What Is the Passive Activity Credit Limitation?

U.S. tax code rules under Section 469 of the Internal Revenue Code prevent taxpayers from using credits from passive investments to offset tax liability from active business or portfolio income. The purpose is to match the tax benefits from passive activities against the income produced by those same activities, rather than sheltering other income from taxation. These regulations apply to individuals, estates, and trusts with investments in which they do not have significant involvement. The rules create a distinct category for income, losses, and credits from passive endeavors and restrict their application to prevent improper reductions in a taxpayer’s tax burden.

Identifying Passive Activities and Related Credits

A passive activity is a trade or business in which the taxpayer does not materially participate. This includes any rental activity, unless the taxpayer qualifies as a real estate professional. The concept of “material participation” is central to this definition and is determined by satisfying one of seven specific tests outlined by the IRS that measure a taxpayer’s involvement.

The seven material participation tests provide clear benchmarks for involvement. The first test is met if an individual participates for more than 500 hours during the year. Another test is satisfied if the individual’s participation constitutes substantially all of the participation in the activity. A taxpayer can also meet the standard by participating for more than 100 hours, provided that no other individual participated more.

A fourth test examines significant participation activities, requiring more than 100 hours in several activities that total over 500 hours combined. The fifth test looks at prior years, deeming participation material if the taxpayer materially participated in the activity for any five of the preceding ten tax years. For personal service activities, the standard is met if the taxpayer materially participated for any three prior tax years. The final test relies on the specific facts and circumstances of the case.

When these activities generate tax credits, they are subject to the passive activity limitations. Common credits that fall under this umbrella include:

• The investment credit from certain business property
• The low-income housing credit for affordable rental housing
• The rehabilitation credit for restoring older buildings
• Various energy-related credits

Calculating the Credit Limitation

The rule for passive activity credits is that they can only be used to offset tax liability that is directly attributable to net passive income. This means a taxpayer cannot use credits from a passive rental activity to reduce the tax owed on their salary or portfolio investments. The calculation involves figuring tax liability twice: once including net passive income, and a second time without it. The difference between these two tax figures represents the tax attributable to passive activities, which is the maximum amount of passive credits that can be claimed.

A significant exception is the special allowance for rental real estate activities in which the taxpayer actively participates. This provision allows eligible taxpayers to offset up to $25,000 of nonpassive income with the deduction equivalent of their passive activity credits. “Active participation” is a less stringent standard than “material participation” and requires making management decisions in a significant and bona fide sense, such as approving new tenants or deciding on rental terms.

This $25,000 allowance is subject to a phase-out based on the taxpayer’s modified adjusted gross income (MAGI). The allowance begins to decrease once MAGI exceeds $100,000 and is completely phased out when MAGI reaches $150,000. For taxpayers who are married but file separately and lived apart from their spouse for the entire year, the phase-out range is between $50,000 and $75,000 of MAGI.

More generous phase-out rules apply to certain credits. For the rehabilitation credit, the phase-out range does not begin until MAGI exceeds $200,000. For the low-income housing credit, the special allowance is not subject to a MAGI phase-out. The limitations on passive activity losses are applied first, before the passive activity credit limitations are calculated on Form 8582-CR.

Required Information for Form 8582-CR

To complete Form 8582-CR, Passive Activity Credit Limitations, a taxpayer must gather several pieces of financial information. The primary requirement is the total income or loss from all passive activities for the tax year. This information is aggregated from sources such as Schedule E for rental real estate and Schedule K-1 for income from partnerships, S corporations, and estates or trusts.

The taxpayer must also have specific details for each passive activity credit they intend to claim. This includes identifying the source of the credit and the full amount generated during the year, before any limitations. This data is found on a Schedule K-1 or from source forms like Form 3468 for the Investment Credit or Form 8586 for the Low-Income Housing Credit.

A taxpayer’s overall tax liability figures are also needed. Specifically, the regular tax liability before any credits, calculated on Form 1040, is a starting point. The form also requires the tentative minimum tax from Form 6251, as this figure can impact the credit calculation. The form is structured to first handle the special allowance for rental real estate activities, then address other passive credits, and finally compute the total passive tax liability.

Reporting Allowed Credits and Managing Carryforwards

Once the calculations on Form 8582-CR are complete, the allowed amount of passive activity credits is transferred to the appropriate credit forms. For most credits, the allowed portion is carried to Form 3800, General Business Credit. The credit is then combined with any other business credits and is subject to its own set of limitations before the final amount is reported on Schedule 3 and applied against the tax on Form 1040.

Any passive activity credits that are not allowed in the current year due to the limitations are not permanently lost. Instead, these disallowed credits are suspended and carried forward indefinitely to future tax years. The taxpayer is responsible for tracking these carryforwards using the worksheets included with Form 8582-CR.

In a subsequent year, these suspended credits can be used if the taxpayer has sufficient net passive income to absorb them. A special rule allows for the release of all suspended credits associated with a particular passive activity. If a taxpayer makes a fully taxable disposition of their entire interest in that activity to an unrelated party, all suspended credits from that activity are freed from the passive activity limitations.