PASSIVE LOSS RULES MAY FOSTER ECONOMIC INEFFICIENCY, CRS FINDS.

GERALD MAYER ANALYST IN PUBLIC FINANCE ECONOMICS DIVISION

December 5, 1991

THE PASSIVE ACTIVITY LOSS RULES

SUMMARY

In the mid-1980s Congress was concerned that many taxpayers were losing confidence in the Federal income tax system. Many taxpayers were able to lower their Federal income tax by using tax preferences from one activity to shelter income from other activities. Congress concluded that action was needed to curb the excessive use of tax shelters. Therefore, as part of the Tax Reform Act of 1986 (P.L. 99- 514), Congress enacted the passive activity loss rules.

Under the passive loss rules, excess deductions and tax credits from one passive activity can only be used to offset income and taxes from other passive activities. Unused losses and credits are suspended and can be carried forward indefinitely. Suspended losses from an activity are allowed in full when a taxpayer disposes of his entire interest in the activity.

Passive losses and credits cannot be used to reduce taxes on portfolio income, even if the portfolio income is from a passive activity.

The passive loss rules apply to individuals, estates, trusts, and certain corporations. The rules do not apply to partnerships, S corporations, or regular C corporations.

A passive activity is a business activity in which a taxpayer does not materially participate. With certain exceptions, a limited partner's interest in a partnership is treated as an investment in a passive activity. Working interests in the oil and gas industry are not treated as passive activities, while it is presumed that rental activities are passive activities.

A taxpayer materially participates in an activity if he is involved in the operations of the activity on a regular, continuous, and substantial basis. The tests for material participation are different for individuals and corporations.

It is argued that by curbing the use of tax shelters the passive loss rules will improve economic efficiency. To the extent that the passive loss rules defer the use of artificial losses, they will improve economic efficiency. But the passive loss rules do not distinguish between artificial losses and real economic losses. Therefore, to some extent, the rules may contribute to economic inefficiency.

It is also argued that, by curbing the use of tax shelters, the passive loss rules will benefit taxpayers who own and operate their own businesses. The rules may have this effect if they reduce the relative amount of investment in passive activities.

The passive loss rules defer and may discourage the use of tax preferences, but they do not prevent the use of tax preferences. As a result, some taxpayers may structure their investments to avoid the rules.

Finally, the passive loss rules likely increase the complexity of the tax code.

                              CONTENTS

Most taxpayers receive more than one kind of income. They may receive income in the form of wages, interest, dividends, capital gains, or income of some other kind. A taxpayer typically combines his income from all sources and deducts the allowable costs of earning that income. The deductions or tax credits from a particular activity may exceed the income or tax from that activity. In general, before the Tax Reform Act of 1986 (P.L. 99-514) taxpayers could use the excess deductions from one activity to reduce their taxable income from other activities. Similarly, any excess tax credits from one activity could be used to reduce the tax on income from other activities.

In the mid-1980s Congress was concerned that many taxpayers were losing confidence in the Federal income tax system. Many taxpayers, especially upper-income taxpayers, were able to lower their Federal income tax by using tax preferences from one activity to shelter income from other activities. Congress did not want to eliminate all tax preferences, because it believed that many tax preferences provide social or economic benefits. Nevertheless, Congress concluded that action was needed to curb the excessive use of tax shelters. Therefore, in addition to eliminating or restricting the availability of many tax preferences, Congress enacted the passive loss rules. Under the passive loss rules, excess deductions and tax credits from one passive activity can only be used to offset income and taxes from other passive activities.

The purpose of this report is to describe the passive loss rules enacted by the Tax Reform Act of 1986. The report also discusses the principal reasons for the rules and the main issues underlying the provisions.

THE PASSIVE LOSS RULES

This section provides an overview of the passive loss rules. The section begins with a discussion of how tax preferences may give rise to tax shelters.

TAX SHELTERS

It is generally believed that a tax on individual income should be based on economic income (also called net income). Annual economic income is equal to gross income minus the costs of earning that income. Tax preferences reduce or defer the tax on economic income. Tax preferences take several forms: a tax preference may exempt or defer income from taxation; a preference may allow a deduction that is greater than or in advance of the actual expense associated with the cost of earning income; a preference may allow a credit against the tax on income from a particular source; or certain kinds of income may be taxed at preferential rates. ¹

In general, a tax shelter is an investment where a portion of aftertax income is derived from taxes saved on other income. The tax savings may come from tax preferences generated by the investment. That is, excess deductions or credits generated by an investment in one activity may be used to reduce the tax on income from other sources. Because tax preferences reduce or defer tax on economic income, they are often called artificial deductions, tax losses, or paper losses.

