Understanding Passive Activity Loss Rules and How They Affect You
- Discover the income-producing activities the IRS deems passive.
- Learn more about passive activity loss rules and what they cover.
- Find out how to treat passive activity losses for tax purposes.
- Learn how passive activity loss rules apply to rental activities.
Do you wonder if the passive activity loss rules affect business ventures you engage in — or might engage in?
If the IRS considers these ventures passive activities, the passive activity loss rules apply. These rules prevent you from deducting expenses generated by passive activities in excess of their income. You can’t deduct the excess expenses (losses) against earned income or against other nonpassive income. Nonpassive income for this purpose includes interest, dividends, annuities, royalties, gains and losses from most property dispositions, and income from certain oil and gas property interests. So, you can’t deduct passive losses against those income items either.
You don’t have to consider any losses that you can’t use as lost, though. Instead, you may carry them forward, indefinitely, to tax years in which your passive activities generate enough income to absorb the losses. To the extent that you don’t use up your passive losses from an activity in this way, you have another option. The IRS will allow you to use them in the tax year in which you dispose of your interest in the activity in a fully taxable transaction. You may also use them in the tax year you die.
Passive vs. material
The IRS considers passive activities as trades, businesses, or income-producing activities in which you don’t “materially participate.” The passive activity loss rules also apply to any items passed through to you by partnerships in which you’re a partner, or by S corporations in which you’re a shareholder. This means that any losses passed through to you by partnerships or S corporations will be treated as passive, unless the activities aren’t passive for you.
For example, let’s say that in addition to your regular professional job, you’re a limited partner in a partnership that cleans offices. Or perhaps you’re a shareholder in an S corp that operates a manufacturing business (but you don’t participate in the operations).
If you don’t materially participate in the partnership or S corporation, the IRS considers those activities as passive. So, passive activity loss rules will apply to you. On the other hand, if you “materially participate,” the IRS doesn’t consider those activities as passive (except for rental activities, discussed below). Therefore, the passive activity loss rules won’t apply to the losses. To materially participate, you must involve yourself in the operations on a regular, continuous and substantial basis.
The IRS uses several tests to establish material participation. Under the most frequently used test, you’re treated as materially participating in an activity if you participate in it for more than 500 hours in the tax year. Other tests require fewer hours. However, all the tests require you to establish how you participated and the amount of time spent. You can establish this by any reasonable means such as contemporaneous appointment books, calendars, time reports or logs.
Rental activities and passive activity loss rules
The IRS automatically considers rental activities as passive and treats them as such, regardless of your participation. This means that, even if you materially participate in them, you can’t deduct the losses against your earned income, interest, dividends, etc. There are two important exceptions:
- You can deduct up to $25,000 of losses from rental real estate activities (even though they’re passive) against earned income, interest, dividends, etc., if you “actively participate” in the activities (requiring less participation than “material participation”) and if your adjusted gross income doesn’t exceed specified levels.
- If you qualify as a “real estate professional” (which requires performing substantial services in real property trades or businesses), your rental real estate activities aren’t automatically treated as passive. So, you may deduct losses from those activities against earned income, interest, dividends, etc., if you materially participate.
Would you like to discuss how these passive loss activity rules apply to your business? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations. Ready to book an appointment now? Click here. Know someone who might need our services? We love referrals!