Passive activities generally include any activity involving the conduct of a trade or business or the production of income and in which the taxpayer does not materially participate (Sec. 469). However, Sec. 469(c)(3) of the tax code excludes from the passive activity definition any working interest in oil or gas property in which the form of ownership does not limit liability. This is true whether or not the taxpayer-owner materially participates in the activity (Publication 925).

Section 465 generally limits losses from an activity for each year to the amount the taxpayer has at-risk in the activity at year end. A taxpayer is generally considered at-risk for money and the adjusted basis of property contributed to the activity and amounts borrowed for use in the activity. But amounts borrowed for use in the activity are not included as at-risk if the lender has no recourse against the borrower personally, except for certain qualified financing with respect to real property (Publication 925).

The at-risk rules are contained in Sec. 465 and limit a taxpayer’s deductible losses from each business and income-producing activity to the amount for which the taxpayer is at risk with respect to that activity. Although originally designed to limit deductible losses from tax shelters, the at-risk rules apply across the board to most activities (Publication 925).

Rent is income from an investment. Gross income includes the value received by a landlord for modifying a lease, rent payments, lessee improvements made to the property in lieu of rent, prepaid rent regardless of the method of accounting used, and a bonus received by a landlord for granting a lease. Thus, the amount to be reported by Johnson as taxable income is $12,250 ($50 + $10,000 + $1,500 + $500 + $200). A lessee’s refundable deposit intended to secure performance under the lease is not income to the lessor (Publication 17).

Both cash- and accrual-basis taxpayers must include amounts in gross income upon actual or constructive receipt if the taxpayer has an unrestricted claim to such amounts under Reg. 1.61-8(b). Thus, all rent payments received should be included in the current year’s gross rental income. If a security deposit is intended as an advance rent payment, it must be included in income in the year received. Security deposits not intended as rent are income only if the lessor becomes entitled to them upon the lessee’s violation of the lease (Publication 17). Johnny must include the $18,200 ($700 + $7,700 + $9,000 + $800) plus the $750 security deposit intended as an advance rent payment. The $500 security deposit is not included because Johnny does not have an unrestricted claim to the money.

The $25,000 allowance of losses from active participation in rental real estate activities against nonpassive income is reduced by 50% of the amount by which adjusted gross income (determined without regard to Social Security benefits, IRA contributions, and passive losses) exceeds $100,000 [Sec. 469(i)(3)]. Dr. J’s adjusted gross income exceeds $100,000 by $30,000 ($130,000 income – $100,000 threshold). Therefore, the $25,000 allowance is reduced by $15,000 ($30,000 × 50%). This leaves $10,000 of losses ($25,000 allowance – $15,000 reduction) that can be deducted (Publication 925).

Bryant Corporation is a closely held corporation because more than 50% of the value of its stock is held by five or fewer individuals during the last half of the year. After December 31, 1993, a closely held C corporation is not subject to the passive activity loss rules for real estate trades or businesses if during the tax year the corporation derives more than 50% of its gross receipts from the real property trades or businesses in which it materially participates [Sec.469(c)(7) and Publication 925]. Therefore, Bryant may offset its $300,000 passive loss against active and portfolio income.