Claiming Passive Activity Credits

Credits arising from passive activities are allowable only to the extent a shareholder’s regular tax liability is attributable to passive activities for the year. The tax attributable to passive activities is the difference between the:

1. Shareholder’s regular tax liability under Sec. 26(b) based on all income (disregarding credits), and
2. Regular tax liability (disregarding credits) if taxable income were reduced by net passive activity income; see Temp. Regs. Sec. 1.469-3T(a) and (d).

Example

Albert’s Schedule K-1 from Alco, an S corporation, shows a $15,000 alcohol fuels credit. Albert does not materially participate in Alco, and the $15,000 is the only credit to which he is entitled. Disregarding the credit, Albert’s regular tax liability would be $60,000. If the tax were computed without considering passive activity income, Albert’s tax would be $50,000. Thus, Albert can take up to $10,000 in passive credits. The unused balance of the credit ($5,000) carries forward as a passive activity credit to apply against tax on passive activity income in future years.

In the following year, Albert’s regular tax liability is $75,000, while his tax computed without considering passive activity income is $65,000. The $5,000 alcohol fuels credit carryover is the only credit to which he is entitled. Because the tax attributable to passive activity income exceeds $5,000, the entire credit carryover can be used in the following year.

The credits subject to the passive activity credit rules include the general business credits. Under Temp. Regs. Sec. 1.469-3T(b), the passive activity credit rules apply if the credits are attributable to a passive activity.

Caution: The credits for Federal tax on fuels and for the purchase of a diesel-powered vehicle (claimed on Form 4136, Credit for Federal Tax Paid on Fuels) are not passive activity credits.

Using Passive Activity Credits from Rental Real Estate

Sec. 469(i) allows up to $25,000 of nonpassive income to be offset per year with the deduction equivalent of the passive activity credits attributable to a rental real estate activity in which the taxpayer actively participates. Under Sec. 469(j)(5), a deduction equivalent is the amount of deduction it takes to reduce the regular tax liability by an amount equal to the credit. For example, if a taxpayer is in the 28% bracket, $100 of credit carries a deduction equivalent of $357 ($100/.28); that is, it would take a $357 deduction to reduce the tax by $100. For a taxpayer in the 33% bracket, an $8,250 credit would use the full $25,000 rental real estate amount that can be deducted against nonpassive income.

A maximum of $25,000 per year can offset nonpassive income generated by rental real estate; see Sec. 469(i). Rental losses must be combined with deduction equivalents when determining the $25,000 reduction in nonpassive income. First, rental losses are applied against the $25,000 limit. Second, real estate credits other than the rehabilitation and low-income housing credits are applied. Third, the rehabilitation credit is used; finally, the low-income housing credit is applied (see Sec. 469(i)(3)(D)).

Low-income housing credit: For the Sec. 42 low-income housing credit, the allowance of up to $25,000 of deduction equivalents against nonpassive income applies whether or not the shareholder actively participates in the rental real estate activity; see Sec. 469(i)(6)(B)(i).

Further, the low-income housing credit does not phase out regardless of the shareholder’s adjusted gross income (AGI) if the S interest was acquired after 1989; see Sec. 469(i)(3)(D). The phaseout applies if the interest in the S corporation was acquired before 1990—the phaseout begins at $200,000 of AGI and ends at $250,000; see Sec. 469(i)(3)(B) before amendment by the Revenue Reconciliation Act of 1989, Act Section 7109(a) and (b)(2). Special rules apply to married taxpayers who file separately.

Planning tip: Under the passive activity loss rules, the low-income housing credit is the only credit a high-income taxpayer can use that will offset up to $25,000 of income without reference to the taxpayer’s AGI.

Rehabilitation credits: As with the low-income housing credit, the active participation standard does not affect rehabilitation credits under Sec. 47; under Sec. 469(i)(6)(B)(ii), the deduction equivalent can be taken (within the $25,000 limit) even if the shareholder does not actively participate in the real estate activity. However, unlike the low-income housing credit, the rehabilitation credit phases out when the shareholder’s AGI is between $200,000 and $250,000; see Sec. 469(i)(3)(B).