What is a 'Passive Loss'

A passive loss is 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.

Breaking Down 'Passive Loss'

A passive loss may be claimed by a rental property owner or a limited partner based on their proportional share of a partnership. Passive losses can be written off only against passive gains. When losses (which can include a loss from the sale of the passive business or property) exceed the income from passive activities, the rest of the loss can be carried forward to the next tax year provided there is some passive income to write it off against.

Passive Loss: IRS Definition

According to the Internal Revenue Service (IRS), a passive activity is "any rental activity or any business in which the taxpayer does not materially participate." This includes rentals (such as rental real estate and equipment) regardless of the level of participation by the investor. By comparison, a nonpassive activity is a business in which a taxpayer works on "a regular, continuous, and substantial basis." The IRS specifies that passive income does not include investment or portfolio income (such as dividends), salary or wages. Passive losses may be claimed in IRS Form 8582: Passive Activity Loss Limitations.

On a tax return, income and losses are listed in two categories: Passive and nonpassive. Passive income and losses includes businesses and rentals without material participation by the investor/taxpayer. Limited partners are usually passive given the restrictions of the tests for material participation. Given the nature of limited partnerships, participants tend to have passive losses or income from them.

Nonpassive income and losses, by comparison, include business activities in which the taxpayer/investor is an active, material participant. This may include salaries, 1099 commission income, portfolio or investment income, or any other income deemed to be nonpassive. Portfolio income may include royalties, dividends, interest income, gains and losses on stocks, lottery winnings, pensions and other property held for investment purposes.

Passive Loss Activities

Generally, passive losses (and income) from can come from the following activities:

  • Equipment leasing
  • Rental real estate (though there are some exceptions)
  • Sole proprietorship or 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
RELATED TERMS
  1. Passive Activity Loss Rules

    Passive activity loss rules are a set of IRS rules that prohibits ...
  2. Passive Income

    Passive income is earnings derived from a rental property, limited ...
  3. Passive Activity

    Passive activity is activity that a taxpayer did not materially ...
  4. Passive ETF

    A passive ETF is a method to invest in an entire index or sector ...
  5. Material Participation Tests

    Material participation tests review taxpayer business activity ...
  6. Passive Investing

    Passive investing is an investment strategy that limits buying ...
Related Articles
  1. Investing

    Why Your Passive Fund Is Crushing Active Managers

    A new study shows passive funds outperformed over 5, 10 and 15 years
  2. Retirement

    Active vs. Passive Investing During Retirement

    How these two investing approaches work – and how to decide which best suits your precious nest egg.
  3. Investing

    A Closer Look at Passive Vs. Active Management

    Find out what the data has to say about the passive management vs. active management debate, and why there isn't necessarily a clear winner.
  4. Managing Wealth

    9 Ways to Make Money with Passive Income

    It's not easy in the beginning, but you can generate passive income that increases with time.
  5. Investing

    4 Reasons Most ETFs are Passively Managed

    Find out the top four reasons most ETFs are passively managed, including the benefits of lower costs, greater tax efficiency and low asset turnover.
  6. Investing

    Funds with the Largest Inflows for September, 2016 (VTI, XLRE)

    As the third quarter drew to a close, investors continued to pour money into passive funds, while active funds battled heavy outflows.
  7. Investing

    The Link Between ETF Popularity and Debt

    There may be a link between a firm's weight in bond indexes and how indebted that firm is.
  8. Investing

    Money Managers Unite Against Passively Managed Funds

    Money managers put their heads together at summit in early November to strategize on how to overcome the loss of clients to passively managed funds.
  9. Investing

    Use Passive Investing to Protect Against Volatility

    Passive investment strategies are the best for protecting your assets during volatility.
RELATED FAQS
  1. What is the difference between residual income and passive income?

    Learn how passive income helps pay the bills with little work involved. Determine how residual income affects your ability ... Read Answer >>
Hot Definitions
  1. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  2. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  3. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  4. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  5. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  6. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
Trading Center