Comprehensive Example The following example shows how to report your passive activities.In addition to Form 1040, Charles and Lily Woods use Form 8582 (tofigure allowed passive activity deductions), Schedule E (to reportrental activities and partnership activities), Form 4797 (to figurethe gain and allowable loss from assets sold that were used in theactivities), and Schedule D (to report the sale of partnershipinterests). General Information Charles and Lily are married, file a joint return, and havecombined wages of $132,000 in 1999. They own interests in theactivities listed below. They are at risk for their investment in theactivities. They did not materially participate in any of the businessactivities. They actively participated in the rental real estateactivities in 1999 and all prior years. Charles and Lily are not realestate professionals. Activity A is a rental real estate activity. The income andexpenses are reported on Schedule E. Charles and Lily's records show aloss from operations of $15,000 in 1999. Their records also show again of $2,776 in 1999 from the sale of section 1231 assets used inthe activity. That section 1231 gain is reported in Part I of Form4797. In 1998 they completed the Worksheets in the instructions forForm 8582 and calculated that $6,667 of Activity A's Schedule E lossfor 1998 was disallowed by the passive activity rules. That loss iscarried over to 1999 as a prior year unallowed Schedule E loss. Activity B is a rental real estate activity. Its income andexpenses are reported on Schedule E. Charles and Lily's records show aloss from operations of $11,600 in 1999. In 1998 they completed theWorksheets in the instructions for Form 8582 and calculated that$8,225 of Activity B's Schedule E loss for 1998 was disallowed by thepassive activity rules. That loss is carried over to 1999 as a prioryear unallowed Schedule E loss. Partnership #1 is a trade or business activity and is not apublicly traded partnership (PTP). Partnership #1 reports a $4,000distributive share of its 1999 profits to Charles and Lily on line 1of Schedule K-1 (Form 1065). They report that profit on ScheduleE. In 1998 they completed the Worksheets in the instructions for Form8582 and calculated that $2,600 of their distributive share of theloss from Partnership #1 in 1998 was disallowed by the passiveactivity rules. That loss is carried over to 1999 as a prior yearunallowed Schedule E loss. Partnership #2 is a trade or business activity and also aPTP. In 1999 Charles and Lily disposed of their entire interest inPartnership #2. They do not report that gain on Form 8582 becausePartnership #2 is a PTP. They recognize a long-term capital gain of$15,300 ($25,300 selling price minus $10,000 adjusted basis), whichthey report on Schedule D. The partnership reports a $1,200distributive share of its 1999 losses to them on line 1 of ScheduleK-1 (Form 1065). They report that loss on Schedule E. In 1998they followed the instructions for Form 8582 and calculated that$2,445 of their distributive share of Partnership #2's 1998 loss wasdisallowed by the passive activity rules. That loss is carried overfrom 1998 and added to the $1,200 Schedule E loss for 1999. (Fordiscussion of PTPs, see the instructions for Form 8582.) Partnership #3 is a single trade or business activity and isnot a PTP. Charles and Lily sold their entire interest in partnership#3 in November 1999. They recognize a $4,000 ($15,000 selling priceminus $11,000 adjusted basis) long-term capital gain, which theyreport on Schedule D. In 1998 they completed the Worksheets in the Form 8582 instructionsand calculated that $3,000 of their distributive share of thepartnership's loss for 1998 was disallowed by the passive activityrules. That loss is carried over to 1999 as a prior year unallowedSchedule E loss. Charles and Lily's distributive share of partnershiplosses for 1999 reported on line 1 of Schedule K-1 (Form 1065)is $6,000. Partnership #4 is a trade or business activity that is alimited partnership. Charles and Lily are limited partners who did notmeet any of the material participation tests. Their distributive shareof 1999 partnership loss, reported on line 1 of Schedule K-1(Form 1065), is $2,400. In 1998 they completed the Worksheets in theForm 8582 instructions and calculated that $1,500 of theirdistributive share of loss for 1998 was disallowed by the passiveactivity rules. That loss is carried over to 1999 as a prior yearunallowed Schedule E loss. Step One--Completing the Tax Forms Before Figuring thePassive Activity Loss Limits Charles and Lily complete the forms they usually use to reportincome or expenses from their activities. They enter their combinedwages, $132,000, on Form 1040. They complete line 8 of Schedule Dshowing long-term capital gains of $15,300 from Partnership #2 and$4,000 from Partnership #3. Because Partnership #2 is a PTP, it is notentered on Form 8582. Because the disposition of Partnership #3 is adisposition of an entire interest in an activity with an overall lossof $5,000 ($4,000 - $3,000 - $6,000), that partnership