What Are Passive Activity Loss Rules?
Passive activity loss rules are a set of IRS rules that prohibit using passive losses to offset earned or ordinary income. Passive activity loss rules prevent investors from using losses incurred from income-producing activities in which they are not materially involved.
Being materially involved with earned or ordinary income-producing activities means the income is active income and may not be reduced by passive losses. Passive losses can be used only to offset passive income.
- Passive activity loss rules are a set of IRS rules stating that passive losses can be used only to offset passive income.
- A passive activity is one wherein the taxpayer did not materially participate in its ongoing operation during the year in question.
- Common passive activity losses may stem from leasing equipment, real estate rentals, or limited partnerships.
Understanding Passive Activity Loss Rules
The key issue with passive activity loss rules is material participation. According to IRS Topic No. 425, "material participation" is involvement in the operation of a trade or business activity on a "regular, continuous, and substantial basis." There are seven tests that can define material participation, but the most common one is working at least 500 hours in the business in the course of a year.
If the taxpayer does not materially participate in the activity that is producing the passive losses, those losses can be matched only against passive income. If there is no passive income, no loss can be deducted. Note that rental activities—including real estate rental activities—are considered passive activities even if there is material participation ("real estate professionals" have their own rules for determining material participation).
Passive activity losses can only be applied in the current year. However, if they exceed passive income they can be carried forward without limitation; they cannot be carried back.
Passive activity loss rules are generally applied at the individual level, but they also extend to virtually all businesses and rental activity in various reporting entities, except C corporations, in order to deter abusive tax shelters. There are detailed rules about how much in passive losses is deductible; the Tax Cut and Jobs Act of 2017 changed some of these numbers. If you think these rules could apply to your tax situation, consult a tax specialist.
Passive Losses and Passive Activity
Passive activity is activity that a taxpayer did not materially participate in during the tax year. The Internal Revenue Service (IRS) defines two types of passive activity: trade or business activities to which the taxpayer did not actively contribute, and rental activities. Unless the taxpayer is a real estate professional, rental activities usually provide streams of income that are passive. The IRS defines material participation as involvement in the activity of the business on a regular, continuous and substantial basis.
A passive loss is thus a financial loss within an investment in any trade or business enterprise in which the investor is not a material participant. Passive losses can stem from investments in rental properties, business partnerships, or other activities in which an investor is not materially involved. In order to be considered a non-material participant, the investor cannot be continuously and substantially active or involved in the business activity.
Generally, passive losses (and income) can come from the following activities:
- Equipment leasing
- Rental real estate (though there are some exceptions)
- Sole proprietorship or a farm in which taxpayer has no material participation
- Limited partnerships (though there are some exceptions)
- Partnerships, S-Corporations, and limited liability companies in which taxpayer has no material participation
If you are unsure whether a loss should be classified as passive or not, it is worth consulting with a professional accountant to ensure your taxes are being filed correctly.