Passive Activity Loss Rules

Preface: Some would say that deducting tax losses from one business activity to offset income from another activity would be a great tax strategy. Not so fast, say the tax courts!

Passive Activity Loss Rules

Credit: Benuel B. Glick, EA

Do you own a business (or shares in a business) with minimal or no participation? Perhaps you own, or are considering to purchase, real estate or some other asset to lease out. If so, you may want to familiarize yourself with passive activity loss rules for strategic business and tax planning.

What is Considered a Passive Activity?
In IRC section 469(c), passive activity is defined as any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate. Section 469(c)(2) also says except as otherwise provided, the term “passive activity” includes any rental activity.

Why is This Part of the Tax Code?
Prior to 1986, a taxpayer could usually deduct losses in full from rental activities and businesses regardless of his or her participation. This gave rise to a significant number of tax shelters that allowed taxpayers to deduct non-economic losses against wages and investment income, thus the Tax Reform Act of 1986 added IRC 469 to the package. Section 469 limits the taxpayer’s ability to deduct losses from passive activities.

Passive or Non-Passive Activity?
A trade or business activity is not a passive activity if you “materially participated” in the activity during the tax year. According to IRS Publication 925, you materially participated in a trade or business activity for a tax year if you satisfy any of the following tests. There are other requirements for rental properties.

        • You participated in the activity for more than 500 hours.
        • Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
        • You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
        • The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests….
        • You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
        • The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.

Based on all the facts and circumstances you participated in the activity on a regular, continuous, and substantial basis during the year.

There are a few additional stipulations to the above list but in general, any work you do in connection with an activity in which you own an interest is treated as participation in the activity. Do not treat the work you do in connection with an activity as participation in the activity if both the work isn’t work that’s customarily done by the owner of that type of activity and, one of your main reasons for doing the work is to avoid the disallowance of any loss or credit from the activity under the passive activity rules.

Passive Activity Income and Loss
Passive activity income includes all income from passive activities and generally includes gain from disposition of an interest in a passive activity or property used in a passive activity. It is noteworthy that investment income, e.g. stocks, bonds, interest from financial institutions etc., is not classified as passive income.

Passive activity loss is the amount, if any, by which the aggregate losses from all passive activities for the taxable year, exceed the aggregate income from all passive activities for such year.

Active Participation for Real Estate
If you or your spouse actively participated in a passive rental real estate activity, provided you’re not a limited partner or less than 10% partner without regard to limited partners, there is a special provision that allows you to deduct up to $25,000 of loss against your non-passive activity income. This special allowance is an exception to the general rule disallowing the passive activity loss. Additionally, there is a phase-out rule based on your filing status and MAGI that limits or disallows this special allowance.

Not to be confused with material participation, the IRS says that you may be treated as actively participating if you make management decisions in a significant and genuine sense. Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

Activity Groupings
To add to the Section 469 complexities, it has a provision for “grouping” activities if they form an “appropriate economic unit.” This essentially says that if business A is appropriately connected to business B economically, you can elect to group these activities. This could potentially offset otherwise passive activity gains with non-passive losses. Unless the original election is obviously inappropriate, this election is permanent and should be considered carefully prior to making the election.

While Section 469 provides rules for passive activity losses, there are some strategies that can be employed by the prudent entrepreneur to efficiently maximize his or her business’s resources. One consideration might be grouping appropriate economic units. Yet another might be materially participating in the correct enterprise.

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