isalso not entered on Form 8582. They combine the PTP $1,200 currentyear loss with its $2,445 prior year loss, and also combine thePartnership #3 $6,000 current year loss with its $3,000 prior yearloss, and enter the two combined amounts in column (g) on line 27 ofSchedule E, Part II. They enter the $4,000 profit from Partnership #1in column (h). Before completing Part II of Schedule E, they mustcomplete Form 8582 to figure out how much of their losses fromPartnerships #1 and #4 they can deduct. They complete Schedule E, Part I, through line 22. Since theirrental activities are passive, they must complete Form 8582 to figurethe deductible losses to enter on line 23. They enter the gain from the sale of the section 1231 assets ofActivity A on Form 4797. Step Two--Form 8582and its Worksheets Charles and Lily now complete Form 8582 and the worksheets thatapply to their passive activities. Because they are at risk for theirinvestment in the activities, they do not need to complete Form 6198before Form 8582. (The second part of this publication explains theat-risk rules.) Worksheet 1.Charles and Lily enter the gains and losses on Worksheet 1 forActivity A and Activity B (rental real estate activities with activeparticipation). They enter all amounts from the activities even thoughthey already reported the gain of $2,776 from Activity A on Form 4797,since all income or loss from these activities must be taken intoaccount to figure the loss allowed. They write "Activity A" on the first line underName of activity. Then they enter: $2,776 gain in column (a) from Form 4797, line 2, column(g), ($15,000) loss in column (b) from Schedule E, line 22,column A, and ($6,667) prior year unallowed loss in column (c) from theirworksheets used in 1998. They combine the three amounts. Since the result, ($18,891), is anoverall loss, they enter it in column (e). Charles and Lily write "Activity B" on the second lineunder Name of activity. Then they enter: ($11,600) loss in column (b) from Schedule E, line 22,column B, and ($8,225) prior year unallowed loss in column (c) from their1998 worksheets. Then they combine these two figures and enter the total loss,($19,825), in column (e). They separately add columns (a), (b), and (c). They enter $2,776 in column (a) on the "Total" line andalso on Form 8582, Part I, line 1a. They enter ($26,600) in column (b) on the "Total" lineand also on Form 8582, Part I, line 1b. They enter ($14,892) in column (c) on the "Total" lineand also on Form 8582, Part I, line 1c. They combine lines 1a, 1b, and 1c, Form 8582, and put thenet loss, ($38,716), on line 1d. Worksheet 2.Because Partnership #1 and Partnership #4 are nonrental passiveactivities, Charles and Lily enter the appropriate information onWorksheet 2 similar to the way they reported their rental activitieson Worksheet 1. Then they enter the totals on Form 8582, Part I, lines2a through 2d. Reporting income from column (d), Worksheets 1 and 2.Activities that have an overall gain in column (d) are not used anyfurther in the calculations for Form 8582. At this point, overall gainactivities should be entered on the forms or schedules that wouldnormally be used. Charles and Lily have one activity with an overallgain ($4,000 - $2,600 = $1,400). This is Partnership #1, whichis shown in Worksheet 2. They report this partnership income directlyon Part II, Schedule E. Step Three--CompletingForm 8582 Next, Charles and Lily complete Part II, Form 8582, to determinethe amount they can deduct for their net losses from real estateactivities with active participation (Activities A and B). They enterall amounts as though they were positive (without brackets aroundlosses). They then complete Part III of Form 8582. They enter $38,716 on line 4 since this is the smaller ofline 1d or line 3. They enter $150,000 on line 5 since they are married andfiling a joint return. They enter $138,655, their modified adjusted gross income,on line 6. (See the instructions for Form 8582 for a discussion ofmodified adjusted gross income.) The $138,655 is made up of theirwages, $132,000, plus their overall gain of $11,655 from Partnership#2, a PTP, plus their $5,000 overall loss from Partnership #3. On Schedule D, they reported long-term gains of $15,300 from thePTP disposition and $4,000 from the partnership #3 disposition. Also,on Schedule E they combined the PTP 1999 loss of $1,200 with its prioryear loss of $2,445, and combined the Partnership #3 1999 loss of$6,000 with its prior year loss of $3,000. Netting these amounts givesthem the PTP overall gain of $11,655 ($15,300 - $1,200 -$2,445) and the Partnership #3 overall loss of $5,000 ($4,000 -$6,000 - $3,000) that were used in figuring modified adjustedgross income. They subtract line 6 from line 5 and enter the result,$11,345, on line 7. They multiply line 7 by 50% and enter the result, $5,673, online 8. No matter what the result, they cannot enter more than $25,000on line 8. They enter the smaller of line 4 or line 8, $5,673, on line9. They add the income on lines 1a and 2a and enter the result,$6,776, on line 