What Are Passive Activity Loss Rules?

Passive activity loss rules are a set of tax regulations that prohibit taxpayers from using passive losses to offset earned or ordinary income. The regulations 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.

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 in most cases. 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, with the exception of C corporations. These are designed to deter the abusive use of tax shelters.

There are detailed rules about how much passive loss is deductible. 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:

1. Trade or business activities to which the taxpayer did not actively contribute
2. 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.

Passive losses (and income) can come from the following activities, though there may be some exceptions in each category:

• Equipment leasing
• Rental real estate if you aren't a real estate professional
  
• Limited partnerships
• Partnerships, S-Corporations, and limited liability companies in which the taxpayer has no material participation
• Farm in which the 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.

The Bottom Line

The concept of passive income has been a hot topic recently given the proliferation of side gigs that the internet spawned. Passive income is income that is earned without material participation from the taxpayer. This is different than income from investments, which are considered capital gains (or losses).

In general, passive income is taxed the same way as active income. However, the difference becomes important when you experience passive income losses. If you lose money, you can't deduct your losses incurred in passive income from gains made through active income sources.