions. Free efile federal Example. Free efile federal Maple Corporation is in the business of leasing cars. Free efile federal At the end of their useful lives, when the cars are no longer profitable to lease, Maple sells them. Free efile federal Maple does not have a showroom, used car lot, or individuals to sell the cars. Free efile federal Instead, it sells them through wholesalers or by similar arrangements in which a dealer's profit is not intended or considered. Free efile federal Maple can depreciate the leased cars because the cars are not held primarily for sale to customers in the ordinary course of business, but are leased. Free efile federal If Maple buys cars at wholesale prices, leases them for a short time, and then sells them at retail prices or in sales in which a dealer's profit is intended, the cars are treated as inventory and are not depreciable property. Free efile federal In this situation, the cars are held primarily for sale to customers in the ordinary course of business. Free efile federal Containers. Free efile federal   Generally, containers for the products you sell are part of inventory and you cannot depreciate them. Free efile federal However, you can depreciate containers used to ship your products if they have a life longer than one year and meet the following requirements. Free efile federal They qualify as property used in your business. Free efile federal Title to the containers does not pass to the buyer. Free efile federal   To determine if these requirements are met, consider the following questions. Free efile federal Does your sales contract, sales invoice, or other type of order acknowledgment indicate whether you have retained title? Does your invoice treat the containers as separate items? Do any of your records state your basis in the containers? Property Having a Determinable Useful Life To be depreciable, your property must have a determinable useful life. Free efile federal This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes. Free efile federal Property Lasting More Than One Year To be depreciable, property must have a useful life that extends substantially beyond the year you place it in service. Free efile federal Example. Free efile federal You maintain a library for use in your profession. Free efile federal You can depreciate it. Free efile federal However, if you buy technical books, journals, or information services for use in your business that have a useful life of one year or less, you cannot depreciate them. Free efile federal Instead, you deduct their cost as a business expense. Free efile federal What Property Cannot Be Depreciated? Certain property cannot be depreciated. Free efile federal This includes land and certain excepted property. Free efile federal Land You cannot depreciate the cost of land because land does not wear out, become obsolete, or get used up. Free efile federal The cost of land generally includes the cost of clearing, grading, planting, and landscaping. Free efile federal Although you cannot depreciate land, you can depreciate certain land preparation costs, such as landscaping costs, incurred in preparing land for business use. Free efile federal These costs must be so closely associated with other depreciable property that you can determine a life for them along with the life of the associated property. Free efile federal Example. Free efile federal You constructed a new building for use in your business and paid for grading, clearing, seeding, and planting bushes and trees. Free efile federal Some of the bushes and trees were planted right next to the building, while others were planted around the outer border of the lot. Free efile federal If you replace the building, you would have to destroy the bushes and trees right next to it. Free efile federal These bushes and trees are closely associated with the building, so they have a determinable useful life. Free efile federal Therefore, you can depreciate them. Free efile federal Add your other land preparation costs to the basis of your land because they have no determinable life and you cannot depreciate them. Free efile federal Excepted Property Even if the requirements explained in the preceding discussions are met, you cannot depreciate the following property. Free efile federal Property placed in service and disposed of in the same year. Free efile federal Determining when property is placed in service is explained later. Free efile federal Equipment used to build capital improvements. Free efile federal You must add otherwise allowable depreciation on the equipment during the period of construction to the basis of your improvements. Free efile federal See Uniform Capitalization Rules in Publication 551. Free efile federal Section 197 intangibles. Free efile federal You must amortize these costs. Free efile federal Section 197 intangibles are discussed in detail in Chapter 8 of Publication 535. Free efile federal Intangible property, such as certain computer software, that is not section 197 intangible property, can be depreciated if it meets certain requirements. Free efile federal See Intangible Property , later. Free efile federal Certain term interests. Free efile federal Certain term interests in property. Free efile federal   You cannot depreciate a term interest in property created or acquired after July 27, 1989, for any period during which the remainder interest is held, directly or indirectly, by a person related to you. Free efile federal A term interest in property means a life interest in property, an interest in property for a term of years, or an income interest in a trust. Free efile federal Related persons. Free efile federal   For a description of related persons, see Related Persons, later. Free efile federal For this purpose, however, treat as related persons only the relationships listed in items (1) through (10) of that discussion and substitute “50%” for “10%” each place it appears. Free efile federal Basis adjustments. Free efile federal   If you would be allowed a depreciation deduction for a term interest in property except that the holder of the remainder interest is related to you, you generally must reduce your basis in the term interest by any depreciation or amortization not allowed. Free efile federal   If you hold the remainder interest, you generally must increase your basis in that interest by the depreciation not allowed to the term interest holder. Free efile federal However, do not increase your basis for depreciation not allowed for periods during which either of the following situations applies. Free efile federal The term interest is held by an organization exempt from tax. Free efile federal The term interest is held by a nonresident alien individual or foreign corporation, and the income from the term interest is not effectively connected with the conduct of a trade or business in the United States. Free efile federal Exceptions. Free efile federal   The above rules do not apply to the holder of a term interest in property acquired by gift, bequest, or inheritance. Free efile federal They also do not apply to the holder of dividend rights that were separated from any stripped preferred stock if the rights were purchased after April 30, 1993, or to a person whose basis in the stock is determined by reference to the basis in the hands of the purchaser. Free efile federal When Does Depreciation Begin and End? You begin to depreciate your property when you place it in service for use in your trade or business or for the production of income. Free efile federal You stop depreciating property either when you have fully recovered your cost or other basis or when you retire it from service, whichever happens first. Free efile federal Placed in Service You place property in service when it is ready and available for a specific use, whether in a business activity, an income-producing activity, a tax-exempt activity, or a personal activity. Free efile federal Even if you are not using the property, it is in service when it is ready and available for its specific use. Free efile federal Example 1. Free efile federal Donald Steep bought a machine for his business. Free efile federal The machine was delivered last year. Free efile federal However, it was not installed and operational until this year. Free efile federal It is considered placed in service this year. Free efile federal If the machine had been ready and available for use when it was delivered, it would be considered placed in service last year even if it was not actually used until this year. Free efile federal Example 2. Free efile federal On April 6, Sue Thorn bought a house to use as residential rental property. Free efile federal She made several repairs and had it ready for rent on July 5. Free efile federal At that time, she began to advertise it for rent in the local newspaper. Free efile federal The house is considered placed in service in July when it was ready and available for rent. Free efile federal She can begin to depreciate it in July. Free efile federal Example 3. Free efile federal James Elm is a building contractor who specializes in constructing office buildings. Free efile federal He bought a truck last year that had to be modified to lift materials to second-story levels. Free efile federal The installation of the lifting equipment was completed and James accepted delivery of the modified truck on January 10 of this year. Free efile federal The truck was placed in service on January 10, the date it was ready and available to perform the function for which it was bought. Free efile federal Conversion to business use. Free efile federal   If you place property in service in a personal activity, you cannot claim depreciation. Free efile federal However, if you change the property's use to use in a business or income-producing activity, then you can begin to depreciate it at the time of the change. Free efile federal You place the property in service in the business or income-producing activity on the date of the change. Free efile federal Example. Free efile federal You bought a home and used it as your personal home several years before you converted it to rental property. Free efile federal Although its specific use was personal and no depreciation was allowable, you placed the home in service when you began using it as your home. Free efile federal You can begin to claim depreciation in the year you converted it to rental property because its use changed to an income-producing use at that time. Free efile federal Idle Property Continue to claim a deduction for depreciation on property used in your business or for the production of income even if it is temporarily idle (not in use). Free efile federal For example, if you stop using a machine because there is a temporary lack of a market for a product made with that machine, continue to deduct depreciation on the machine. Free efile federal Cost or Other Basis Fully Recovered You stop depreciating property when you have fully recovered your cost or other basis. Free efile federal You recover your basis when your section 179 and allowed or allowable depreciation deductions equal your cost or investment in the property. Free efile federal See What Is the Basis of Your Depreciable Property , later. Free efile federal Retired From Service You stop depreciating property when you retire it from service, even if you have not fully recovered its cost or other basis. Free efile federal You retire property from service when you permanently withdraw it from use in a trade or business or from use in the production of income because of any of the following events. Free efile federal You sell or exchange the property. Free efile federal You convert the property to personal use. Free efile federal You abandon the property. Free efile federal