10. They add lines 9 and 10 and enter the result, $12,449, online 11. Step Four--Completing Worksheet 3 Charles and Lily must complete Worksheet 3 since they have anactivity with an overall loss in column (e) of Worksheet 1 and anamount on line 9 of Form 8582. This worksheet allocates the amount online 9 (their special allowance for active participation rental realestate activities) between Activity A and Activity B. In the two left columns, they write the names of theactivities, A and B, and the schedules the activities are reported on,Schedule E. They fill in column (a) with the losses from Worksheet 1,column (e). They add up the amounts, and enter the result, $38,716, inthe "Total" line without brackets. They figure the ratios for column (b) by dividing eachamount in column (a) by the amount on the column (a) Totalline and entering the result in (b). The total of the ratiosmust equal 1.00. They multiply the amount from line 9, Form 8582, $5,673, byeach of the ratios in Worksheet 3, column (b) and enter the results onthe appropriate line in column (c). The total must equal $5,673. They subtract column (c) from column (a) and enter eachresult in column (d). Step Five--Completing Worksheet 4 Worksheet 4 must be completed if there is an overall loss in column(e) of Worksheet 2 or losses in column (d) of Worksheet 3 (or column(e) of Worksheet 1 if Worksheet 3 was not needed). This worksheetallocates the unallowed loss among the activities with an overallloss. Charles and Lily fill out Worksheet 4 with the activities fromWorksheet 3 and the one activity showing a loss in Worksheet 2, column(e). They fill in the names of the activities and the schedules orforms on which each loss will be reported in the two left columns ofWorksheet 4. In column (a), they enter the losses from Worksheet 2,column (e) and Worksheet 3, column (d). These losses are entered aspositive numbers, not in brackets. They add the numbers and enter thetotal, $36,943, on the Total line. They divide each of the losses in column (a) by the amounton the column (a) Total line, and enter each result incolumn (b). The ratios must total 1.00. Now they use the computation worksheet for column (c) (seeWorksheet 4 in the instructions for Form 8582) to figurethe unallowed loss to allocate in column (c). On line A of the computation worksheet, they enter theamount from line 3 of Form 8582, $41,216, as a positive number. On line B, they enter the amount from line 9 of Form 8582,$5,673. They subtract line B from line A and enter the result,$35,543, on line C. This is the total unallowed loss. They multiply line C, $35,543, by each of the ratios in column(b) and enter the results in column (c). These amounts are theunallowed loss from each activity and must add up to $35,543. Step Six--UsingWorksheets 5 and 6 Charles and Lily now decide whether they must use Worksheet 5,Worksheet 6, or both to figure their allowed losses. If the loss froman activity entered on Worksheet 4 is reported on only one form orschedule, then Worksheet 5 is used. If an activity has a loss that isreported on two or more schedules or forms (for example, a loss thatmust be reported partly on Schedule C and partly on Form 4797),Worksheet 6 is used. Charles and Lily determine that all of theactivities they entered on Worksheet 4 will be reported on Schedule E.Therefore, they use Worksheet 5 to figure the allowed loss for eachactivity. (Worksheet 6 is not illustrated.) Worksheet 5.They fill out Worksheet 5 with the activities from Worksheet 4. They enter the names of the activities and the schedules tobe used in the two left columns of Worksheet 5. In column (a), they enter the total loss for each activity.These losses include the current year loss plus the prior yearunallowed loss. They find these amounts by adding columns (b) and (c)on Worksheets 1 and 2. In column (b), they enter the unallowed loss for eachactivity already figured in Worksheet 4, column (c). They must savethis information to use next year in figuring their passive losses. In column (c), they figure their allowed losses for 1999 bysubtracting their unallowed losses, column (b), from their totallosses, column (a). These allowed losses are entered on theappropriate schedules. Reporting allowed losses.Charles and Lily enter their allowed losses from Activities A and Bon Schedule E, Part I, line 23, because these are rental properties.They report their allowed loss from Partnership #4 on Schedule E, PartII. Step Seven--Finishing the Reporting of the PassiveActivities Charles and Lily summarize the entries on Schedule E, Schedule D,and Form 4797, and enter the amounts on the appropriate lines of theirForm 1040. They enter: The total Schedule D gain, $22,076, on line 13, and The Schedule E loss, ($21,094), on line 17. Charles and Lily are now able to complete their tax return, havingcorrectly limited their losses from their passive activities. Form 1040, page 1 Schedule D (Form 1040), page 1 Schedule E (Form 1040), page 1 Schedule E (Form 1040), page 2 Form 4797, page 1 Form 8582 Worksheets 1--5 for Form 8582