Why Isn’t This A Passive Activity?

In a prior post I began addressing some of the issues that face taxpayers who receive a K-1 form from a hedge fund or other publically traded partnership.  This time I want to focus on a footnote that shows up on some K-1s that indicates that the partnership or LLC is not a passive activity.  Passive vs non passive is an important distinction because losses generated by passive activities are limited.  I’m going to skip the background stuff and cut right to the chase.  The question is, if I have no involvement in the company (other than my investment), how can it be non-passive?

The short answer is, “because the IRC says so”.

Code section 1.469-1t(e) gives us the definition of a passive activity.  Paragraph (6) of that section specifically states that “an activity of trading personal property for the account of owners of interests in the activity is not a passive activity”.  So, the K-1 telling the investor that the partnership or LLC meets this definition.  The K-1 reflects income and loss from the trading of personal property on the investors behalf.

So what?  Why is it such a big deal if the income is passive or non-passive?

It’s a big deal because of passive losses.  Passive losses are only deductible to the extent of passive income.  If, in a given year, you have more passive loss than you have passive income you can’t use the excess.  It has to be carried forward to future years.  If you are a taxpayer with big passive losses, you are looking for passive income.  The bad news is that income from a hedge fund that falls under 1.469-1T(e)(6) will not help you.

On the other hand, certain types of losses generated by a hedge fund might be fully deductible since they escape the passive loss rules.  However, the capital loss rules still apply.

Thanks to the sources for this post:

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