Many investors in real estate, oil & gas partnerships, or other partnership entities expect to receive and accumulate passive activity losses. A common misconception is that these losses from an oil & gas partnership can be used each year to offset earned income (from W2 or other active business interests). However, passive partners do not get the same type of tax benefits from partnership losses that an active partner would get. A passive partner’s losses accumulate on form 8582 (IRS form for passive activity loss limitation) and are only “released” or “unlocked” when the partnership ceases to exist, at which point these expenses are deductible against earned income from active employment.
A managing partner or a partnership, on the other hand, is considered an active participant in the business, and is allowed to deduct these ordinary business loss items from box one of his 1065 K-1 directly on page one of his 1040.
How to “release” these prior unallowed passive activity losses if you are a passive partner in an oil & gas limited partnership:
If you are a passive partner and want to release these accumulated unallowed passive losses, make sure that you select in your tax software that the K-1 is the final K-1 and make sure that you have entered the amount of unallowed losses from prior years from the prior year’s tax return. The same applies to passive real estate holdings (owning a rental property, for instance). When the rental is sold and this business no longer exists, these accumulated losses can be used to offset income and any remaining portion of unallowed loss can get carried over to a subsequent year indefinitely.
What does basis have to do with deductible amounts of prior unallowed passive activity losses?
One limitation that comes up in my private practice regarding oil & gas partnerships (and other passive interest partnerships) from the perspective of the limited partner revolves around the total amount of deductions that can be used. Generally, you cannot deduct more than what you have “put in” or recognized as an increase. The general rule is that you cannot deduct more than your basis.
What is basis? Basis is the total amount of money (or fair market value of assets contributed) adjusted upward/downward for recognized unrealized gains/losses, distributions, additions, etc. The principle here is that you are not supposed to deduct more than what you have put in. If you put in 100 and lose it, you can deduct 100. If you put in 100 and then took out 50 but then lost the remaining 50, then you can deduct 50. If you contributed 100 and use accrual accounting, then through your income statement recognized (and possibly paid taxes on) unrealized increases in the fair market value of the property valuing it at 150, but then in a subsequent year lost the entire investment, you can deduct 150 (100 original investment and 50 that you were already taxed on and have added to your basis).
Your basis calculation worksheets should show how basis has been calculated and kept track of over time. These normally come with the partnership’s 1065 tax return. If you do not have a copy of your basis worksheet, it is important to obtain it either from the CPA that prepared your return or the General Partner.