You transfer the property to a supplies or scrap account. Free efile federal The property is destroyed. Free efile federal If you included the property in a general asset account, see How Do You Use General Asset Accounts in chapter 4 for the rules that apply when you dispose of that property. Free efile federal What Method Can You Use To Depreciate Your Property? You must use the Modified Accelerated Cost Recovery System (MACRS) to depreciate most property. Free efile federal MACRS is discussed in chapter 4. Free efile federal You cannot use MACRS to depreciate the following property. Free efile federal Property you placed in service before 1987. Free efile federal Certain property owned or used in 1986. Free efile federal Intangible property. Free efile federal Films, video tapes, and recordings. Free efile federal Certain corporate or partnership property acquired in a nontaxable transfer. Free efile federal Property you elected to exclude from MACRS. Free efile federal The following discussions describe the property listed above and explain what depreciation method should be used. Free efile federal Property You Placed in Service Before 1987 You cannot use MACRS for property you placed in service before 1987 (except property you placed in service after July 31, 1986, if MACRS was elected). Free efile federal Property placed in service before 1987 must be depreciated under the methods discussed in Publication 534. Free efile federal For a discussion of when property is placed in service, see When Does Depreciation Begin and End , earlier. Free efile federal Use of real property changed. Free efile federal   You generally must use MACRS to depreciate real property that you acquired for personal use before 1987 and changed to business or income-producing use after 1986. Free efile federal Improvements made after 1986. Free efile federal   You must treat an improvement made after 1986 to property you placed in service before 1987 as separate depreciable property. Free efile federal Therefore, you can depreciate that improvement as separate property under MACRS if it is the type of property that otherwise qualifies for MACRS depreciation. Free efile federal For more information about improvements, see How Do You Treat Repairs and Improvements , later and Additions and Improvements under Which Recovery Period Applies in chapter 4. Free efile federal Property Owned or Used in 1986 You may not be able to use MACRS for property you acquired and placed in service after 1986 if any of the situations described below apply. Free efile federal If you cannot use MACRS, the property must be depreciated under the methods discussed in Publication 534. Free efile federal For the following discussions, do not treat property as owned before you placed it in service. Free efile federal If you owned property in 1986 but did not place it in service until 1987, you do not treat it as owned in 1986. Free efile federal Personal property. Free efile federal   You cannot use MACRS for personal property (section 1245 property) in any of the following situations. Free efile federal You or someone related to you owned or used the property in 1986. Free efile federal You acquired the property from a person who owned it in 1986 and as part of the transaction the user of the property did not change. Free efile federal You lease the property to a person (or someone related to this person) who owned or used the property in 1986. Free efile federal You acquired the property in a transaction in which: The user of the property did not change, and The property was not MACRS property in the hands of the person from whom you acquired it because of (2) or (3) above. Free efile federal Real property. Free efile federal   You generally cannot use MACRS for real property (section 1250 property) in any of the following situations. Free efile federal You or someone related to you owned the property in 1986. Free efile federal You lease the property to a person who owned the property in 1986 (or someone related to that person). Free efile federal You acquired the property in a like-kind exchange, involuntary conversion, or repossession of property you or someone related to you owned in 1986. Free efile federal MACRS applies only to that part of your basis in the acquired property that represents cash paid or unlike property given up. Free efile federal It does not apply to the carried-over part of the basis. Free efile federal Exceptions. Free efile federal   The rules above do not apply to the following. Free efile federal Residential rental property or nonresidential real property. Free efile federal Any property if, in the first tax year it is placed in service, the deduction under the Accelerated Cost Recovery System (ACRS) is more than the deduction under MACRS using the half-year convention. Free efile federal For information on how to figure depreciation under ACRS, see Publication 534. Free efile federal Property that was MACRS property in the hands of the person from whom you acquired it because of (2) above. Free efile federal Related persons. Free efile federal   For this purpose, the following are related persons. Free efile federal An individual and a member of his or her family, including only a spouse, child, parent, brother, sister, half-brother, half-sister, ancestor, and lineal descendant. Free efile federal A corporation and an individual who directly or indirectly owns more than 10% of the value of the outstanding stock of that corporation. Free efile federal Two corporations that are members of the same controlled group. Free efile federal A trust fiduciary and a corporation if more than 10% of the value of the outstanding stock is directly or indirectly owned by or for the trust or grantor of the trust. Free efile federal The grantor and fiduciary, and the fiduciary and beneficiary, of any trust. Free efile federal The fiduciaries of two different trusts, and the fiduciaries and beneficiaries of two different trusts, if the same person is the grantor of both trusts. Free efile federal A tax-exempt educational or charitable organization and any person (or, if that person is an individual, a member of that person's family) who directly or indirectly controls the organization. Free efile federal Two S corporations, and an S corporation and a regular corporation, if the same persons own more than 10% of the value of the outstanding stock of each corporation. Free efile federal A corporation and a partnership if the same persons own both of the following. Free efile federal More than 10% of the value of the outstanding stock of the corporation. Free efile federal More than 10% of the capital or profits interest in the partnership. Free efile federal The executor and beneficiary of any estate. Free efile federal A partnership and a person who directly or indirectly owns more than 10% of the capital or profits interest in the partnership. Free efile federal Two partnerships, if the same persons directly or indirectly own more than 10% of the capital or profits interest in each. Free efile federal The related person and a person who is engaged in trades or businesses under common control. Free efile federal See section 52(a) and 52(b) of the Internal Revenue Code. Free efile federal When to determine relationship. Free efile federal   You must determine whether you are related to another person at the time you acquire the property. Free efile federal   A partnership acquiring property from a terminating partnership must determine whether it is related to the terminating partnership immediately before the event causing the termination. Free efile federal For this rule, a terminating partnership is one that sells or exchanges, within 12 months, 50% or more of its total interest in partnership capital or profits. Free efile federal Constructive ownership of stock or partnership interest. Free efile federal   To determine whether a person directly or indirectly owns any of the outstanding stock of a corporation or an interest in a partnership, apply the following rules. Free efile federal Stock or a partnership interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. Free efile federal However, for a partnership interest owned by or for a C corporation, this applies only to shareholders who directly or indirectly own 5% or more of the value of the stock of the corporation. Free efile federal An individual is considered to own the stock or partnership interest directly or indirectly owned by or for the individual's family. Free efile federal An individual who owns, except by applying rule (2), any stock in a corporation is considered to own the stock directly or indirectly owned by or for the individual's partner. Free efile federal For purposes of rules (1), (2), or (3), stock or a partnership interest considered to be owned by a person under rule (1) is treated as actually owned by that person. Free efile federal However, stock or a partnership interest considered to be owned by an individual under rule (2) or (3) is not treated as owned by that individual for reapplying either rule (2) or (3) to make another person considered to be the owner of the same stock or partnership interest. Free efile federal Intangible Property Generally, if you can depreciate intangible property, you usually use the straight line method of depreciation. Free efile federal However, you can choose to depreciate certain intangible property under the income forecast method (discussed later). Free efile federal You cannot depreciate intangible property that is a section 197 intangible or that otherwise does not meet all the requirements discussed earlier under What Property Can Be Depreciated. Free efile federal Straight Line Method This method lets you deduct the same amount of depreciation each year over the useful life of the property. Free efile federal To figure your deduction, first determine the adjusted basis, salvage value, and estimated useful life of your property. Free efile federal Subtract the salvage value, if any, from the adjusted basis. Free efile federal The balance is the total depreciation you can take over the useful life of the property. Free efile federal Divide the balance by the number of years in the useful life. Free efile federal This gives you your yearly depreciation deduction. Free efile federal Unless there is a big change in adjusted basis or useful life, this amount will stay the same throughout the time you depreciate the property. Free efile federal If, in the first year, you use the property for less than a full year, you must prorate your depreciation deduction for the number of months in use. Free efile federal Example. Free efile federal In April, Frank bought a patent for $5,100 that is not a section 197 intangible. Free efile federal He depreciates the patent under the straight line method, using a 17-year useful life and no salvage value. Free efile federal He divides the $5,100 basis by 17 years to get his $300 yearly depreciation deduction. Free efile federal He only used the patent for 9 months during the first year, so he multiplies $300 by 9/12 to get his deduction of $225 for the first year. Free efile federal Next year, Frank can deduct $300 for the full year. Free efile federal Patents and copyrights. Free efile federal   If you can depreciate the cost of a patent or copyright, use the straight line method over the useful life. Free efile federal The useful life of a patent or copyright is the lesser of the life granted to it by the government or the remaining life when you acquire it. Free efile federal However, if the patent or copyright becomes valueless before the end of its useful life, you can deduct in that year any of its remaining cost or other basis. Free efile federal Computer software. Free efile federal   Computer software is