Because of their effect on the aftertax rate of return, the availability of tax preferences may affect investment decisions. Table 1 on page 3 illustrates the effects of tax preferences on the aftertax rate of return from a hypothetical investment. The illustration is based on income and deductions for a particular year. ² It is assumed that a taxpayer has made a $25,000 investment in an unspecified enterprise. In row A it is assumed that economic income from the investment is equal to $2,500. In row B it is assumed that economic income is zero. In row C it is assumed that the investment results in an economic loss of $2,500. For columns 1 and 2 it is assumed that deductions from the activity are equal to the actual costs of earning economic income. For column 3 it is assumed that tax preferences result in deductions that are $10,000 in excess of actual expenses. It is also assumed that, in addition to the $25,000 investment, the taxpayer has at least $12,500 of taxable income from other sources from which to deduct his losses. Finally, it is assumed that the taxpayer's marginal tax rate is 31 percent.

Column 1 shows the assumed before tax economic rate of return. But for investment purposes, taxpayers are interested in the aftertax rate of return. As can be seen by comparing columns 2 and 3, tax preferences increase the after tax rate of return on this investment. Moreover, this relationship holds whether the economic income from the investment is positive or negative. In the case where economic income is $2,500, the aftertax rate of return is 19.3 percent. The aftertax rate of return consists of two parts. First, the excess deductions of $10,000 eliminate the tax on the economic income of $2,500. Second, the remaining excess deductions of $7,500 eliminate the tax on $7,500 of income from other sources. In the case where the investment results in an economic loss of $2,500, the aftertax rate of return is 5.5 percent. This is because the excess deductions of $10,000 and the economic loss of $2,500 result in tax savings of $3,875 on income from other sources (31 percent of $12,500). The result is a net aftertax return of $1,375 ($3,875 minus $2,500), although the investment itself is currently losing money.

           TABLE 1. Economic and Aftertax Rate of Return for

In order to limit the ability of taxpayers to use tax preferences from one activity to shelter other income from taxation, Congress enacted the passive loss rules. The rules provide that deductions and losses from passive activities can only be deducted from income from passive activities. Similarly, tax credits from passive activities can only be used to reduce taxes on income from passive activities. ³

If the deductions from passive activities exceed the income from those activities, the excess deductions are "suspended." Suspended losses can be carried forward to future tax years but cannot be carried back. Likewise, if the tax credits from passive activities exceed the taxes on income from passive activities, the unused credits are suspended and can be carried forward to later tax years but cannot be carried back.

Suspended losses are allocated proportionately to each passive activity that generates a loss. These are treated as passive activity deductions from the activities in future tax years.

DISPOSITIONS

Suspended losses are allowed in full when a taxpayer disposes of his entire interest in a passive activity. Suspended losses are allowed in full, whether the losses represent artificial deductions or real economic losses. The disposition must be a fully taxable transaction, which generally involves the sale of the property at its fair market value.

Upon disposition, any current and suspended losses are first used to offset any gain realized upon disposition of the activity. Any remaining losses are then deducted from any net income from other passive activities and then from any income from other sources.

Unlike suspended losses, suspended credits are not likely to represent real economic costs, Therefore, suspended credits are not allowed upon disposition, but they may be carried forward and deducted from taxes on future income from other passive activities.

PORTFOLIO INCOME

Passive losses and credits cannot be used to reduce taxes on portfolio income, even if the portfolio income is from a passive activity. Portfolio income generally includes interest, dividends, royalties from the licensing of property, and annuities. It also includes gains or losses from property that produces these kinds of income.

TAXPAYERS SUBJECT TO THE RULES

The passive loss rules apply to individuals, estates, trusts, and certain corporations. The rules do not apply to partnerships and S corporations, since income, losses, and credits from these entities are generally passed through to partners and shareholders who are subject to the rules. ⁴ Nor do the passive loss rules apply to regular corporations (also known as C corporations), since losses are generally carried over at the corporate level to years when the corporation has net income. But to prevent individuals from avoiding the passive loss rules, closely held C corporations and personal service corporations are subject to the rules.

