Passive activity loss rules prohibit you from claiming a tax deduction for losses associated with a trade or business in which you didn’t materially participate. The rules are provided under Section 469 of the Internal Revenue Code (IRC).
The IRS provides a detailed definition of what it means to “materially participate,” but there are a few confusing gray areas. It’s important to understand what constitutes passive versus material activity, which we’ll dive into below.
Definition and Examples of Passive Activity Loss Rules
Passive activity loss rules dictate you must participate in a trade or business on a “regular, continuous, and substantial basis” in order to claim a loss for it, according to the IRS. The rules apply if you own the business or even just a portion of the business, such as if you were a partner in a partnership or a shareholder in an S corporation. The rules don’t apply to the partnership or corporation itself.
Passive activity loss rules apply to:
- Trusts (other than grantor trusts)
- Personal service corporations
- Closely held corporations
Passive activities fall into one of two basic categories:
- You do not materially participate in the business
- Your business involves renting real estate
However, this isn’t quite as black-and-white as it sounds.
For example, your activity would be considered passive if you purchase a home then rent it out, even if you find the tenant, manage the lease, and meet all other rules for material participation. Your activity would not be considered passive if you did the same thing but you also qualify as a real estate professional (meaning you materially participated in the business).
How Passive Activity Loss Rules Work
Active losses can only be claimed against active income under IRC rules—income you earned from actively participating in the operation of the trade or business. And passive losses can only be claimed against passive income. Passive losses can’t offset active income, including income from things like other investments. This means you can’t apply passive activity losses to active income if the passive losses exceed the amount of passive income you earned from the passive activity.
You can carry passive losses forward to future years and claim them against passive income in the future if they exceed the passive income you earned in the current tax year.
Passive activity loss rules apply until you “dispose of your entire interest” in the activity. The IRS allows you to claim any unclaimed losses—those that exceeded your passive income in the activity—in full in the year you dispose of your interest.
You might also be eligible for a special $25,000 allowance if your losses were the result of a rental real estate activity. The IRS indicates you can effectively subtract up to $25,000 of any associated loss from your active income if you actively participated in this type of activity. You actively participate if your interest in the endeavor was at least 10% by value. This is different from the rules for material participation in other types of business enterprises.
The special allowance drops to $12,500, however, if you’re married but lived separately from your spouse for the entire year and filed a separate tax return. And there’s no special allowance if you lived with your spouse at any time during the tax year but filed a separate return. This allowance also phases out if your modified adjusted gross income (MAGI) is more than $100,000.
For example, let’s say your MAGI was $90,000 for the year, and your rental properties produced a loss of $25,000. As long as you actively participated, you could deduct all $25,000 of the loss against your ordinary income.
Calculating all these complicated rules and their effect on your tax bill can be done on IRS Form 8582, Passive Activity Loss Limitations. You must submit this form with your tax return.
What the Rules Mean for Business Owners
Business owners can navigate around the passive activity loss rules if they can establish that they are, indeed, materially participating in the trade or business. The IRS has seven material participation “tests” for this. However, you don’t have to pass all of them; you just need to pass one:
- You engaged in specific activity for the business for more than 500 hours during the tax year.
- You were the sole participant in the activity during the tax year. No one assisted you in running its operation.
- You participated for more than 100 hours during the tax year and no one else participated for more hours than you.
- You met the 500-hour test by performing multiple activities for the business, none of which constituted 500 hours by itself.
- You materially participated according to the first four rules in five of the last 10 years. The years don’t have to be consecutive.
- You engaged in a “personal service activity,” such as law or health care, for at least three years at any point during your lifetime and without the intention of making money. The three years do not have to be consecutive.
- You participated in the activity for more than 100 hours, and all records show you did so regularly, continuously, and substantially based on “all facts and circumstances.”
You cannot have performed the activity in question under the supervision of another individual who was paid for managing it, or if they spent more time managing the activity than you did.
- The Internal Revenue Code (IRC) and IRS define a passive activity as one in which you’re not involved in the operation of a trade or business on a “regular, continuous, and substantial basis.”
- You can’t claim a tax deduction for passive activity losses to offset other non-passive income. You can only claim the losses against your passive income derived from that passive activity.
- The IRS provides a special $25,000 allowance loophole if your losses were the result of rental real estate activity, although it also depends on your modified adjusted gross income (MAGI).
- This is a highly complicated area of tax law and it may be wise to work with a tax professional before claiming losses on your tax return.