Passive Activity Loss Rules

Passive activity loss rules limit how and when losses from passive activities can reduce taxable income. Losses from activities in which the taxpayer did not materially participate generally can be used only to offset passive income, not earned (active) income.

Key takeaways

• Passive losses can offset only passive income.
• A passive activity is one in which the taxpayer did not materially participate during the year.
• Common passive sources include rental real estate (unless you qualify as a real estate professional), equipment leasing, limited partnerships, and interests in partnerships, S corporations, or LLCs where you don’t materially participate.
• Excess passive losses are suspended and carried forward indefinitely until they can be used; they cannot be carried back.

What counts as a passive activity

The IRS treats two broad categories as passive activities:
* Trade or business activities in which the taxpayer does not materially participate.
* Rental activities (including most real estate rentals), which are passive by default unless special rules for real estate professionals apply.

Material participation means involvement in the business on a “regular, continuous, and substantial” basis. The IRS sets seven alternative tests for material participation; the most commonly used test is performing at least 500 hours of work in the activity during the year.

How passive losses are used

• Passive losses may be deducted only against passive income from other passive activities.
• If you have no passive income in a year, passive losses are not deductible that year; they are suspended and carried forward to future years.
• When you sell or otherwise dispose of your entire interest in a passive activity in a fully taxable transaction, suspended passive losses from that activity are generally deductible in full in the year of disposition.

Passive income vs. portfolio income vs. active income

• Active (earned) income: wages, salary, business income from activities where you materially participate.
• Passive income: income from passive activities (see above).
• Portfolio income: investment income such as interest, dividends, and capital gains. Portfolio income is generally not treated as passive income for purposes of offsetting passive losses.
  All three types are taxable, but only passive income can be offset by passive losses.

Common sources of passive losses

• Equipment leasing
• Rental real estate (unless you qualify as a real estate professional)
• Limited partnerships and other entities where you have no material participation
• Farms or other businesses in which you are not materially involved

Special notes and exceptions

• Real estate professionals: different rules apply for determining material participation for real estate activities; qualifying may allow rental real estate losses to be treated as nonpassive.
• Entity rules: passive activity loss rules generally apply to individuals and most pass-through entities; C corporations are treated differently under some aspects of the rules.
• These rules are complex and contain numerous detailed tests and exceptions.

Practical advice

If passive activity loss rules might affect your tax situation, review the material participation tests carefully and keep thorough records of time spent on each activity. Because the rules are technical and consequences can be significant, consult a tax professional for guidance tailored to your circumstances.