7.1.3.1. Passive Losses and Tax Credits
DPPs were formerly known as highly effective tax shelters. Because their investments often are high-risk, losses are common and previously could be deducted from ordinary income. More recently, legislation has reduced investors’ ability to use DPPs as tax shelters.
The IRS allows passive losses to be deducted from passive income when calculating the amount of tax due for an investor. Deduction of an investor’s passive losses is limited to his amount of passive income. The IRS defines passive income as primarily income from rental property and limited partnerships, including DPPs. The IRS considers the investor not to be actively involved in earning this type of income and, thus, labels it “passive” income (the same idea holds for “passive” losses). Passive income does not include portfolio income, such as income from annuities, mutual funds, or stocks and bonds. The deduction of passive losses can be a major benefit for those with enough passive income to take advantage of it. See the next example.
Passive investors may receive either tax deductions or tax credits. Investors in government-assisted housing may receive tax credits. As opposed to tax deductions, which reduce the amount of income on which tax must be paid, tax credits are subtracted from the amount of tax due. The following highly simplified example demonstrates the differing amounts of taxes due between equal deductions (Case 1) and credits (Case 2).
Case 1: Bill earned $50,000 last year, of which $10,000 was passive income. He had a passive loss of $5,000. His tax rate is 25%.
The first step is to figure out how much of Bill’s passive loss is deductible. It is c