generally a section 197 intangible and cannot be depreciated if you acquired it in connection with the acquisition of assets constituting a business or a substantial part of a business. Free efile federal   However, computer software is not a section 197 intangible and can be depreciated, even if acquired in connection with the acquisition of a business, if it meets all of the following tests. Free efile federal It is readily available for purchase by the general public. Free efile federal It is subject to a nonexclusive license. Free efile federal It has not been substantially modified. Free efile federal   If the software meets the tests above, it may also qualify for the section 179 deduction and the special depreciation allowance, discussed later. Free efile federal If you can depreciate the cost of computer software, use the straight line method over a useful life of 36 months. Free efile federal    Tax-exempt use property subject to a lease. Free efile federal   The useful life of computer software leased under a lease agreement entered into after March 12, 2004, to a tax-exempt organization, governmental unit, or foreign person or entity (other than a partnership), cannot be less than 125% of the lease term. Free efile federal Certain created intangibles. Free efile federal   You can amortize certain intangibles created on or after December 31, 2003, over a 15-year period using the straight line method and no salvage value, even though they have a useful life that cannot be estimated with reasonable accuracy. Free efile federal For example, amounts paid to acquire memberships or privileges of indefinite duration, such as a trade association membership, are eligible costs. Free efile federal   The following are not eligible. Free efile federal Any intangible asset acquired from another person. Free efile federal Created financial interests. Free efile federal Any intangible asset that has a useful life that can be estimated with reasonable accuracy. Free efile federal Any intangible asset that has an amortization period or limited useful life that is specifically prescribed or prohibited by the Code, regulations, or other published IRS guidance. Free efile federal Any amount paid to facilitate an acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions. Free efile federal   You must also increase the 15-year safe harbor amortization period to a 25-year period for certain intangibles related to benefits arising from the provision, production, or improvement of real property. Free efile federal For this purpose, real property includes property that will remain attached to the real property for an indefinite period of time, such as roads, bridges, tunnels, pavements, and pollution control facilities. Free efile federal Income Forecast Method You can choose to use the income forecast method instead of the straight line method to depreciate the following depreciable intangibles. Free efile federal Motion picture films or video tapes. Free efile federal Sound recordings. Free efile federal Copyrights. Free efile federal Books. Free efile federal Patents. Free efile federal Under the income forecast method, each year's depreciation deduction is equal to the cost of the property, multiplied by a fraction. Free efile federal The numerator of the fraction is the current year's net income from the property, and the denominator is the total income anticipated from the property through the end of the 10th taxable year following the taxable year the property is placed in service. Free efile federal For more information, see section 167(g) of the Internal Revenue Code. Free efile federal Films, video tapes, and recordings. Free efile federal   You cannot use MACRS for motion picture films, video tapes, and sound recordings. Free efile federal For this purpose, sound recordings are discs, tapes, or other phonorecordings resulting from the fixation of a series of sounds. Free efile federal You can depreciate this property using either the straight line method or the income forecast method. Free efile federal Participations and residuals. Free efile federal   You can include participations and residuals in the adjusted basis of the property for purposes of computing your depreciation deduction under the income forecast method. Free efile federal The participations and residuals must relate to income to be derived from the property before the end of the 10th taxable year after the property is placed in service. Free efile federal For this purpose, participations and residuals are defined as costs which by contract vary with the amount of income earned in connection with the property. Free efile federal   Instead of including these amounts in the adjusted basis of the property, you can deduct the costs in the taxable year that they are paid. Free efile federal Videocassettes. Free efile federal   If you are in the business of renting videocassettes, you can depreciate only those videocassettes bought for rental. Free efile federal If the videocassette has a useful life of one year or less, you can currently deduct the cost as a business expense. Free efile federal Corporate or Partnership Property Acquired in a Nontaxable Transfer MACRS does not apply to property used before 1987 and transferred after 1986 to a corporation or partnership (except property the transferor placed in service after July 31, 1986, if MACRS was elected) to the extent its basis is carried over from the property's adjusted basis in the transferor's hands. Free efile federal You must continue to use the same depreciation method as the transferor and figure depreciation as if the transfer had not occurred. Free efile federal However, if MACRS would otherwise apply, you can use it to depreciate the part of the property's basis that exceeds the carried-over basis. Free efile federal The nontaxable transfers covered by this rule include the following. Free efile federal A distribution in complete liquidation of a subsidiary. Free efile federal A transfer to a corporation controlled by the transferor. Free efile federal An exchange of property solely for corporate stock or securities in a reorganization. Free efile federal A contribution of property to a partnership in exchange for a partnership interest. Free efile federal A partnership distribution of property to a partner. Free efile federal Election To Exclude Property From MACRS If you can properly depreciate any property under a method not based on a term of years, such as the unit-of-production method, you can elect to exclude that property from MACRS. Free efile federal You make the election by reporting your depreciation for the property on line 15 in Part II of Form 4562 and attaching a statement as described in the instructions for Form 4562. Free efile federal You must make this election by the return due date (including extensions) for the tax year you place your property in service. Free efile federal However, if you timely filed your return for the year without making the election, you can still make the election by filing an amended return within six months of the due date of the return (excluding extensions). Free efile federal Attach the election to the amended return and write “Filed pursuant to section 301. Free efile federal 9100-2” on the election statement. Free efile federal File the amended return at the same address you filed the original return. Free efile federal Use of standard mileage rate. Free efile federal   If you use the standard mileage rate to figure your tax deduction for your business automobile, you are treated as having made an election to exclude the automobile from MACRS. Free efile federal See Publication 463 for a discussion of the standard mileage rate. Free efile federal What Is the Basis of Your Depreciable Property? To figure your depreciation deduction, you must determine the basis of your property. Free efile federal To determine basis, you need to know the cost or other basis of your property. Free efile federal Cost as Basis The basis of property you buy is its cost plus amounts you paid for items such as sales tax (see Exception , below), freight charges, and installation and testing fees. Free efile federal The cost includes the amount you pay in cash, debt obligations, other property, or services. Free efile federal Exception. Free efile federal   You can elect to deduct state and local general sales taxes instead of state and local income taxes as an itemized deduction on Schedule A (Form 1040). Free efile federal If you make that choice, you cannot include those sales taxes as part of your cost basis. Free efile federal Assumed debt. Free efile federal   If you buy property and assume (or buy subject to) an existing mortgage or other debt on the property, your basis includes the amount you pay for the property plus the amount of the assumed debt. Free efile federal Example. Free efile federal You make a $20,000 down payment on property and assume the seller's mortgage of $120,000. Free efile federal Your total cost is $140,000, the cash you paid plus the mortgage you assumed. Free efile federal Settlement costs. Free efile federal   The basis of real property also includes certain fees and charges you pay in addition to the purchase price. Free efile federal These generally are shown on your settlement statement and include the following. Free efile federal Legal and recording fees. Free efile federal Abstract fees. Free efile federal Survey charges. Free efile federal Owner's title insurance. Free efile federal Amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions. Free efile federal   For fees and charges you cannot include in the basis of property, see Real Property in Publication 551. Free efile federal Property you construct or build. Free efile federal   If you construct, build, or otherwise produce property for use in your business, you may have to use the uniform capitalization rules to determine the basis of your property. Free efile federal For information about the uniform capitalization rules, see Publication 551 and the regulations under section 263A of the Internal Revenue Code. Free efile federal Other Basis Other basis usually refers to basis that is determined by the way you received the property. Free efile federal For example, your basis is other than cost if you acquired the property in exchange for other property, as payment for services you performed, as a gift, or as an inheritance. Free efile federal If you acquired property in this or some other way, see Publication 551 to determine your basis. Free efile federal Property changed from personal use. Free efile federal   If you held property for personal use and later use it in your business or income-producing activity, your depreciable basis is the lesser of the following. Free efile federal The fair market value (FMV) of the property on the date of the change in use. Free efile federal Your original cost or other basis adjusted as follows. Free efile federal Increased by the cost of any permanent improvements or additions and other costs that must be added to basis. Free efile federal Decreased by any deductions you claimed for casualty and theft losses and other items that reduced your basis. Free efile federal Example. Free efile federal Several years ago, Nia paid $160,000 to have her home built on a lot that cost her $25,000. Free efile federal Before changing the property to rental use last year, she paid $20,000 for permanent improvements to the house and claimed a $2,000 casualty loss deduction for damage to the house. Free efile federal Land is not depreciable, so she includes only the cost of the house when figuring the basis for depreciation. Free efile federal Nia's adjusted basis in the house when she changed its use was $178,000 ($160,000 + $20,000 − $2,000). Free efile federal On