Why Transferable Tax Credits Can't Offset W-2 Income

If most of your income is wages, buying a transferable credit will usually not lower your current federal tax. This page explains why, so you do not spend money on a credit you cannot use.

The basic reason

An individual who buys a credit under §6418 is treated as holding a passive activity credit (§1.6418-2(f)(3)). The credit offsets only the tax attributable to passive income (§469(d)(2)). Wages are not passive income, nor is portfolio income such as interest, dividends and investment gains (§469(e)(1)).

Example

	Taxpayer A	Taxpayer B
W-2 wages	$600,000	$150,000
Net passive rental / LP income	$0	$250,000
Tax attributable to passive income	$0	a CPA computes it
Credit usable currently	$0	Up to that passive tax, then the §38(c) cap

Taxpayer A may owe far more federal tax than B, but none of it is attributable to passive income.

What does not change this

• Having a large tax bill.
• Owning a business through an S corporation if you actively work there: the income is not passive for you.
• Buying a bigger credit. Unused credit carries forward but does not help until you have passive income tax.

What W-2 earners can ask their CPA about

• Whether any of their income is passive after all, such as rental or K-1 income (K-1 passive income).
• Whether they own a closely held C corporation that could be the buyer (closely held C corps).
• Whether other tax planning is appropriate. That is outside what we advise on.

Myths we hear

• "I'll buy through an LLC." Passive status is tested for the taxpayer under §469, not by the label of the entity that holds the credit.
• "I own a business, so my income is business income." If you materially participate, it is not passive (Temp. Reg. §1.469-5T). Active business income cannot absorb a passive activity credit.
• "Active losses can offset passive income, so it must work the other way." The rules are asymmetric. See can active losses offset passive income?
• "Capital gains are investment income, so they are passive." No. §469(e)(1) treats gains on investment property as portfolio income, not passive.

The honest answer for most W-2 earners

A purchased credit is probably the wrong tool. The IRS FAQ says most taxpayers do not have passive income tax liability. We would rather tell you that than take your inquiry. If you do have passive income, the quiz will say so.

Educational only, not tax advice.