State Passive Losses When There Are State Modifications

[Night Owl]

I am preparing an IL tax return as part of an individual return with over 20 state returns.  There are several K-1s which are partially sourced to IL.  One also has IL additions and subtractions for bonus depreciation because IL decouples from Federal.  On the Federal level, for simplicity, let's say the net passive losses from IL sources total $10,000 and because passive losses exceed passive income on the federal level are partially disallowed and carried forward on the Federal 8582.  However, for Illinois purposes there is a net add back for bonus depreciation of $15,000 which results in $5,000 ($10,000 federal loss plus $15,000 of bonus depreciation add back) of passive income from IL sources.  However, LaCerte is disallowing the full $10,000 of IL source passive losses that were partially disallowed for federal and fully taxing the $15,000 of IL net additions.  This doesn't make sense to me.  Aren't the additions considered passive income and shouldn't the $10,000 of passive losses be available to offset the $15,000 so that the net income taxed in IL is $5,000 and not $15,000?

Any thoughts on this would be much appreciated.

[PhoebeRoberts]

That's really a question of "what does IL law require," and I have no clue there. For my big multi-state returns, I figure the correct answer in Excel and make Lacerte agree, mostly because the -1 errors add up.  My best guess is that you need entries in both the State if Different and State Source columns for each K-1, but even then, you might need to judiciously override. The more K-1s and the more states, the less able you are to rely on Lacerte producing exactly the right output, even if you know what exactly the right input is.

[abctax55]

FWIW, Screen 55.071 is where I do the Illinois overrides for a similar issue.

Lacerte and/or Illinois doesn't make this easy or logical 😉

[Night Owl]

Thanks, Phoebe!  I tried to determine what IL law is regarding passive losses but the only guidance I can find is “You should follow the federal law concerning passive activity income and losses. You are not allowed to refigure your federal passive activity losses.”  This actually makes little sense when the state decouples from bonus depreciation since there could be passive income on the state level while a passive loss on the federal level which is what happened in my case.  Additionally, I would be interested in finding guidance on how to apply the passive loss rules to the states which follow the federal.  Often the state and federal passive losses are very different.  Are you supposed to track the state losses uses the same percentages as the federal allowance/disallowance?  Are you supposed to carryforward how much of the state passive loss is still unused each year?  How would that be accomplished in practice?

[Night Owl]

Thank you. That is exactly what I did, abctax55! To me it makes no sense for LaCerte to fully tax IL addbacks for depreciation which are passive but disallow the associated passive loss.  I basically used that screen to enter my IL passive losses (before the add back for depreciation). 

[taxmo]

My understanding is this is a known issue with some states (New York, Arizona, Illinois, and possibly some others) where the passive loss is limited, but then the state addition is still added on top of it, and so you end up with this "phantom income" issue.

According to the information I've found on this, it's not a tax software mistake, or a mistake at all. It's the actual reality of the correct reporting, and the result of bad state tax law.  To quote someone else's article on this issue:  

"Do you see the problem here?! Despite the fact that you did not deduct the passive loss, which was the original source of the bonus depreciation, New York still makes you add back the bonus depreciation (which you never deducted in the first place)!"

Yes, this situation is absurd.  But apparently, if you want to report it correctly, this is what it is.  It does at least later reduce their tax obligation to the state when the investment has a net profit in the future.