Understanding Passive Loss Limitations

tax preparer helping client calculate passive loss limitations

A passive activity is defined as 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 Form1040), 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.

Determining Participation

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.”There are seven criteria the IRS uses to determine whether an activity qualifies as passive or not, but a simple gauge of participation is whether yourclient 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.

Calculating Passive Activity Loss

Passive activity loss is calculated by subtracting the sum of passive activity gross income and net active income from all allowable passive activity deductions.

Passive 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.

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 are allowed to 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 long, 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 Works

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.

https://www.irs.gov/publications/p925#en_US_2018_publink1000104582 [RR1]