Passive activity loss rules apply to:
IndividualsEstatesTrusts (other than grantor trusts)Personal service corporationsClosely held corporations
Passive activities fall into one of two basic categories: 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. 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.
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 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.
