What Are Passive Activity Loss Rules?
Passive activity loss rules are a set of tax regulations that prevent taxpayers from using passive losses to offset earned or ordinary income. Essentially, these rules ensure that losses from income-producing activities, where the taxpayer is not materially involved, cannot reduce active income.
Key Takeaways
- Passive activity loss rules specify that passive losses can offset only passive income.
- Passive activities are those where the taxpayer did not materially participate during the year in question.
- Common sources of passive activity losses include leasing equipment, real estate rentals, and limited partnerships.
Understanding Passive Activity Loss Rules
A crucial aspect of passive activity loss rules is material participation. According to the IRS, material participation involves significant, continuous, and regular involvement in a business or trade activity. There are seven tests to determine material participation, the most common being the requirement to work at least 500 hours annually in the business.
If a taxpayer doesn’t materially participate in the activity causing the passive losses, these can only be matched against passive income. Lacking such income, the losses cannot be deducted in that year, though they can be carried forward without limitation. These rules generally apply to individuals but extend to virtually all businesses and rental activities, except C corporations, deterring abuse of tax shelters.
Detailed regulations on deductible passive losses make it advisable to consult a tax specialist if these rules may impact your tax situation.
Passive Losses and Passive Activity
Passive activities include any business or trade activities where the taxpayer didn’t materially contribute and rental activities unless the taxpayer is a real estate professional. Passive losses occur in ventures where the investor isn’t actively involved, coming from investments in rental properties, business partnerships, or other such activities.
Passive losses and income often come from:
- Equipment leasing
- Rental real estate (if not a real estate professional)
- Limited partnerships
- Partnerships, S-Corporations, and LLCs without material participation
- Farms without material participation
Consulting a professional accountant is wise if you’re unsure about classifying a loss as passive or active.
What Is a Passive Activity?
a passive activity under U.S. tax law generates income or losses without material taxpayer participation. For instance, earning from rented farmland operated by someone else is a form of passive income, which can only offset other passive income, not earned income.
Is Passive Income Taxable?
Yes, passive income is taxable, typically at the same rate as earned income. However, if you have passive income, certain deductions might help offset the taxes due.
Active Income vs. Passive Income
Active income is gained from producing or aiding in the production of goods or services, while passive income is received with little efforts. Both types of income are taxable, but significant because passive activity loss rules can disallow offsetting passive losses against active income.
The Bottom Line
The recent boom in side gigs has sparked interest in passive income. It’s essential to understand that while active and passive incomes are generally taxed alike, you can’t use current passive income losses to offset gains from active income streams.
Related Terms: Active Income, Portfolio Income, Material Participation Test.
References
- Internal Revenue Service. “Instructions for Form 8582, Passive Activity Loss Limitations”. Page 1.
- Internal Revenue Service. “Topic No. 425, Passive Activities – Losses and Credits”.
- Internal Revenue Service. “Publication 925, Passive Activity and At-Risk Rules”. Page 5.
- Internal Revenue Service. “Publication 925, Passive Activity and At-Risk Rules”. Pages 5-6.
- Internal Revenue Service. “Publication 925, Passive Activity and At-Risk Rules”. Page 7.
- Internal Revenue Service. “Publication 925, Passive Activity and At-Risk Rules”. Page 2.
- Internal Revenue Service. “Publication 925, Passive Activity and At-Risk Rules”. Pages 6-8.
- Internal Revenue Service. “Publication 925, Passive Activity and At-Risk Rules”. Page 3.
- Internal Revenue Service. “Publication 925, Passive Activity and At-Risk Rules”. Pages 3, 5-6.
- Internal Revenue Service. “Publication 925, Passive Activity and At-Risk Rules”. Pages 3-4.
- Internal Revenue Service. “Publication 925, Passive Activity and At-Risk Rules”. Pages 2-4, 6, 12.
- Internal Revenue Service. “Instructions for Schedule F Profit and Loss From Farming”. Page 2.
- Internal Revenue Service. “Form 4835, Farm Rental Income and Expenses”. Page 2.
- CMP. “Passive Income Tax: Guide to Taxation for Your Passive Income Streams”.
