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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: April 18, 2023

Due to depreciation and other operational costs, it’s not unusual for rental property owners to declare a loss on their tax returns.

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 participating in 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?

    A passive activity loss occurs when your passive activity deductions are bigger than your passive activity income. 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.The passive activity loss rules also ensure that investors do not use the losses incurred from passive activities if they don’t materially participate in the trade or business. You materially participate in a business if you are regularly involved in its operations. 

    The one exception when passive activity loss may be allowed is if you are a rental real estate owner. Rental real estate owners may qualify for a special $25,000 allowance that they might be able to deduct against their ordinary income.

    Turn Tax Pains Into Tax Gains

    How Passive Activity Loss Rules Work

    Active losses can be only  claimed against active or ordinary income. These rules are outlined under Section 469 of the Internal Revenue Code. The tax code states that you must be actively participating in the business or trade operations to claim active losses. 

    Passive activity loss rules were 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 income from the passive activity. The rules apply as long as there is still interest in the business activity.

    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 incurred losses can only be applied against passive income. It means that if you don’t have passive income, then it’s not possible to have any losses deducted. 

    Passive losses that exceed your passive income, can be carried forward to future tax years. 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 one passive loss exception that allows the deduction of passive losses. It is called a Special $25,000 allowance and only losses from a rental real estate activity are eligible. According to the IRS, you can subtract up to $25,000 of 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.

    Rental activity losses are usually always considered passive losses even if you materially participate in the activity. An exception to this rule is if you qualify as a Real Estate Professional. Being a Real Estate Professional in the IRS’s eyes is not being a real estate agent or a broker. To qualify, you will need to spend more than half of your service hours in a real estate related trade or business in which you also materially participate. You will also need to spend at least 750 hours in that trade or business.

    It's Time For Owners To Own Tax Season

    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 will need to pass at least one of the tests. The seven tests for passive activity loss rules are: 

    • You participated in the business activity for more than 500 hours during the year.
    • Your participation in all the business activities was substantially all of the participation from individuals.
    • You have participated in the business activity for more than 100 hours during the year and no one else must have participated more hours than you.
    • The activity is a significant participation activity, and you participated in all other significant participation activities for more than 500 combined hours. You must have participated in the other significant activities for at least 100 hours and you didn’t materially participate under any of the material participation tests, other than this test.
    • You materially participated in the business activity for any 5 of the 10 last tax years. The 5 years don’t have to be consecutive.
    • The activity is a personal service activity in which you participated for any 3 preceding tax years. Personal service activities can be in the fields of health, law, engineering, accounting, consulting or any other businesses in which capital isn’t a income-producing factor.
    • You participated in the activity on a regular, continuous and substantial basis for at least 100 hours and no one else was paid for managing the activity or spent more time on it than you. This test is based on all the facts and circumstances of an activity.

    What Is An Example of a Passive Loss?

    An easy example to understand passive loss is looking at real estate investors. A real estate investor owns a rental house, which generated rental income of $10,000 for the tax year. 

    All deductions like interest, taxes and depreciation total up to $11,000. The income and deductions result in a $1,000 of passive loss, which can be applied against the ordinary income because of the Special $25,000 allowance. 

    If the passive loss resulted from any other business activity, the $1,000 loss would not be allowed in that year and would need to be carried forward to the next  tax year. 

    Summary

    The IRS established the passive activity loss rules and they are outlined in Section 469 of the Internal Revenue Code. The rules were created in part to help remove the possibility for investors to use passive losses to offset non-passive income, like regular wages. You’re only able to claim losses against the passive income earned from the specific passive activity. 

    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.

    Less Taxin'. More Relaxin'
    Sandra Habinger headshot

    Written by Sandra Habiger

    Sandra Habiger is a Certified Public Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Learn more about her work at http://www.sixfiguresaccounting.com/ .

    Sandra Habinger headshot

    Written by Sandra Habiger

    Sandra Habiger is a Certified Public Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Learn more about her work at http://www.sixfiguresaccounting.com/ .

    FAQs About Passive Activity Loss Rules

    How Much Passive Losses Can You Deduct?

    You can deduct passive losses to the extent of passive income. If you own a rental real estate, 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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