the same date, her property had an FMV of $180,000, of which $15,000 was for the land and $165,000 was for the house. Free efile federal The basis for depreciation on the house is the FMV on the date of change ($165,000), because it is less than her adjusted basis ($178,000). Free efile federal Property acquired in a nontaxable transaction. Free efile federal   Generally, if you receive property in a nontaxable exchange, the basis of the property you receive is the same as the adjusted basis of the property you gave up. Free efile federal Special rules apply in determining the basis and figuring the MACRS depreciation deduction and special depreciation allowance for property acquired in a like-kind exchange or involuntary conversion. Free efile federal See Like-kind exchanges and involuntary conversions. Free efile federal under How Much Can You Deduct? in chapter 3 and Figuring the Deduction for Property Acquired in a Nontaxable Exchange in chapter 4. Free efile federal   There are also special rules for determining the basis of MACRS property involved in a like-kind exchange or involuntary conversion when the property is contained in a general asset account. Free efile federal See How Do You Use General Asset Accounts in chapter 4. Free efile federal Adjusted Basis To find your property's basis for depreciation, you may have to make certain adjustments (increases and decreases) to the basis of the property for events occurring between the time you acquired the property and the time you placed it in service. Free efile federal These events could include the following. Free efile federal Installing utility lines. Free efile federal Paying legal fees for perfecting the title. Free efile federal Settling zoning issues. Free efile federal Receiving rebates. Free efile federal Incurring a casualty or theft loss. Free efile federal For a discussion of adjustments to the basis of your property, see Adjusted Basis in Publication 551. Free efile federal If you depreciate your property under MACRS, you also may have to reduce your basis by certain deductions and credits with respect to the property. Free efile federal For more information, see What Is the Basis for Depreciation in chapter 4. Free efile federal . Free efile federal Basis adjustment for depreciation allowed or allowable. Free efile federal   You must reduce the basis of property by the depreciation allowed or allowable, whichever is greater. Free efile federal Depreciation allowed is depreciation you actually deducted (from which you received a tax benefit). Free efile federal Depreciation allowable is depreciation you are entitled to deduct. Free efile federal   If you do not claim depreciation you are entitled to deduct, you must still reduce the basis of the property by the full amount of depreciation allowable. Free efile federal   If you deduct more depreciation than you should, you must reduce your basis by any amount deducted from which you received a tax benefit (the depreciation allowed). Free efile federal How Do You Treat Repairs and Improvements? If you improve depreciable property, you must treat the improvement as separate depreciable property. Free efile federal Improvement means an addition to or partial replacement of property that adds to its value, appreciably lengthens the time you can use it, or adapts it to a different use. Free efile federal You generally deduct the cost of repairing business property in the same way as any other business expense. Free efile federal However, if a repair or replacement increases the value of your property, makes it more useful, or lengthens its life, you must treat it as an improvement and depreciate it. Free efile federal Example. Free efile federal You repair a small section on one corner of the roof of a rental house. Free efile federal You deduct the cost of the repair as a rental expense. Free efile federal However, if you completely replace the roof, the new roof is an improvement because it increases the value and lengthens the life of the property. Free efile federal You depreciate the cost of the new roof. Free efile federal Improvements to rented property. Free efile federal   You can depreciate permanent improvements you make to business property you rent from someone else. Free efile federal Do You Have To File Form 4562? Use Form 4562 to figure your deduction for depreciation and amortization. Free efile federal Attach Form 4562 to your tax return for the current tax year if you are claiming any of the following items. Free efile federal A section 179 deduction for the current year or a section 179 carryover from a prior year. Free efile federal See chapter 2 for information on the section 179 deduction. Free efile federal Depreciation for property placed in service during the current year. Free efile federal Depreciation on any vehicle or other listed property, regardless of when it was placed in service. Free efile federal See chapter 5 for information on listed property. Free efile federal A deduction for any vehicle if the deduction is reported on a form other than Schedule C (Form 1040) or Schedule C-EZ (Form 1040). Free efile federal Amortization of costs if the current year is the first year of the amortization period. Free efile federal Depreciation or amortization on any asset on a corporate income tax return (other than Form 1120S, U. Free efile federal S. Free efile federal Income Tax Return for an S Corporation) regardless of when it was placed in service. Free efile federal You must submit a separate Form 4562 for each business or activity on your return for which a Form 4562 is required. Free efile federal Table 1-1 presents an overview of the purpose of the various parts of Form 4562. Free efile federal Employee. Free efile federal   Do not use Form 4562 if you are an employee and you deduct job-related vehicle expenses using either actual expenses (including depreciation) or the standard mileage rate. Free efile federal Instead, use either Form 2106 or Form 2106-EZ. Free efile federal Use Form 2106-EZ if you are claiming the standard mileage rate and you are not reimbursed by your employer for any expenses. Free efile federal How Do You Correct Depreciation Deductions? If you deducted an incorrect amount of depreciation in any year, you may be able to make a correction by filing an amended return for that year. Free efile federal See Filing an Amended Return , next. Free efile federal If you are not allowed to make the correction on an amended return, you may be able to change your accounting method to claim the correct amount of depreciation. Free efile federal See Changing Your Accounting Method , later. Free efile federal Filing an Amended Return You can file an amended return to correct the amount of depreciation claimed for any property in any of the following situations. Free efile federal You claimed the incorrect amount because of a mathematical error made in any year. Free efile federal You claimed the incorrect amount because of a posting error made in any year. Free efile federal You have not adopted a method of accounting for property placed in service by you in tax years ending after December 29, 2003. Free efile federal You claimed the incorrect amount on property placed in service by you in tax years ending before December 30, 2003. Free efile federal Adoption of accounting method defined. Free efile federal   Generally, you adopt a method of accounting for depreciation by using a permissible method of determining depreciation when you file your first tax return, or by using the same impermissible method of determining depreciation in two or more consecutively filed tax returns. Free efile federal   For an exception to this 2-year rule, see Revenue Procedure 2011-14 on page 330 of the Internal Revenue Bulletin 2011-4, available at www. Free efile federal irs. Free efile federal gov/pub/irs-irbs/irb11-04. Free efile federal pdf. Free efile federal (Note. Free efile federal Revenue Procedure 2011-14 is clarified and modified by Revenue Procedure 2012-20. Free efile federal For more information, see Revenue Procedure 2012-20 on page 700 of the Internal Revenue Bulletin 2012-14, available at www. Free efile federal irs. Free efile federal gov/pub/irs-irbs/irb12-14. Free efile federal pdf. Free efile federal )   For a safe harbor method of accounting to treat rotable spare parts as depreciable assets and procedures to obtain automatic consent to change to the safe harbor method of accounting, see Revenue Procedure 2007-48 on page 110 of Internal Revenue Bulletin 2007-29, available at www. Free efile federal irs. Free efile federal gov/pub/irs-irbs/irb07-29. Free efile federal pdf. Free efile federal When to file. Free efile federal   If an amended return is allowed, you must file it by the later of the following. Free efile federal 3 years from the date you filed your original return for the year in which you did not deduct the correct amount. Free efile federal A return filed before an unextended due date is considered filed on that due date. Free efile federal 2 years from the time you paid your tax for that year. Free efile federal Changing Your Accounting Method Generally, you must get IRS approval to change your method of accounting. Free efile federal You generally must file Form 3115, Application for Change in Accounting Method, to request a change in your method of accounting for depreciation. Free efile federal The following are examples of a change in method of accounting for depreciation. Free efile federal A change from an impermissible method of determining depreciation for depreciable property, if the impermissible method was used in two or more consecutively filed tax returns. Free efile federal A change in the treatment of an asset from nondepreciable to depreciable or vice versa. Free efile federal A change in the depreciation method, period of recovery, or convention of a depreciable asset. Free efile federal A change from not claiming to claiming the special depreciation allowance if you did not make the election to not claim any special allowance. Free efile federal A change from claiming a 50% special depreciation allowance to claiming a 30% special depreciation allowance for qualified property (including property that is included in a class of property for which you elected a 30% special allowance instead of a 50% special allowance). Free efile federal Changes in depreciation that are not a change in method of accounting (and may only be made on an amended return) include the following. Free efile federal An adjustment in the useful life of a depreciable asset for which depreciation is determined under section 167. Free efile federal A change in use of an asset in the hands of the same taxpayer. Free efile federal Making a late depreciation election or revoking a timely valid depreciation election (including the election not to deduct the special depreciation allowance). Free efile federal If you elected not to claim any special allowance, a change from not claiming to claiming the special allowance is a revocation of the election and is not an accounting method change. Free efile federal Generally, you must get IRS approval to make a late depreciation election or revoke a depreciation election. Free efile federal You must submit a request for a letter ruling to make a late election or revoke an election. Free efile federal Any change in the placed in service date of a depreciable asset. Free efile federal See section 1. Free efile federal 446-1(e)(2)(ii)(d) of the regulations for more information and examples. Free efile federal IRS approval. Free efile federal   In some instances, you may be able to get approval from the IRS to change your method of accounting for depreciation under the automatic change request procedures generally covered in Revenue Procedure 