Understanding the passive activity loss rules

Are you wondering if the passive activity loss rules affect business ventures you’re engaged in — or might engage in?

If the ventures are passive activities, the passive activity loss rules prevent you from deducting expenses that are generated by them in excess of their income. You cannot 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 cannot deduct passive losses against those income items either.

Any losses that you cannot use are not lost. Instead, they are carried forward, indefinitely, to tax years in which your passive activities generate enough income to absorb the losses. To the extent your passive losses from an activity aren’t used up in this way, you will be allowed to use them in the tax year in which you dispose of your interest in the activity in a fully taxable transaction, or in the tax year you die.

Passive vs. material

Passive activities are trades, businesses or income-producing activities in which you do not “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 are not 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 are a shareholder in an S corp that operates a manufacturing business (but you do not participate in the operations).

If you do not materially participate in the partnership or S corporation, those activities are passive. On the other hand, if you “materially participate,” the activities are not passive (except for rental activities, discussed below), and the passive activity rules will not apply to the losses. To materially participate, you must be involved 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 are treated as materially participating in an activity if you participate in it for more than 500 hours in the tax year. While other tests require fewer hours, 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

Rental activities are automatically treated as passive, regardless of your participation. This means that, even if you materially participate in them, you cannot 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 are 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 losses from those activities can be deducted against earned income, interest, dividends, etc., if you materially participate.

Contact us if you’d like to discuss how these rules apply to your business.

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