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I received a K-1 with a positive value X in Box 1, and a negative value Y in Box 2.

The partner's instructions for K1 seem to treat them completely independently, even if both are passive, although they reference the same lines in Schedule E.

Instructions for Box 1:

  • If income is reported in box 1, report the income on Schedule E (Form 1040), line 28, column (h).
  • If a loss is reported in box 1, follow the Instructions for Form 8582 to figure how much of the loss can be reported on Schedule E (Form 1040), line 28, column (g).

Instructions for Box 2:

  • If you have a loss from a passive activity in box 2 and you do not meet all the conditions in (1) above, follow the Instructions for Form 8582 to figure how much of the loss you can report on Schedule E (Form 1040), line 28, column (g).
  • If you have income from a passive activity in box 2, report the income on Schedule E (Form 1040), line 28, column (h).

If I am interpreting these instructions literally, then I should have passive income from Box 1, while the loss from Box 2 is disallowed, resulting in a net gain of X.

Is this correct interpretation, or should the values in Box 1 and Box 2 be combined and treated together as either a gain or loss?

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If I am interpreting these instructions literally, then I should have passive income from Box 1, while the loss from Box 2 is disallowed, resulting in a net gain of X.

This is entirely plausible. You should follow the instructions for the calculations.

Box 1 is for ordinary income, box 2 is for rental real estate income - these are separate different categories. For positive values (net income) they end up being treated the same. But for losses, you'll have passive activity limitations kick in and you need to follow the instructions for the form 8582 to figure it out.

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