2011-14. Free efile federal If you do not qualify to use the automatic procedures to get approval, you must use the advance consent request procedures generally covered in Revenue Procedure 97-27, 1997-1 C. Free efile federal B. Free efile federal 680. Free efile federal Also see the Instructions for Form 3115 for more information on getting approval, including lists of scope limitations and automatic accounting method changes. Free efile federal Additional guidance. Free efile federal    For additional guidance and special procedures for changing your accounting method, automatic change procedures, amending your return, and filing Form 3115, see Revenue Procedure 2011-14 on page 330 of the Internal Revenue Bulletin 2011-4, available at www. Free efile federal irs. Free efile federal gov/pub/irs-irbs/irb11-04. Free efile federal pdf. Free efile federal (Note. Free efile federal Revenue Procedure 2011-14 is clarified and modified by Revenue Procedure 2012-20. Free efile federal For more information, see Revenue Procedure 2012-20 on page 700 of the Internal Revenue Bulletin 2012-14, available at www. Free efile federal irs. Free efile federal gov/pub/irs-irbs/irb12-14. Free efile federal pdf. Free efile federal )   For a safe harbor method of accounting to treat rotable spare parts as depreciable assets, see Revenue Procedure 2007-48 on page 110 of Internal Revenue Bulletin 2007-29, available at www. Free efile federal irs. Free efile federal gov/pub/irs-irbs/irb07-29. Free efile federal pdf. Free efile federal Table 1-1. Free efile federal Purpose of Form 4562 This table describes the purpose of the various parts of Form 4562. Free efile federal For more information, see Form 4562 and its instructions. Free efile federal Part Purpose I • Electing the section 179 deduction • Figuring the maximum section 179 deduction for the current year • Figuring any section 179 deduction carryover to the next year II • Reporting the special depreciation allowance for property (other than listed property) placed in service during the tax year • Reporting depreciation deductions on property being depreciated under any method other than Modified Accelerated Cost Recovery System (MACRS) III • Reporting MACRS depreciation deductions for property placed in service before this year • Reporting MACRS depreciation deductions for property (other than listed property) placed in service during the current year IV • Summarizing other parts V • Reporting the special depreciation allowance for automobiles and other listed property • Reporting MACRS depreciation on automobiles and other listed property • Reporting the section 179 cost elected for automobiles and other listed property • Reporting information on the use of automobiles and other transportation vehicles VI • Reporting amortization deductions Section 481(a) adjustment. Free efile federal   If you file Form 3115 and change from an impermissible method to a permissible method of accounting for depreciation, you can make a section 481(a) adjustment for any unclaimed or excess amount of allowable depreciation. Free efile federal The adjustment is the difference between the total depreciation actually deducted for the property and the total amount allowable prior to the year of change. Free efile federal If no depreciation was deducted, the adjustment is the total depreciation allowable prior to the year of change. Free efile federal A negative section 481(a) adjustment results in a decrease in taxable income. Free efile federal It is taken into account in the year of change and is reported on your business tax returns as “other expenses. Free efile federal ” A positive section 481(a) adjustment results in an increase in taxable income. Free efile federal It is generally taken into account over 4 tax years and is reported on your business tax returns as “other income. Free efile federal ” However, you can elect to use a one-year adjustment period and report the adjustment in the year of change if the total adjustment is less than $25,000. Free efile federal Make the election by completing the appropriate line on Form 3115. Free efile federal   If you file a Form 3115 and change from one permissible method to another permissible method, the section 481(a) adjustment is zero. Free efile federal Prev  Up  Next   Home   More Online Publications
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Free efile federal 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. Free efile federal Even though the rules do not apply to grantor trusts, partnerships, and S corporations directly, they do apply to the owners of these entities. Free efile federal 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. Free efile federal 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. Free efile federal See Passive Activity Deductions, later. Free efile federal Passive Activity Loss Generally, the passive activity loss for the tax year is not allowed. Free efile federal However, there is a special allowance under which some or all of your passive activity loss may be allowed. Free efile federal See Special $25,000 allowance , later. Free efile federal Definition of passive activity loss. Free efile federal    Generally, your passive activity loss for the tax year is the excess of your passive activity deductions over your passive activity gross income. Free efile federal See Passive Activity Income and Deductions , later. Free efile federal   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. Free efile federal For details on net active income, see the Instructions for Form 8810. Free efile federal For the definition of passive activity gross income, see Passive Activity Income , later. Free efile federal For the definition of passive activity deductions, see Passive Activity Deductions , later. Free efile federal 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. Free efile federal Allocation of disallowed passive activity loss among activities. Free efile federal   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. Free efile federal 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. Free efile federal Use Worksheet 5 of Form 8582 to figure the ratable portion of the loss from each activity that is disallowed. Free efile federal Loss from an activity. Free efile federal   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. Free efile federal   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. Free efile federal See Significant Participation Passive Activities , later. Free efile federal Example. Free efile federal John Pine holds interests in three passive activities, A, B, and C. Free efile federal 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. Free efile federal Therefore, a ratable portion of the losses from activities A and B is disallowed. Free efile federal 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. Free efile federal   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. Free efile federal 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. Free efile federal Excluded deductions. Free efile federal    “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. Free efile federal See Recharacterization of Passive Income , later. Free efile federal Separately identified deductions. Free efile federal   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. Free efile federal   Use Form 8582, Worksheet 7, for any activity if you have passive activity deductions for that activity that must be separately identified. Free efile federal   Deductions that must be accounted for separately include (but are not limited to) the following deductions. Free efile federal Deductions that arise in a rental real estate activity in tax years in which you actively participate in such activity. Free efile federal See Active participation , later. Free efile federal Deductions that arise in a rental real estate activity in tax years in which you do not actively participate in such activity. Free efile federal See Active participation , later. Free efile federal Losses from sales or exchanges of capital assets. Free efile federal Section 1231 losses. Free efile federal See Section 1231 Gains and Losses in Publication 544, Sales and Other Disposition of Assets, for more information. Free efile federal 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. Free efile federal 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. Free efile federal For more information, see Regulations section 1. Free efile federal 469-1(f)(4). Free efile federal Passive Activity Credit Generally, the passive activity credit for the tax year is disallowed. Free efile federal 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. Free efile federal Credits that are included in figuring the general business credit are subject to the passive activity rules. Free efile federal See the Instructions for Form 8582-CR for more information. Free efile federal 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). Free efile federal You also must apply the limit on passive activity credits separately to your credits from a passive activity held through a PTP. Free efile federal You can offset deductions from passive activities of a PTP only against income or gain from passive activities of the same PTP. Free efile federal Likewise, you can offset credits from passive activities of a PTP only against the tax on the net passive income from the same PTP. Free efile federal This separate treatment rule also applies to a regulated investment company holding an interest in a PTP for the items attributable to that interest. Free efile federal 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. Free efile federal 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. Free efile federal These rules do not apply to C corporations. Free efile federal For information, see the Instructions for Schedule F (Form 1040), Profit or Loss From Farming. Free efile federal Passive Activities There are two kinds of passive activities. Free efile federal Trade or business activities in which you do not materially participate during the year. Free efile federal Rental activities, even if you do materially participate in them, unless you are a real estate professional. Free efile federal Material participation in a trade or business is discussed later, under Activities That Are Not Passive Activities . Free efile federal Treatment of former passive activities. Free efile federal   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. Free efile federal 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. Free efile federal Treat any remaining prior year unallowed loss like you treat any other passive loss. Free efile federal   In addition, any prior year unallowed passive activity credits from a former passive activity offset the allocable part of your current year tax liability. Free efile federal 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. Free efile federal 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). Free efile federal 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). Free efile federal 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. Free efile federal You generally report trade or business activities on Schedule C, C-EZ, F, or in Part II or III of Schedule E. Free efile federal 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. Free efile federal See Real Estate Professional under Activities That Are Not Passive Activities, later. Free efile federal 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. Free efile federal It does not matter whether the use is under a lease, a service contract, or some other arrangement. Free efile federal Exceptions. Free efile federal   Your activity is not a rental activity if any of the following apply. Free efile federal The average period of customer use of the