Closely Held Corporations

In the case of closely held corporations, a special rule limits the use of deductions and credits from passive activities against portfolio income. Closely held corporations may offset passive losses and credits against active business income (income from a trade or business that is not a passive income), but they may not deduct passive losses or credits from portfolio income. The purpose of this special rule is to prevent taxpayers from avoiding the passive loss rules by incorporating portfolio investments and offsetting the income from these investments with losses from other investments held by the corporation. Without this rule, losses and credits from passive activities could be used to shelter portfolio income.

Closely held corporations are generally corporations where five or fewer individuals, directly or indirectly, own more than 50 percent of the value of the corporation's stock.

Personal Service Corporations

The passive losses of a personal service corporation may not offset the corporation's portfolio income or income from active business operations. The purpose of this rule is to prevent a taxpayer from incorporating as a personal service corporation and using the losses from investments to shelter income that are actually payments for personal services.

A personal service corporation is a corporation the principal activity of which is the performance of personal services by employee-owners (such as doctors, accountants, engineers, or lawyers) who own more than 10 percent of the fair market value of the corporation's outstanding stock.

DEFINITION OF A PASSIVE ACTIVITY

In general, a passive activity is a business activity in which a taxpayer does not materially participate. With certain exceptions, a limited partner's interest in a partnership is treated as an investment in a passive activity. Rental activities are treated as passive activities whether or not the taxpayer materially participates in the activity. Working interests in the oil and gas industry are not treated as passive activities.

Temporary regulations (section 1.469-4T) provide a detailed definition of all activity. Under the regulations, an undertaking is the smallest unit that can constitute an activity. An undertaking is a business or rental operation that constitutes a separate source of income. Business and rental operations that are conducted at the same location and owned by the same taxpayer are treated as one undertaking and constitute a single activity. Rental and nonrental operations conducted at the same location and owned by the same taxpayer are treated as separate undertakings unless one of the operations generates more than 80 percent of the income from all operations at that location. Business undertakings that are similar and commonly controlled must be treated as a single activity. Business activities that are commonly controlled and operated in an integrated manner must also be treated as a single activity. Professional service undertakings that are commonly controlled or that provide similar services must be treated as a single activity.

Under the same regulations, a taxpayer may elect to treat several business undertakings as separate activities. In this case, material participation must still be established with respect to the activity as a whole. A taxpayer may also elect to combine several rental real estate undertakings into one activity or separate them into one or more activities. The reason for these elections is to allow a taxpayer to claim suspended losses upon disposition of his entire interest in an undertaking. Without the election, the suspended losses from an undertaking could not be claimed until disposition of the larger activity.

DEFINITION OF MATERIAL PARTICIPATION

A taxpayer materially participates in an activity if he is involved in the operations of the activity on a regular, continuous, and substantial basis. The tests for material participation are different for individuals and corporations. Like individuals, closely held corporations and personal service corporations may materially participate in some activities but not in others.

Temporary regulations (section 1.469-5T) provide seven tests to determine material participation for individuals. An individual is considered to participate materially in an activity if he meets any one of the following tests: ⁵ (1) the individual participates in the activity for more than 500 hours during the year; (2) the individual's participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals involved in the activity (including nonowners); (3) the individual participates in the activity for more than 100 hours during the tax year, and the individual's participation in the activity for the tax year is more than the participation in the activity of any other individual (including nonowners); (4) the individual's aggregate participation in all significant participation activities (activities in which he participates for more than 100 hours during the tax year) exceeds 500 hours for the year; (5) the individual materially participated in the activity for any five tax years (whether or not consecutive) during the ten tax years immediately preceding the tax year; (6) the activity involves the performance of personal services and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; ⁶ or (7) based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the tax year.

A special rule exempts certain retired or disabled farmers from the tests for material participation. Retired or disabled farmers are treated as materially participating in a farming activity if they materially participated in the activity for five of the eight years preceding their retirement or disability.

A closely held corporation or personal service corporation materially participates in an activity if one or more shareholders who own more than 50 percent of the value of outstanding stock materially participate in the activity. In addition, a closely held corporation (that is not a personal service corporation) is treated as materially participating in an activity if: (1) during the previous 12-month period at least one full-time employee provided sufficient services in the management of the activity; (2) during the same period at least three full-time nonowner employees provided sufficient services directly related to the activity; and (3) the amount of business deductions by the taxpayer attributable to the activity exceeded 15 percent of the gross income from the activity for the period.

