In the broadest of terms, passive activity rules govern the annual reporting of certain taxpayers’ income and loss activity associated with certain limited work activities. Passive activity rules were established in an effort to curb tax sheltering. Individuals, corporations, and real estate professionals are among the rules’ targeted sectors, and each group has its own tax planning and compliance considerations. So, what’s the first general rule in tax reporting across industry sectors? Passive losses can only be used to offset other forms of passive income; any excess remaining passive losses are carried forward to be used against future passive income.
Who’s affected by these rules?
Individuals, Trusts (Except Grantor Trusts), & Estates
- Passive activity rules also apply to entity owners in their grantor, partner, or shareholder capacities (even though grantor trusts, partnerships, and S corporations aren’t directly subject to the rules).
- Taxpayers with passive income and losses held through a publicly traded partnership (the rules are applied separately here).
Personal Service Corporations
- If one or more shareholders, holding more than 50% by value of the outstanding stock, materially participate in the activity.
Closely Held Corporations
- If one or more shareholders, holding more than 50% by value of the outstanding stock, materially participate in the activity.
Passive activity rules apply to you if you fall in one of the categories above and were involved in a trade or business activity that generally allows for tax deductions, but you didn’t meet the standards for material participation. These rules also apply if you were involved in rental activities in any capacity, other than those you actively participated in as a “qualified real estate professional.” I’ll revisit that a little later.
How do I know if my participation was material?
Passive activity rules are based on “material participation.” The IRS has seven material participation tests available to determine whether your involvement in activity operations was “on a regular, continuous, and substantial basis.” If you meet any one test, you’re considered nonpassive, meaning your income and losses associated with that business activity generally cannot be offset by deductions generated by passive activity income or losses.
So, what’s the good news?
Taxpayers qualifying as passive investors may use passive real estate losses to offset passive income. However, for qualified real estate professionals, 100% of real estate losses may be deducted against ordinary income. If you can’t meet the stringent criteria to be a real estate professional, but can qualify as active, then you may deduct up to $25,000 in losses for the year against ordinary income, up to $100,000 of AGI if filing single, or up to $150,000 if filing as married filing jointly.
If your passive losses ultimately exceed your passive income, they are suspended rather than deducted in the current tax year. This suspension of losses does not have an expiration date. So, if you have a carryover of passive losses, they may be deducted against your passive activity income in future years.
Suspended passive activity losses are released in the year of disposal of the property or business that generated the passive loss. And, if the disposal was made to an unrelated party through a fully taxable transaction, you may deduct any loss on the disposition and the current and suspended passive activity losses generated by that activity.
Do you understand where you fall on the spectrum for material participation? What about your capacity as a qualified real estate professional or a passive or active investor? Passive activity rules bring about a number of complexities and considerations. We regularly advise clients in this area, and we can help you too.
Contact LGA
Are you taking full advantage of passive activity loss deductions and forestalling issues leading to noncompliance? Our team is here to help you implement strategies designed to minimize the tax impact of passive activity rules and maximize your success. To learn more, or to discuss your real estate professional or owner managed business strategy, contact me today.
Donna Martin, CPA is a tax manager at LGA. She has over 23 years of experience working with family and owner managed business. In addition to assisting clients with their annual tax compliance, both at the corporate level and individually, she is a resource to clients all year for business decisions, tax planning and strategies on the effect on their business.