property is 7 days or less. Free efile federal 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. Free efile federal If the activity involves renting more than one class of property, multiply the average period of customer use of each class by a fraction. Free efile federal 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. Free efile federal The activity's average period of customer use will equal the sum of the amounts for each class. Free efile federal 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. Free efile federal Significant personal services include only services performed by individuals. Free efile federal 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. Free efile federal Significant personal services do not include the following. Free efile federal 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. Free efile federal You provide extraordinary personal services in making the rental property available for customer use. Free efile federal 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. Free efile federal The rental is incidental to a nonrental activity. Free efile federal 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. Free efile federal The unadjusted basis of property is its cost not reduced by depreciation or any other basis adjustment. Free efile federal The rental of property is incidental to a trade or business activity if all of the following apply. Free efile federal You own an interest in the trade or business activity during the year. Free efile federal 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. Free efile federal Your gross rental income from the property is less than 2% of the smaller of its unadjusted basis or fair market value. Free efile federal 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. Free efile federal You customarily make the rental property available during defined business hours for nonexclusive use by various customers. Free efile federal 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. Free efile federal    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. Free efile federal Special $25,000 allowance. Free efile federal   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. Free efile federal This special allowance is an exception to the general rule disallowing the passive activity loss. Free efile federal 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. Free efile federal   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. Free efile federal 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. Free efile federal   The maximum special allowance is reduced if your modified adjusted gross income exceeds certain amounts. Free efile federal See Phaseout rule , later. Free efile federal Example. Free efile federal 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. Free efile federal She can use $15,000 of her $26,000 loss to offset her $15,000 passive income from the partnership. Free efile federal 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). Free efile federal Commercial revitalization deduction (CRD). Free efile federal   The special allowance must first be applied to losses from rental real estate activities figured without the CRD. Free efile federal 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. Free efile federal You cannot claim a CRD for a building placed in service after December 31, 2009. Free efile federal Active participation. Free efile federal   Active participation is not the same as material participation (defined later). Free efile federal Active participation is a less stringent standard than material participation. Free efile federal For example, you may be treated as actively participating if you make management decisions in a significant and bona fide sense. Free efile federal Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions. Free efile federal   Only individuals can actively participate in rental real estate activities. Free efile federal 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. Free efile federal   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. Free efile federal 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. Free efile federal   The choice is irrevocable and cannot be made later than the due date for the estate's first income tax return (including any extensions). Free efile federal   Limited partners are not treated as actively participating in a partnership's rental real estate activities. Free efile federal   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. Free efile federal   Active participation is not required to take the low-income housing credit, the rehabilitation investment credit, or CRD from rental real estate activities. Free efile federal Example. Free efile federal 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. Free efile federal He advertised and rented the house to the current tenant himself. Free efile federal He also collected the rents and did the repairs or hired someone to do them. Free efile federal 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. Free efile federal Phaseout rule. Free efile federal   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). Free efile federal 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. Free efile federal    Modified adjusted gross income for this purpose is your adjusted gross income figured without the following. Free efile federal Taxable social security and tier 1 railroad retirement benefits. Free efile federal Deductible contributions to individual retirement accounts (IRAs) and section 501(c)(18) pension plans. Free efile federal The exclusion from income of interest from qualified U. Free efile federal S. Free efile federal savings bonds used to pay qualified higher education expenses. Free efile federal The exclusion from income of amounts received from an employer's adoption assistance program. Free efile federal Passive activity income or loss included on Form 8582. Free efile federal 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). Free efile federal Any overall loss from a publicly traded partnership (see Publicly Traded Partnerships (PTPs) in the instructions for Form 8582). Free efile federal The deduction for the employer-equivalent portion of self-employment tax. Free efile federal The deduction for domestic production activities. Free efile federal The deduction allowed for interest on student loans. Free efile federal The deduction for qualified tuition and related expenses. Free efile federal Example. Free efile federal During 2013, John was unmarried and was not a real estate professional. Free efile federal For 2013, he had $120,000 in salary and a $31,000 loss from his rental real estate activities in which he actively participated. Free efile federal His modified adjusted gross income is $120,000. Free efile federal When he files his 2013 return, he can deduct only $15,000 of his passive activity loss. Free efile federal He must carry over the remaining $16,000 passive activity loss to 2014. Free efile federal 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. Free efile federal   A higher phaseout range applies to rehabilitation investment credits from rental real estate activities. Free efile federal 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). Free efile federal   There is no phaseout of the $25,000 special allowance for low-income housing credits or for the CRD. Free efile federal Ordering rules. Free efile federal   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. Free efile federal The portion of passive activity losses not attributable to the CRD. Free efile federal The portion of passive activity losses attributable to the CRD. Free efile federal The portion of passive activity credits attributable to credits other than the rehabilitation and low-income housing credits. Free efile federal The portion of passive activity credits attributable to the rehabilitation credit. Free efile federal The portion of passive activity credits attributable to the low-income housing credit. Free efile federal Activities That Are Not Passive Activities The following are not passive activities. Free efile federal Trade or business activities in which you materially participated for the tax year. Free efile federal 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). Free efile federal It does not matter whether you materially participated in the activity for the tax year. Free efile federal 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. Free efile federal  See Temporary Regulations section 1. Free efile federal 469-1T(e)(4)(ii). Free efile federal 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. Free efile federal An activity of trading personal property for the account of those who own interests in the activity. Free efile federal See Temporary Regulations section 1. Free efile federal 469-1T(e)(6). Free efile federal Rental real estate activities in which you materially participated as a real estate professional. Free efile federal See Real Estate Professional , later. Free efile federal You should not enter income and losses from these activities on Form 8582. Free efile federal Instead, enter them on the forms or schedules you would normally use. Free efile federal Material Participation A trade or business activity is not a passive activity if you materially participated in the activity. Free efile federal Material participation tests. Free efile federal    You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests. Free efile federal You participated in the activity for more than 500 hours. Free efile federal 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. Free efile federal 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. Free efile federal The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. Free efile federal 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. Free efile federal See Significant Participation Passive Activities , under Recharacterization of Passive Income, later. Free efile federal You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years. Free efile federal The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. Free efile federal 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. Free efile federal Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year. Free efile federal   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. Free efile federal 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). Free efile federal Participation. Free efile federal   In general, any work you do in connection with an activity in which you own an interest is treated as participation in the activity. Free efile federal Work not usually performed by owners. Free efile federal   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. Free efile federal The work is not work that is customarily done by the owner of that type of activity. Free efile federal 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. Free efile federal Participation as an investor. Free efile federal   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. Free efile federal 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. Free efile federal Spouse's participation. Free efile federal   Your participation in an activity includes your spouse's participation. Free efile federal 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. Free efile federal Proof of participation. Free efile federal You can use any reasonable method to prove your participation in an activity for the year. Free efile federal You do not have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way. Free efile federal 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. Free efile federal Limited partners. Free efile federal   If you owned an activity as a limited partner, you generally are not treated