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Passive Activity Loss Rules

  1. Material Participation Tests
  2. PAL Rules

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What Are Passive Activity Loss Rules & Limitations?

Updated: November 24, 2022

Due to depreciation and other operational costs, it’s not unusual for rental properties to have a net loss for tax reasons for their owners.

Investors frequently misunderstand how these losses are handled for a variety of reasons. Rental property losses are regarded as passive losses and can often only be used to offset passive income. This excludes investments and includes income from the other investment properties or other small businesses in which you have no major involvement.

Read on as we take a closer look at passive activity loss rules and limitations. We’ll see exactly what it is, what the rules are, how it works, and the limitations associated with these rules.

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    KEY TAKEAWAYS

    • Passive activity loss rules were created and put in place by the Internal Revenue Service (IRS). The intent is to remove the possibility of using passive losses to offset ordinary income. 
    • An example of a passive activity is a situation where a taxpayer is not materially involved or participating in actual business operations. 
    • Passive activity losses can occur in a number of situations. Some of the most common include limited partnerships, real estate rentals, and leasing equipment. 
    • Passive activity loss rules are outlined under Section 469 of the Internal Revenue Code (IRC).

    What Are Passive Activity Loss Rules?

    Passive activity loss rules are a specific set of rules outlined by the Internal Revenue Service (IRS). The rules dictate the prohibition of using passive losses to help offset ordinary income. As well, they ensure that investors do not use the losses incurred from activities that generate income if they’re not materially involved.

    To be considered materially involved means that any income earned is active income through business activities. The income isn’t able to get reduced by passive losses, which are only able to be implemented to offset passive income.

    Turn Tax Pains Into Tax Gains

    How Passive Activity Loss Rules Work

    There can sometimes be a lot of information to take into account and consider for passive loss rules. But the good news is that it’s fairly straightforward, and we have broken down the process below. Keep reading to find out how passive activity loss rules work. 

    An active loss is only able to get claimed against active income. These rules are outlined under Section 469 of the Internal Revenue Code. It states that you must be actively participating in the business or trade operations to claim active losses. 

    Passive activity loss rules were—in large part—created and implemented to remove the possibility of investors trying to offset ordinary income through passive losses. In this case, passive losses are only able to get claimed against passive income from business operations. 

    In the grand scheme of things, this means that you aren’t able to apply passive losses to active income if the losses exceed the total amount of income from the activity. The rules apply as long as there is still interest in the business activity. If you have unclaimed losses that exceed your passive income, you can claim these losses in full in the same year. 

    Limitations of Passive Activity Loss Rules 

    One of the biggest challenges with the passive activity loss rules relates to whether or not you are materially participating in the business activity. Based on IRS Topic No. 425, material participation is defined as:

    Having involvement in the operation of a business activity or trade on a regular, continuous, and substantial basis

    To confirm whether or not you align with the details of materially participating, there are seven tests that can be taken to help. The most common is to have worked a minimum of 500 hours at your business or in your trade over the course of a year. 

    If you aren’t materially participating in the business activity, then any losses that get incurred aren’t able to be matched against your passive income. Even further, if you don’t have passive income, then it’s not possible to have any losses deducted. 

    As well, you can only apply passive activity losses within the current year. But, if the losses exceed your passive income, then you can carry them forward with no limitations. They cannot be carried back, however. 

    Typically, passive activity loss rules only apply to individuals, but they can also apply to almost any business except C corporations. 

    There is also eligible to receive a special $25,000 allowance from the IRS. To be eligible, your losses must have been the result of a rental real estate activity. According to the IRS, you can subtract up to $25,000 worth of associated losses from your active income. It’s worth noting that this allowance will get reduced to $12,500 if you’re married but file separate tax returns.

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    How to Determine Material Participation for Passive Activities 

    Business owners have a few options to help navigate the passive activity loss rules. However, they can only do this as long as they are materially participating in the business activity or trade. 

    The IRS has developed and outlined seven specific tests for material participation. You don’t need to pass all seven tests, but you will need to pass at least one. The seven tests for passive activity loss rules are: 

    • You’re in a specific business activity for a minimum of 500 hours in the tax year.
    • You’re the only participant in the business activity or trade during the year and no one else assists in the operation.
    • You’ve engaged in over 100 hours throughout the tax year, and no one else engaged more hours than you.
    • You were able to meet the 500-hour test through multiple different business activities, not a single activity. 
    • You have materially participated in the business activity or trade for the first four rules in five of the previous ten years, which don’t have to be consecutive.
    • You were engaged in a personal service activity for at least three years at any point in your life without the intent of earning profits.
    • You’ve actively participated in the business activity or trade for a minimum of 100 hours regularly, continuously, and substantially.

    The IRS also stipulates that you can’t perform the business activity or trade if you’re being supervised by someone who’s managing it. Or if that person spent a longer amount of time managing the business activity or trade than you did. 

    What Is An Example of a Passive Loss?

    An easy example to understand passive loss is looking at real estate professionals. Let’s say that there is a rental property owned outright and there has been rental activity for the last year. In this time, you have been able to get a total rental income of $10,000. 

    However, the depreciation deduction ends up totaling $11,000. For tax purposes, this would ultimately mean that you have $1,000 in passive losses even though you still have $10,000 in net income

    Real estate passive loss can stem from any tangible property, including a commercial property. However, there are also many non-real estate activities and acquisition activities that can result in a passive loss. The main things to consider are the period of time and the specific participation activity.

    Summary

    The IRS established the passive activity loss rules and they are outlined in Section 469 of the Internal Revenue Code. It states that a passive activity is one where you did not or are not actively participating in the ongoing operations. You must report this activity with income tax returns. 

    The rules were created in part to help remove the possibility for investors to use passive losses to offset non-passive income. You’re only able to claim losses against the passive income earned from the specific passive activity. 

    Some of these rules and limitations can get confusing and convoluted for eligible taxpayers. If you need more assistance, be sure to discuss the activity in question with your tax professional.

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    FAQs About Passive Activity Loss Rules

    How Much Passive Losses Can You Deduct?

    This often depends on your level of your income-producing activities. Under the passive activity rules, you can deduct up to $25,000 against ordinary income if your modified adjusted gross income is $100,000 or less.

    How Long Can Passive Losses Be Carried Forward?

    Passive losses are able to get carried forward indefinitely until one of two things occur. You either dispose of your entire interest in the activity, or you have other passive income you can deduct against it.

    Where Do I Report Passive Activity Losses?

    Individuals use Form 8582 to determine the amount of passive activity losses for the tax year.

    Can Passive Activity Losses Offset Capital Gains?

    The simple answer is no; passive activity losses cannot offset capital gains. You can, however, use passive activity losses to help offset other passive income. This is where real estate rental activities could come into play.

    Passive Activity Loss Rules

    1. Material Participation Tests
    2. PAL Rules

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