Material participation in an activity is determined separately each tax year. Thus, an activity may be a passive activity one year but not the next.

PARTNERSHIPS

Limited partners generally cannot participate in a partnership's business activities and still retain their status as limited partners. Therefore, under the passive loss rules, a limited partner's interest in a partnership is generally treated as a passive activity. But the law gives the Secretary of the Treasury the authority to allow exceptions to the general rule. According to temporary regulations (section 1.469-5T(e)(2)), a limited partner's interest in a partnership is not treated as passive if his participation exceeds 500 hours for the year or if he satisfies one of two other tests that consider participation over several years (see tests 1, 5, and 6 above under "Definition of Material Participation"). Nor does the general rule apply if a taxpayer is both a limited partner and general partner in the same partnership.

The reason for the exceptions to the general rule is to prevent taxpayers from avoiding the passive loss rules. For example, someone who is active in a partnership's business cannot treat partnership income as passive income. Nor can someone who is or has been a general partner create passive income by becoming a limited partner.

The passive loss limitations are applied separately to each publicly traded partnership, unless the partnership is treated as a corporation for tax purposes under section 7704. As a result, any excess losses or credits from an interest in a publicly traded partnership are suspended and can only be deducted from future income from the partnership or when the taxpayer disposes of his entire interest in the partnership. ⁷ Nor can losses from other passive activities be used to offset net income from a publicly traded partnership.

RENTAL ACTIVITIES

Interests in rental activities are treated as passive whether or not the taxpayer materially participates in the activity. Accordingly, losses and credits from rental activities are deductible from income from other passive activities, but not from other sources of income.

The reason rental activities are treated as passive is that Congress believed that rental activities require less ongoing management activity in proportion to the amount of capital invested than business activities involving the production or sale of goods and services.

Rental activities generally involve payments that are principally for the use of tangible property, such as real estate, equipment, and motor vehicles. An activity is not a rental activity if the payments are mainly for the performance of services. Such activities include the short-term use of hotel rooms and most car rentals.

Temporary regulations section 1.469-1T(e)(3) also list six exceptions that will not be considered rental activities, although they involve payments for the use of tangible property. According to regulations, an activity is not a rental activity if: (1) the average rental period is seven days or less; (2) the average rental period is 30 days or less and significant services are provided by or on behalf of the owner of the property; (3) extraordinary personal services are provided by or on behalf of the owner of the property; (4) the rental of the property is treated as incidental to a nonrental activity; (5) the property is customarily made available during defined business hours for the nonexclusive use of customers; or (6) the taxpayer rents property to a partnership, S corporation, or joint venture in which he owns an interest.

A special exclusion from the limitation on passive losses and credits applies to certain rental real estate activities. An individual may deduct from other income up to $25,000 of passive losses or the deduction equivalent of passive activity credits attributable to rental real estate activities. ⁸ The exclusion applies to losses from rental real estate activities in which an individual "actively" participates and owns at least a 10 percent interest. The allowance is phased out by 50 percent of the amount by which a taxpayer's AGI exceeds $100,000. The allowance is completely phased out when the taxpayer's AGI reaches $150,000. Losses exceeding the $25,000 allowance may be carried forward.

The active participation standard for rental real estate is not as strict as the standard for material participation. The active participation standard can be satisfied without regular, continuous, and substantial involvement in the real estate activity. Instead, an individual must participate in management decisions or arrange for others to provide services (such as repairs). Relevant management decisions include approving new tenants, deciding on rental terms, approving capital or repair expenditures, and other similar decisions.

The $25,000 allowance also applies to the low-income housing and the rehabilitation tax credits (in deduction equivalents). In the case of the rehabilitation credit, the allowance is phased out by 50 percent of the amount by which the taxpayer's AGI exceeds $200,000. The allowance is completely phased out when the taxpayer's AGI reaches $250,000. For property placed in service before 1990, the low-income housing credit is phased out in the same way as the rehabilitation credit. For property placed in service after 1989, the low-income housing credit is not phased out. The rehabilitation and low-income housing credits are allowed under the $25,000 rule whether or not the taxpayer actively participates in the activity. ⁹

OIL AND GAS INDUSTRY

Under the passive loss rules working interests in oil and gas properties are not treated as passive activities. Therefore, losses and credits from working interests in oil and gas properties can be used to offset other income, whether or not the taxpayer materially participates in the oil and gas activity.

