Navigating the complex landscape of passive activity loss limitations requires a clear understanding of passive loss rules. To help your clients optimize their tax planning and investments, you’ll need to know what types of activities qualify as passive, the income limit for passive losses, and strategies to mitigate their impact.
What is passive activity loss?
A passive activity is any business or trade in which an investor is not a material participant. Passive activities also include rental real estate activity, even when the owner materially participates, unless they are a real estate professional.
The classification of whether income or loss is from a passive activity is determined at the taxpayer level. This means that individuals (on Form 1040), C-Corporations (on Form 1120), and estates and trusts (on Form 1041) must make this determination. In the case of a Partnership, LLC, or S-Corporation, an activity may be passive for one partner, but the same activity may be considered non-passive for another.
See how to enter Form 8582, Passive Activity Loss Limitations in the TaxSlayer Pro program.
Who qualifies for participation in passive loss?
According to the IRS, an income-producing activity is passive if an investor is not involved in the operation on a “regular, continuous, and substantial basis.”
The IRS uses seven criteria to determine whether an activity qualifies as passive or not, but a simple gauge of participation is whether your client worked more than 500 hours in the business during the year, or they worked 100 or more hours and shared equal responsibility with another individual. The complete list of material participation tests can be found on the IRS website here.
How to calculate passive activity loss
Passive activity loss is calculated by subtracting the sum of passive activity gross income and net active income from all passive activity expenses.
For example, if you have a rental property that generates $50,000 in rental income but incurs $70,000 in expenses, which might include mortgage interest, property taxes, repairs, and management fees, your passive activity loss for the year would be $20,000. This loss can be carried forward to offset future passive income.
Passive activity loss limitations
Passive activity losses can only be used to offset passive activity income. They cannot be used to reduce your client’s ordinary or earned income. Consequently, passive loss is generally disallowed as a deduction on a tax return.
If your client can’t deduct a passive loss for the tax year because they have not earned enough passive income to offset it, the loss can be carried forward until it is used or until the investment responsible for generating the loss is sold. The loss cannot, however, be carried back and applied to prior tax years.
What are the exceptions to passive activity loss rules?
While passive activity losses are generally limited to offsetting passive income, there are a few exceptions where these losses can be deducted against other types of income:
- If your client materially participates in a passive activity, they can deduct passive losses against other types of income.
- If your client engages in certain real estate activities, such as rental real estate, they may qualify for special exceptions that allow them to deduct passive losses against other income.
- If your client has started a new business, they may be able to deduct passive losses against other income, subject to certain conditions and limitations.
Your client can also deduct passive losses from farming against other income, subject to certain rules.
Leverage the special allowance for rental real estate activities
If your client or their spouse is an active participant in rental activity (and neither is a real estate professional), the couple can deduct up to $25,000 of loss related to that activity from their non-passive income. That allowance is reduced if their modified adjusted gross income is $100,000 or more and phases out completely when MAGI exceeds $150,000.
If your client is married filing separately and lives apart from their spouse all year , they may deduct $12,500 of loss from the rental activity. The allowance is reduced if their MAGI is $50,000, and it phases out entirely if their income is $75,000 or more.
How the special allowance for rental real estate activities works
Example: Your client earned $75,000 in wages (active income) and $20,000 from an S-Corp where she was invested but not materially involved (passive income). She also incurred a $25,000 loss from real estate rentals (passive income). She can use $20,000 of loss to offset the $20,000 she earned from the S-Corp. And because she is actively involved in her real estate venture, she can use the remaining $5,000 to reduce her wage income.
Use carryforward of passive losses
Carryforward passive losses can help you optimize your client’s tax planning, allowing you to strategically use losses to offset future passive income and reduce your client’s overall tax liability.
How many years can you carry over passive losses?
You can generally carry passive losses forward indefinitely until they are offset by passive income. This means that if your client has a passive loss in one year, they can carry it forward to offset passive income in future years. However, you cannot use passive losses to offset capital gains, wages, retirement, or investment income.
Passive loss limitation FAQs
Can I deduct passive losses against my active income?
No, passive loss activity rules typically limit use of passive losses to offset passive income. However, there are exceptions for certain individuals and activities.
Can I carry forward passive losses indefinitely?
Yes, you can carry forward passive losses indefinitely until they offset passive income. However, there is an income limit for passive losses.
What is the at-risk rule for passive losses?
The at-risk rule limits your deduction of passive losses to the amount of your at-risk investment in the activity. This means you can only deduct losses up to the amount of money you’ve personally invested in the activity.
Can passive losses offset capital gains?
Generally, passive losses cannot be used to offset capital gains. Passive losses are typically limited to offsetting passive income. However, there are exceptions for certain types of passive activities, such as rental real estate.
What is the income limit for passive losses?
There is no specific income limit for passive losses. However, the amount of passive losses you can deduct against other types of income may be limited based on your overall income level. If your adjusted gross income exceeds certain thresholds, your ability to deduct passive losses may be restricted.
How do you free up passive losses?
To “free up” passive losses means to offset them against other types of income. This allows your client to reduce their overall tax liability. However, there are limitations and rules governing the types of income one can offset with passive losses.
What are the passive loss limitations for married filing jointly?
The passive loss activity limitations for married filing jointly taxpayers can vary based on their income level. If your client’s adjusted gross income (AGI) exceeds certain thresholds, the amount of passive losses they can deduct against other types of income may be restricted.
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