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.
Understanding Passive Losses
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. Passive losses can include a loss from the sale of the passive business or property in addition to expenses exceeding income. When losses 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: the 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 non-passive 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 non-passive. 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.
Non-passive 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 non-passive. 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 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.