A working interest in an oil and gas property is an interest that a taxpayer owns directly or through an entity that does not limit his liability. If a taxpayer's form of ownership limits his liability (for example, a limited partnership interest or stock in an S corporation), the general rules regarding material participation apply.

Working interests in oil and gas properties are excluded from the passive loss rules because Congress believed it was desirable to attract outside investors to the industry. The tax benefit is restricted, however, to investors who accept financial risk in proportion to their investment ¹⁰

RECHARCTERIZATION OF PASSIVE INCOME

Congress granted the Treasury Department the authority to recharacterize income or gain from a passive activity as nonpassive income or portfolio income. Under temporary regulations (section 1.469-2T(f)), several types of income, which would otherwise be treated as passive income, are recharacterized as either nonpassive income or portfolio income. The reason for these rules is to prevent taxpayers from creating passive income that could be used to offset passive losses.

IMPLICATIONS OF THE PASSIVE LOSS RULES

In the mid-1980s Congress believed that as the result of the excessive use of tax shelters many taxpayers were losing confidence in the Federal income tax system. Many taxpayers were able to lower their income taxes by using excess tax preferences from one activity to shelter income from other activities. To help curb the excessive use of tax shelters, Congress enacted the passive loss rules. Under these rules, excess losses and credits from a passive activity can only be used to offset income and taxes from other passive activities. Unused losses and credits are suspended and can be carried forward indefinitely. Suspended losses from an activity are allowed in full when a taxpayer disposes of his entire interest in a passive activity. This section addresses some of the implications of these rules.

EFFECTS ON TAXPAYER BEHAVIOR

The passive loss rules may affect taxpayer behavior in different ways. It is argued that the rules will improve economic efficiency. Others maintain that taxpayers will be able to structure their investments to avoid the rules, which will reduce the effectiveness of the rules in curbing the use of tax shelters.

Economic Efficiency

It is argued that by curbing the use of tax shelters the passive loss rules will improve economic efficiency. In general, a tax promotes economic efficiency if its effects on economic decisions are kept to a minimum. If, as the result of the passive loss rules, relatively more investment decisions are made for economic reasons than for tax reasons, the rules will improve economic efficiency. Whether or not the rules improve economic efficiency depends on how investors respond to the rules.

The passive loss rules may improve economic efficiency by reducing the value of tax preferences and thus discouraging investment in passive activities. Under the passive loss rules, unused losses and credits from passive activities are suspended and carried forward. Since a deduction or credit claimed in the future is worth less than the same deduction or credit today, suspension reduces the value of tax preferences. Therefore, to the extent that the passive loss rules result in the deferral of tax preferences, the rules will improve the match between taxable income and economic income. More investment decisions will be made for economic reasons, which will improve economic efficiency. ¹¹

The passive loss rules do not distinguish between artificial losses and real losses, however. The passive loss rules may, therefore, result in the suspension of real economic losses. The suspension of real losses reduces the value of those deductions and moves taxable income further from economic income. Therefore, some investments that would have been made for economic reasons may not be made, which will contribute to economic inefficiency.

Effectiveness

The passive loss rules defer and may discourage the use of tax preferences, but do not prevent the use of tax preferences. Therefore, some taxpayers may structure their investments to avoid the rules, which will reduce the effectiveness of the rules in curbing the use of tax shelters. So they will not have to defer the deduction of tax preferences, some taxpayers may pair an investment in a passive activity that they expect will generate losses with an investment in a passive activity that they expect will generate positive net income. Other taxpayers may simply avoid investments in passive activities that they think will generate losses. Instead, they will invest in activities in which they materially participate, in passive activities that they expect will generate positive net income, or in activities that generate portfolio income. In addition, to avoid the rules some taxpayers may restructure their existing investments, thus increasing transactions costs (the cost of disposing of one asset and acquiring another). ¹²

ECONOMIC ADVANTAGE

A criticism of tax shelters is that they benefit outside investors over taxpayers who own and operate their own businesses. Thus, supporters of the rules argue that, by curbing the use of tax shelters, the rules will benefit independent business owners. The rules may have this effect if they reduce the relative amount of investment in passive activities.

