The first thing to say about this form is that it does not tell the whole story. To follow through, read the explanations on Worksheets #3 through #5 of Form 8582 after you read this explanation.
The second thing to say about this form is that, for reasons we will explain below, the bottom line of this form has no real significance and can even be somewhat misleading.
This form (Form 8582) finds the total loss from passive activities (if any), and the special allowance for rental real estate activities (if any).
These amounts then serve as input to Worksheets #3 through #5, where the actual allowable passive activity amounts are calculated.
For active participation rental ("APRE") activities, this is the combined net income from all activities with current year net income.
For active participation rental ("APRE") activities, this is the net loss from all activities with current year net loss.
For active participation rental ("APRE") activities, this is the combined carryforward loss from all activities that have a carryforward loss.
This is the net of current income or loss and prior year carryforward loss. It represents the combined net income or loss from APRE activities that has not been recognized on a tax return prior to 2010.
If there is a net loss on this line, it will be eligible for the special $25,000 allowance for rental real estate. Because this amount includes carryforward loss, this mechanism implements the notion that a loss that is disallowed in one year may be carried forward and become eligible for the $25,000 allowance in another year.
Lines 3a through 3d are the same as lines 1a through 1d, but for all activities other than APRE activities.
There is no special allowance for these activities--passive losses will offset passive income, but no losses will be allowed in excess of passive income.
Again, by including carryforward losses, we allow all prior year losses to be brought forward, just in case they get lucky and find passive income this year against which they can be used.
The number on line 4 is your net passive income or loss for this year combined with all prior years' carryforward (that is, unused) losses.
If this number is positive, then you have enough income this year so that you can use up all your passive losses from not only this year but all prior years.
In this case, with no losses that will be carried forward, we do not need Worksheets #3 through #5, and you will not have any "carryforward losses" for next year's tax return.
If this number is negative, then there will be some carryforward losses to 2011 (and perhaps beyond). In this case, we will use Worksheets #3 through #5 to figure the amount of this loss to allocate to each activity.
On lines 5 through 10, we work out the net allowance for rental real estate.
This is tricky because there are several factors that can reduce or eliminate the allowance. We will discuss these factors, and, incidentally, explain the calculations in this part, with the following lines:
Overall net loss. You may not claim a greater allowance than you really need. If there was income from non-APRE activities, that income is applied to offset your loss from the APRE activities. This is implemented by starting on line 5 with the smaller of your APRE loss or your overall loss.
Phase-out. If you are not married filing separately, your $25,000 maximum loss is phased out fifty cents for every dollar that your modified adjusted gross income exceeds $100,000. (We explain "modified adjusted gross income" in our discussion of Line 7.)
What if you are married filing separately? If you are married filing separately, and you lived apart from your spouse during the entire year, the calculation is fundamentally the same, except that the maximum allowance is $12,500 (not $25,000) and the modified AGI for the phase-out starts at $50,000 (not $100,000).
Lines 6 through 9 are doing the same thing as reducing the allowance by fifty cents for every dollar that modified AGI goes over the threshold.
Feel free to puzzle through the arithmetic yourself, or you can just take our word for it.
If you are married filing separately, and you lived with your spouse at any time during the year, you can't claim the special allowance at all--now that makes the calculation easy, doesn't it?
The idea behind modified AGI is to capture what AGI would have been if there had not been any passive income or losses--and to make a couple of other miscellaneous adjustments just for fun.
The following lines describe how we calculate modified AGI.
If you had no net passive activity loss, we report modified AGI as the same as AGI. The number has no significance in this case. The following steps describe the calculation in the other case, namely, where you have an overall passive activity loss this year.
For this purpose, we calculate modified AGI as follows:
We start with AGI.
Rental Activities. We reverse out rental gains or losses. To do this, we check each rental activity to see whether there was a passive loss.
If so, we reverse out line 23A on the associated column of Schedule E (deductible rental loss), otherwise we reverse out line 22A (rental income) on Schedule E.
Partnerships, S Corporations, Estates and Trusts. On the chart on page 2 of Schedule E, we reverse out all the entries in the "passive activity" columns.
Schedule C. We go through each Schedule C. If it is a passive activity (we check the "Is this a passive activity" question on line 6-1 , the passive activity worksheet), we reverse out the income or loss. Exception: If there was a complete disposition of the activity in 2010 and there was an overall loss, then the activity is treated as nonpassive, and we do not reverse out the loss. There is an overall loss if current year net income (or loss), minus carryforward loss, plus gain on disposition (or minus loss on disposition) is a negative number.
Schedule F. Similar to Schedule C.
Form 4835. Similar to Schedules F and C.
K-1 Worksheet. Section 1231, Form 1040, Schedule A and other miscellaneous items. The key K-1 items are carried to Schedule E, and are reversed out from there. But these remaining miscellaneous items are reversed out for modified AGI purposes by reference directly to the K-1 itself.
In general, if the entry on the K-1 was for a passive activity, we reverse out the allowed Section 1231 gain or loss. Exception: If there was a complete disposition of the activity in 2010 and there was an overall loss, then the activity is treated as nonpassive, and we do not reverse out the loss. There is an overall loss if current year net income (or loss), minus carryforward loss, plus gain on disposition (or minus loss on disposition) is a negative number.
With this, we have gotten AGI "as if" there were no passive activity income or loss. Now, we begin the other random adjustments required by the tax law for "modified AGI."
Social Security. We subtract the Social Security taxable amount from Form 1040 line 20b.
IRA. We add back your IRA deduction from Form 1040 lines 32a and 32b.
Deduction for 1/2 of self-employment tax. We add back the amount of your deduction for 1/2 of self-employment tax from Form 1040 line 27.
Exclusion for savings bond interest. We add in the exclusion for savings bond interest from educational bonds, from Schedule B line 3.
Calculation Note: We note that there is precious little guidance from the tax law or the treasury on how to implement this concept of "modified AGI." We have tried to faithfully follow the spirit of the law, but there may well be other acceptable ways of calculating this number. If this modified AGI number has a significant effect on your tax return, you may want to consult with a tax professional. To find out how you can talk to an H&R Block tax professional, click the Ask a Tax Advisor button.
Note on Nomenclature: It's worth mentioning that the tax law loves the phrase "modified AGI." In the passive activity context, it means something like "adjusted gross income calculated as if you had no passive activity income or loss, and with a couple of other adjustments." But be aware that every time the tax law wants to compare something to adjusted gross income, but with a few loopy special calculations, it calls the result "modified AGI." So there are several "modified AGI" numbers scattered through the tax return, and each one means something different from the others.
Now that we have finished calculating your maximum special allowance, (typically $25,000, reduced fifty cents for each dollar of modified AGI over $100,000), we have just one last step. The last step is to say that if your maximum allowance is $20,000 but your actual loss is only $8,000, then your special allowance can't be more than your actual loss.
Accordingly, line 10 is the smaller of line 5 (actual loss) or line 9 (maximum special allowance).
Line 15 is just the combined current year net income from all activities (APRE and non-APRE).
The so-called "allowed loss" on line 16 is NOT--we repeat, NOT--the amount of net passive losses you will be allowed to deduct this year. Overall, the only net passive losses (that is, losses in excess of income) you will be allowed to deduct this year are those in the special allowance (line 10).
You can think of line 16 instead as the amount of "gross" passive losses, which is partly composed of net income against which these losses will be offset, and partly composed of the special allowance.
We have finished our description of Form 8582, but we have not finished describing how your passive activity numbers are computed. For that, we should continue on Worksheet #3 and read through until Worksheet #5.