as materially participating in the activity. Free efile federal 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. Free efile federal   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). Free efile federal Retired or disabled farmer and surviving spouse of a farmer. Free efile federal   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. Free efile federal 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. Free efile federal Corporations. Free efile federal   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. Free efile federal   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. Free efile federal See Special exception for qualified corporations under Activities Covered by the At-Risk Rules, later. Free efile federal Real Estate Professional Generally, rental activities are passive activities even if you materially participated in them. Free efile federal However, if you qualified as a real estate professional, rental real estate activities in which you materially participated are not passive activities. Free efile federal 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. Free efile federal See the Instructions for Schedule E (Form 1040), Supplemental Income and Loss, for information about making this choice. Free efile federal 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). Free efile federal 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. Free efile federal Qualifications. Free efile federal   You qualified as a real estate professional for the year if you met both of the following requirements. Free efile federal 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. Free efile federal You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated. Free efile federal   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. Free efile federal 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. Free efile federal   If you file a joint return, do not count your spouse's personal services to determine whether you met the preceding requirements. Free efile federal However, you can count your spouse's participation in an activity in determining if you materially participated. Free efile federal Real property trades or businesses. Free efile federal   A real property trade or business is a trade or business that does any of the following with real property. Free efile federal Develops or redevelops it. Free efile federal Constructs or reconstructs it. Free efile federal Acquires it. Free efile federal Converts it. Free efile federal Rents or leases it. Free efile federal Operates or manages it. Free efile federal Brokers it. Free efile federal Closely held corporations. Free efile federal   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. Free efile federal 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. Free efile federal Self-charged interest. Free efile federal   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. Free efile federal   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. Free efile federal This includes both loans you made to the partnership or S corporation and loans the partnership or S corporation made to you. Free efile federal   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. Free efile federal    Exception. Free efile federal 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. Free efile federal 469-7(g) to avoid the application of these rules. Free efile federal For more details on the self-charged interest rules, see Regulations section 1. Free efile federal 469-7. Free efile federal 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. Free efile federal Passive activity income does not include the following items. Free efile federal Income from an activity that is not a passive activity. Free efile federal These activities are discussed under Activities That Are Not Passive Activities , earlier. Free efile federal Portfolio income. Free efile federal This includes interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business. Free efile federal It includes gain or loss from the disposition of property that produces these types of income or that is held for investment. Free efile federal The exclusion for portfolio income does not apply to self-charged interest treated as passive activity income. Free efile federal For more information on self-charged interest, see Self-charged interest , earlier. Free efile federal Personal service income. Free efile federal 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. Free efile federal Income from positive section 481 adjustments allocated to activities other than passive activities. Free efile federal (Section 481 adjustments are adjustments that must be made due to changes in your accounting method. Free efile federal ) Income or gain from investments of working capital. Free efile federal 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. Free efile federal 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. Free efile federal 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. Free efile federal Any other income that must be treated as nonpassive income. Free efile federal See Recharacterization of Passive Income , later. Free efile federal Overall gain from any interest in a publicly traded partnership. Free efile federal See Publicly Traded Partnerships (PTPs) in the instructions for Form 8582. Free efile federal State, local, and foreign income tax refunds. Free efile federal Income from a covenant not to compete. Free efile federal 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. Free efile federal Alaska Permanent Fund dividends. Free efile federal 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. Free efile federal See chapter 4 of Publication 535, Business Expenses, for information about the rules for allocating interest. Free efile federal Disposition of property interests. Free efile federal   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. Free efile federal 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. Free efile federal An exception to this general rule may apply if you previously used the property in a different activity. Free efile federal Exception for more than one use in the preceding 12 months. Free efile federal   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. Free efile federal Any gain allocated to a passive activity is passive activity income. Free efile federal   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. Free efile federal Exception for substantially appreciated property. Free efile federal   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. Free efile federal You used the property in a passive activity for 20% of the time you held your interest in the property. Free efile federal You used the property in a passive activity for the entire 24-month period before its disposition. Free efile federal If neither condition applies, the gain is not passive activity income. Free efile federal 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. Free efile federal   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. Free efile federal Also, treat the date you agree to transfer your interest for a fixed or determinable amount as the disposition date. Free efile federal   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. Free efile federal Disposition of property converted to inventory. Free efile federal   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. Free efile federal 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. Free efile federal This rule applies only if you meet all of the following conditions. Free efile federal 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). Free efile federal 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. Free efile federal 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. Free efile federal 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. Free efile federal 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. Free efile federal See Coordination with other limitations on deductions that apply before the passive activity rules , later. Free efile federal 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. Free efile federal Exceptions. Free efile federal   Passive activity deductions do not include the following items. Free efile federal Deductions for expenses (other than interest expense) that are clearly and directly allocable to portfolio income. Free efile federal Qualified home mortgage interest, capitalized interest expenses, and other interest expenses (other than self-charged interest) properly allocable to passive activities. Free efile federal For more information on self-charged interest, see Self-charged interest under Passive Activity Income and Deductions, earlier. Free efile federal Losses from dispositions of property that produce portfolio income or property held for investment. Free efile federal State, local, and foreign income taxes. Free efile federal Miscellaneous itemized deductions that may be disallowed because of the 2%-of-adjusted-gross-income limit. Free efile federal Charitable contribution deductions. Free efile federal Net operating loss deductions. Free efile federal Percentage depletion carryovers for oil and gas wells. Free efile federal Capital loss carrybacks and carryovers. Free efile federal Items of deduction from a passive activity that are disallowed under the limits on deductions that apply before the passive activity rules. Free efile federal See Coordination with other limitations on deductions that apply before the passive activity rules , later. Free efile federal Deductions and losses that would have been allowed for tax years beginning before 1987 but for basis or at-risk limits. Free efile federal Net negative section 481 adjustments allocated to activities other than passive activities. Free efile federal (Section 481 adjustments are adjustments required due to changes in accounting methods. Free efile federal ) Casualty and theft losses, unless losses similar in cause and severity recur regularly in the activity. Free efile federal The deduction for the employer-equivalent portion of self-employment tax. Free efile federal Coordination with other limitations on deductions that apply before the passive activity rules. Free efile federal   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. Free efile federal 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. Free efile federal Proration of deductions disallowed under basis limitations. Free efile federal   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. Free efile federal 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. Free efile federal   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. Free efile federal 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. Free efile federal Proration of deductions disallowed under at-risk limitation. Free efile federal   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. Free efile federal 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. Free efile federal Coordination of basis and at-risk limitations. Free efile federal   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. Free efile federal Separately identified items of deduction and loss. Free efile federal   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. Free efile federal   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. Free efile federal See Grouping Your Activities , later. Free efile federal 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). Free efile federal See Section 1231 Gains and Losses in Publication 544 for more information. Free efile federal Are attributable to pre-enactment interests in activities. Free efile federal See Regulations section 1. Free efile federal 469-11T(c). Free efile federal 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. Free efile