In general, a tax shelter is an investment where a portion of the aftertax return is derived from taxes saved on other income. Supporters of the passive loss rules argue that, without the rules, taxpayers who can use excess tax preferences from one activity to shelter other income from taxation would have an economic advantage over taxpayers whose business is their main or only source of income. This argument is illustrated in table 2 on page 13, which is based on the same assumptions as table 1. It will be recalled that in table 1 it was assumed that, in addition to a $25,000 investment, the taxpayer had at least $12,500 of taxable income from other sources from which to deduct his losses. Column 1 of table 2 is the same as column 3 of table 1. In the second column of table 2, however, it is assumed that the $25,000 investment is the taxpayer's only source of income. In this case, because unused tax preferences cannot be deducted from current income, they must be carried over. As can be seen by comparing columns 1 and 2, a taxpayer who can use excess tax preferences from one activity to reduce taxes on current income from other sources will earn a greater aftertax rate of return than a taxpayer who, because he does not have other income, must defer the use of excess deductions or credits. ¹³

          TABLE 2. Aftertax Rate of Return for One Year on a

The argument that the passive loss rules benefit independent business owners only applies in certain cases, however. Specifically, the argument only applies if taxpayers who have income from nonpassive sources and have investments in passive activities that generate net losses are compared to taxpayers who own and operate their own businesses and have no income or only limited income from other sources. But taxpayers may invest in more than one passive activity and taxpayers who own and operate their own businesses may have significant income from other sources (both passive and nonpassive). Taxpayers with investments in more than one passive activity can use losses from one passive activity to shelter income from other passive activities. Independent business owners with significant income from other sources can use losses from a nonpassive source to shelter income from other sources. The passive loss rules will have less effect on the latter two groups of taxpayers than on taxpayers whose investments in passive activities generate net losses and who have income from nonpassive sources.

In general, the passive loss rules will benefit taxpayers who own and operate their own businesses and who have limited income from other sources if the rules result in relatively less investment in passive activities. This would reduce the amount of competition faced by independent business owners.

COMPLEXITY

Tax provisions are often judged in terms of their costs of compliance and administration. Whether or not the passive loss rules curb the use of tax shelters, they will increase the costs of compliance. For example, material participation must be determined with respect to each activity. The scope of each activity must be identified. Taxpayers searching for investments that generate passive income will have to take the recharacterization rules into account. Because suspended losses are fully deductible upon disposition of a passive activity, separate records must be kept on suspended losses from each passive activity. Information on portfolio income from a passive activity must be kept separate from information on other income from the activity. For purposes of claiming the $25,000 allowance for rental losses, separate records must be kept on rental real estate activities.

For its part, the Internal Revenue Service (IRS) is responsible for developing regulations and forms to implement the passive loss rules. It must also maintain records to be used in the case of audits. Future changes in the passive loss rules may require additional forms and regulations. Taxpayer confusion over the rules will also increase demands on IRS resources.

Finally, some analysts argue that because of other changes enacted by the Tax Reform Act of 1986, the passive loss rules will not be as effective in curbing the use of tax preferences as would otherwise have been the case. For example, the Tax Reform Act also eliminated accelerated depreciation for most real property, repealed the Investment Tax Credit, reduced marginal tax rates, eliminated the partial exclusion for realized capital gains, extended the Alternative Minimum Tax, and expanded the at-risk rules.

TAX REVENUES

The passive loss rules will generally raise tax revenues to the extent that the amount of losses and credits suspended each year is greater than the amount of suspended losses and credits claimed each year. Under the rules, the deduction of real and artificial losses is deferred. Therefore, the increase in tax revenues resulting from the passive loss rules will come primarily from the increased present value of tax liabilities. ¹⁴

Data from individual income tax returns indicate that approximately $13.9 billion in passive losses were disallowed for 1987. ¹⁵ When the passive loss rules were enacted it was expected that they would raise an estimated $753 million in fiscal year 1987. This figure was expected to rise to an estimated $8 billion in fiscal year 1991, the year the rules became fully effective. ¹⁶

ADDITIONAL READING

Commerce Clearing House, Inc. PALS: Working with the passive activity loss rules. Chicago, Commerce Clearing House, Inc., 1989. 94p.

--- U.S. master tax guide, 1991. 74th ed. Chicago, Commerce Clearing House, Inc., 1990. p. 460-65.

Koppelman, Stanley A. At-risk and passive activity limitations: Can complexity be reduced? Tax law review, v. 45, fall 1989: 97-120.

Lipton, Richard M. Fun and games with our new PALs. Taxes: The tax magazine, v, 64, December 1986: 801-13.

