In the U.S., a limited partnership is a business entity formed under state limited partnership laws. Limited partners are investors whose personal liability in a business entity is limited to the amount of capital contributed, or required to be contributed, to the business entity. Their ability to deduct, for personal income tax purposes, losses of the business entity depends upon their basis in the limited partnership and whether the income is classified as active or passive.
Limited partnerships must file Form 1065, U.S. Return of Partnership Income, with the Internal Revenue Service. Form 1065 lists all income and deductions of the partnership and allocates the income and deductions to the general and limited partners. Limited Partners will receive a Schedule K-1 from the partnership, which reports to them their share of income and deductions from the partnership. A copy of the Schedule K-1 is also sent by the partnership directly to the IRS.
If a limited partner is allocated a loss from a limited partnership on a Schedule K-1, the limited partner may only claim the loss on his individual income tax return if the partner has sufficient basis. A partner's basis refers to the amount of money or property a partner has contributed to the partnership plus any loans made to the partnership. Recognizing income from a partnership also creates additional basis while losses reduce basis. Limited partners may not deduct losses that would create negative basis.
Passive vs. Active
The IRS generally does not allow limited partners to deduct losses related to passive activities, except to the extent that those losses can offset other income from passive activities. The IRS considers passive activities to be "trade or business activities in which you did not materially participate." Generally, if you are not involved in the management of a limited partnership, it is a passive activity. Almost all rental activities are considered passive, although exceptions exist allowing low-income taxpayers to deduct a limited amount of losses related to rental activities.
Individual Income Tax Reporting
Deductible losses are reported by the individual limited partners to the IRS on Schedule E of Form 1040, U.S. Individual Income Tax Return. These losses are then used to reduce income from all other sources. When losses are not deductible, the limited partner must separately track the limitation. Generally, losses limited by basis become deductible when the limited partner achieves sufficient basis and losses limited as passive activities become deductible when the limited partner recognizes other passive income or the activity generating the losses is sold.