Depending on the type of business ventures you are engaged in, the passive activity loss rules may or may not apply to your earnings. It is important to know the difference between passive and nonpassive income and see if these rules apply to you.
The rules that apply to passive activities say that you can’t deduct any expenses generated by those activities that exceed their income. In other words, you can’t take losses against earned income or other passive income if those losses are the result of passive activity. Nonpassive income includes interests, dividends, annuities, gains and losses from property disposition, royalties, and income from certain oil and gas property interest. You also can’t deduct passive losses against those types of income.
Instead, any losses from passive income are carried forward to tax years in which your passive activities generate enough to erase those losses. If passive losses aren’t used up, you can claim them in the tax year in which you cease the passive activity or the year in which you die.
Passive vs. material
Activities are deemed passive if you don't materially participate in them. These activities can be trades, businesses, or other activities that generate income. They also apply to items you acquire through partnerships in or S corporations in which you participate as a shareholder. In other words, S corporation or partnership losses that pass to you are considered passive unless you materially participate in those activities.
Here’s an example. If you are a partner in a small business in addition to your regular professional job but don't materially participate in that partnership, these activities are passive. Material participation means participating in business operations on a regular, continuous, and substantial basis.
The most frequent test the IRS uses to determine material participation says if you participate in an activity for more than 500 hours per tax year, you materially participate in it. Other tests require fewer hours, but require you to record the nature and time expenditure of your participation. This can be recorded in appointment books, time logs, or calendars.
Rental activities
Rental activities are always considered passive, meaning that you can’t deduct the losses against your earned income. There exceptions are
- Losses of up to $25,000 if you actively participate in the activities and your adjusted gross income doesn’t exceed specified levels.
- Losses If you qualify as a real estate professional. In this case, rental real estate activities aren’t automatically treated as passive.
Contact us to find out how these rules might apply to you.