--- More fun and games with PALs: The first set of section 469 regulations. Taxes: The tax magazine, v. 66, April 1988: 235-61.

--- The activity regulations: Playing new games with building blocks. Taxes: The tax magazine, v. 67, July 1989: 411-37.

Oberst, Michael A. The passive activity provisions: A tax policy blooper. University of Florida law review, v. 40, 1988: 641-88.

Nelson, Susan, and Tom Petska. Partnerships, passive losses, and tax reform. Statistics of income bulletin, v. 9, Winter 1989-1990: 31-39.

Peroni, Robert J. A policy critique of the section 469 passive loss rules. Southern California law review, v. 62, November 1988: 1- 104.

Rock, Cecily, and Daniel N. Shaviro. Passive losses and the improvement of net income measurement. Virginia tax review, v. 7, summer 1987: 1-87.

U.S. Congress. Joint Committee on Taxation. General explanation of the tax reform act of 1986. Report to accompany H.R. 3838. 99th Congress, 1st session. Washington, U.S. Govt. Print Off., May 4, 1987. p. 209-54.

U.S. Library of Congress. Congressional Research Service. Rental real estate: Passive activity loss limits, by Richard Bourdon. [Washington] 1991. (Updated regularly)

CRS Issue Brief IB90076

² Although the illustration in table 1 is based on income and deductions for only one year, the general conclusions would be the same if the argument were presented in terms of the present value of aftertax income over the life of the investment. The present value of aftertax income from an investment that generates excess tax preferences is greater if those preferences are used to shelter current income from taxation.

³ For interests in passive activities held before enactment of the Tax Reform Act of 1986, the passive loss rules were phased in over a four-year period and became fully effective for tax years beginning in 1991. For other passive activities, the rules became effective for tax years beginning in 1987.

⁴ An S corporation is a corporation that has 35 or fewer stockholders, has elected not to be taxed at the corporate level, and meets several other restrictions.

⁵ The participation of an individual's spouse is combined with that of the taxpayer in determining whether the individual materially participates.

⁶ For the purpose of this test, personal services include services in the fields of health, 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.

⁷ A publicly traded partnership is a partnership in which interests are traded on an established securities market or on a secondary market. These markets include any national securities exchange, local exchange, or over-the-counter market.

⁸ The deduction equivalent of a passive activity credit is the deduction amount that would reduce a taxpayer's regular tax liability by an amount equal to the amount of the credit.

⁹ For a more detailed explanation of the passive loss rules as they apply to rental real estate see: U.S. Library of Congress. Congressional Research Service. Rental Real Estate: Passive Activity Loss Limits. Issue Brief IB900076, by Richard Bourdon. Washington, October 31, 1991 (updated regularly).

¹⁰ According to the General Explanation of the Tax Reform Act of 1986, when the passive rules were enacted the oil and gas industry "was suffering severe hardship due to the worldwide decline in oil prices." U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. Report to Accompany H.R. 3838. 99th Cong., 1st Sess. Washington, U.S. Govt. Print Off., May 4, 1987. p. 214.

¹¹ Economic income includes capital gains, which are not taxed until they are realized. Therefore, all or part of the reported losses from an activity may be due to the underreporting of income (that is, to unrecognized capital gains). The passive loss rules would bring taxable income closer to economic income if they identified and deferred the deduction of these losses. The same result would be achieved if capital gains were taxed when they were accrued.

¹² Investment planning must take into account the special treatment given to rental activities and working interests in the oil and gas industry. Working interests in oil and gas are exempt from the passive loss rules, while it is presumed that rental activities are passive activities.

¹³ The illustration in table 2 is based on income and deductions for only one year. But the general conclusions would be the same if the present value of the aftertax income stream from an investment that generates excess tax preferences were compared to the present value of the combined income stream from an investment that generates excess tax preferences and a source of positive income.

¹⁴ The deferral of deductions may also affect the rate at which income is taxed. Currently, there are three marginal tax rates on ordinary income: 15, 28, and 31 percent. Long-term capital gains (assets held for at least 12 months) are taxed at a rate of 28 percent. Suspended losses are first deducted from any gain realized upon disposition.

¹⁵ Internal Revenue Service. Statistics of Income Division. Individual Income Tax Returns 1987. Washington, 1990. p. 10.

¹⁶ For property held before the passive loss rules were enacted 35 percent of passive losses were disallowed for 1987. Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, p. 252, 254.