Passive Activity Losses and Deductions
Many investors in real estate, oil & gas partnerships, or other entities expect to accumulate passive activity losses. A common misconception is that these losses can offset earned income (such as W2 income or other active business interests) each year. In reality, passive partners do not receive the same tax benefits as active partners. Their losses accumulate on Form 8582 (the IRS form for passive activity loss limitation) and become deductible only when the partnership ends.
A managing partner or a partnership is considered an active participant. They can deduct ordinary business losses directly from box one of their 1065 K-1 on page one of their 1040.
Releasing Prior Unallowed Passive Losses
To release accumulated passive losses as a passive partner in an oil & gas limited partnership, ensure your tax software marks the K-1 as final. Enter the amount of unallowed losses from prior years. The same principle applies to passive real estate holdings. When you sell the rental property, you can use the accumulated losses to offset income. Any remaining unallowed losses can carry over to future years indefinitely.
Basis and Deductible Amounts
One common limitation is the amount of deductions you can use, which generally cannot exceed your basis. Basis refers to the total amount of money or fair market value of assets contributed, adjusted for unrealized gains or losses, distributions, and additions. You cannot deduct more than your basis. For example, if you contribute $100 and lose it, you can deduct $100. If you contribute $100, withdraw $50, and lose the remaining $50, you can deduct $50. If you contribute $100 and your investment’s fair market value increases to $150, you can deduct up to $150 if you lose the entire investment.
Tracking Basis
Your basis calculation worksheets, usually included with the partnership’s 1065 tax return, should detail how the basis was calculated. If you lack this worksheet, obtain it from the CPA who prepared your return or the General Partner.
Hi Mr Dimov, Do you agree that when the “Limited Partner” box is checked on the K-1 than the Oil and Gas Working Interest exemption is not met? See the below for my referencing please. And thank you for your input!
Active vs. Passive Income
The Tax Reform Act of 1986 introduced into the Tax Code the concepts of “Passive” income and “Active” income. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. The Tax Code specifically states that a Working Interest in an oil and gas well is not a “Passive” Activity, therefore, deductions can be offset against income from active stock trades, business income, salaries, etc. (See Section 469(c)(3) of the Tax Code).
Hi,
Thank you for your message. Because of the passive loss exception, working interests in oil and natural gas are removed from the passive income basket. They are treated as non-passive activity, whether or not you materially participate. We are happy to comment and research more once engaged.