federal Grouping is important for a number of reasons. Free efile federal If you group two activities into one larger activity, you need only show material participation in the activity as a whole. Free efile federal But if the two activities are separate, you must show material participation in each one. Free efile federal 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. Free efile federal 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. Free efile federal Grouping can also be important in determining whether you meet the 10% ownership requirement for actively participating in a rental real estate activity. Free efile federal Appropriate Economic Units Generally, to determine if activities form an appropriate economic unit, you must consider all the relevant facts and circumstances. Free efile federal You can use any reasonable method of applying the relevant facts and circumstances in grouping activities. Free efile federal The following factors have the greatest weight in determining whether activities form an appropriate economic unit. Free efile federal All of the factors do not have to apply to treat more than one activity as a single activity. Free efile federal 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. Free efile federal Example 1. Free efile federal John Jackson owns a bakery and a movie theater at a shopping mall in Baltimore and a bakery and movie theater in Philadelphia. Free efile federal Based on all the relevant facts and circumstances, there may be more than one reasonable method for grouping John's activities. Free efile federal 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. Free efile federal Example 2. Free efile federal Betty is a partner in ABC partnership, which sells nonfood items to grocery stores. Free efile federal Betty is also a partner in DEF (a trucking business). Free efile federal ABC and DEF are under common control. Free efile federal The main part of DEF's business is transporting goods for ABC. Free efile federal DEF is the only trucking business in which Betty is involved. Free efile federal Based on the rules of this section, Betty treats ABC's wholesale activity and DEF's trucking activity as a single activity. Free efile federal Consistency and disclosure requirement. Free efile federal   Generally, when you group activities into appropriate economic units, you may not regroup those activities in a later tax year. Free efile federal 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. Free efile federal   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. Free efile federal   See Disclosure Requirement , later. Free efile federal Regrouping by the IRS. Free efile federal   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. Free efile federal Rental activities. Free efile federal   In general, you cannot group a rental activity with a trade or business activity. Free efile federal 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. Free efile federal Example. Free efile federal Herbert and Wilma are married and file a joint return. Free efile federal Healthy Food, an S corporation, is a grocery store business. Free efile federal Herbert is Healthy Food's only shareholder. Free efile federal Plum Tower, an S corporation, owns and rents out the building. Free efile federal Wilma is Plum Tower's only shareholder. Free efile federal Plum Tower rents part of its building to Healthy Food. Free efile federal Plum Tower's grocery store rental business and Healthy Food's grocery business are not insubstantial in relation to each other. Free efile federal Herbert and Wilma file a joint return, so they are treated as one taxpayer for purposes of the passive activity rules. Free efile federal The same owner (Herbert and Wilma) owns both Healthy Food and Plum Tower with the same ownership interest (100% in each). Free efile federal 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. Free efile federal Grouping of real and personal property rentals. Free efile federal   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. Free efile federal 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. Free efile federal Certain activities may not be grouped. Free efile federal   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. Free efile federal Holding, producing, or distributing motion picture films or video tapes. Free efile federal Farming. Free efile federal Leasing any section 1245 property (as defined in section 1245(a)(3) of the Internal Revenue Code). Free efile federal For a list of section 1245 property, see Section 1245 property under Activities Covered by the At-Risk Rules , later. Free efile federal Exploring for, or exploiting, oil and gas resources. Free efile federal Exploring for, or exploiting, geothermal deposits. Free efile federal   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. Free efile federal Limited entrepreneur. Free efile federal   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. Free efile federal Activities conducted through another entity. Free efile federal   A personal service corporation, closely held corporation, partnership, or S corporation must group its activities using the rules discussed in this section. Free efile federal 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. Free efile federal    You may not treat activities grouped together by the entity as separate activities. Free efile federal Personal service and closely held corporations. Free efile federal   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. Free efile federal See Material Participation , earlier, and Significant Participation Passive Activities , later. Free efile federal Publicly traded partnership (PTP). Free efile federal   You may not group activities conducted through a PTP with any other activity, including an activity conducted through another PTP. Free efile federal Partial dispositions. Free efile federal   If you dispose of substantially all of an activity during your tax year, you may treat the part disposed of as a separate activity. Free efile federal 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. Free efile federal Disclosure Requirement For tax years beginning after January 24, 2010, the following disclosure requirements for groupings apply. Free efile federal You are required to report certain changes to your groupings that occur during the tax year to the IRS. Free efile federal If you fail to report these changes, each trade or business activity or rental activity will be treated as a separate activity. Free efile federal 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. Free efile federal If the IRS discovered the failure to disclose, you must have reasonable cause for not making the required disclosure. Free efile federal New grouping. Free efile federal   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. Free efile federal The statement must provide the names, addresses, and employer identification numbers (EINs), if applicable, for the activities being grouped as a single activity. Free efile federal 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. Free efile federal Addition to an existing grouping. Free efile federal   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. Free efile federal 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. Free efile federal 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. Free efile federal Regrouping. Free efile federal   You must file a written statement with your original income tax return for the tax year in which you regroup the activities. Free efile federal The statement must provide the names, addresses, and EINs, if applicable, for the activities that are being regrouped. Free efile federal 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. Free efile federal In addition, the statement must contain an explanation of the material change in the facts and circumstances that made the original grouping clearly inappropriate. Free efile federal Groupings by partnerships and S corporations. Free efile federal   Partnerships and S corporations are not subject to the rules for new grouping, addition to an existing grouping, or regrouping. Free efile federal Instead, they must comply with the disclosure instructions for grouping activities provided in their Form 1065, U. Free efile federal S. Free efile federal Return of Partnership Income, or Form 1120S, U. Free efile federal S. Free efile federal Income Tax Return for an S Corporation, whichever is applicable. Free efile federal   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. Free efile federal   A partner or shareholder may not treat activities grouped together by the entity as separate activities. Free efile federal Recharacterization of Passive Income Net income from the following passive activities may have to be recharacterized and excluded from passive activity income. Free efile federal 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. Free efile federal 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. Free efile federal 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). Free efile federal 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. Free efile federal Instead, enter income or losses on the form and schedules you normally use. Free efile federal 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. Free efile federal Limit on recharacterized passive income. Free efile federal   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. Free efile federal Investment income and investment expense. Free efile federal   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. Free efile federal 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. Free efile federal 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. Free efile federal Corporations. Free efile federal   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. Free efile federal The corporation is not treated as materially participating in the activity for the year. Free efile federal 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. Free efile federal Worksheet A. Free efile federal   Complete Worksheet A. Free efile federal Significant Participation Passive Activities , below, if you have income or losses from any significant participation activity. Free efile federal Begin by entering the name of each activity in the left column. Free efile federal Column (a). Free efile federal   Enter the number of hours you participated in each activity and total the column. Free efile federal   If the total is more than 500, do not complete Worksheet A or B. Free efile federal None of the activities are passive activities because you satisfy test 4 for material participation. Free efile federal (See Material participation tests , earlier. Free efile federal ) Report all the income and losses from these activities on the forms and schedules you normally use. Free efile federal Do not include the income and losses on Form 8582. Free efile federal Column (b). Free efile federal   Enter the net loss, if any, from the activity. Free efile federal 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). Free efile federal Enter -0- here if the prior year unallowed loss is the same as the current year net income. Free efile federal Column (c). Free efile federal   Enter net income (if any) from the activity. Free efile federal Net income means the excess of the current year's net income from the activity over any prior year unallowed losses from the activity. Free efile federal Column (d). Free efile federal   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). Free efile federal If column (d) is a net loss, skip Worksheet B, Significant Participation Activities With Net Income. Free efile federal Include the income and losses in Worksheet 3 of Form 8582 (or Worksheet 2 in the Form 88