Passive Losses
As a taxpayer you have many types of losses that you can deduct on your tax return. These losses can be in the form of capital losses, ordinary losses, casualty losses, and passive losses. Of these types of losses one of the most common is the passive loss and that is what is going to be discussed here.
What is a passive loss?
A passive loss is any loss from a business in which the taxpayer does not materially participate in the business. If the taxpayer does materially participate in the business then the loss is an active loss. Why the distinction between a passive loss and an active loss? The primary reason is that with a passive loss the loss can only be deducted and offset against passive income. However, there are exceptions to this rule which we will discuss later. An active loss can be completely deductible and does not have to offset by other types of income.
What is material participation?
There are six requirements in order to qualify for material participation. Any one of these requirements are acceptable in order to qualify:
1) Taxpayer must work at least 500 hours in the business for the year
2) Taxpayer can work at least 100 hours in the business but it is more than any of the other employees.
3) Taxpayer performs all of the work in the business. i.e. taxpayer has no employees and does all of the work.
4) If taxpayer materially participated in his business 5 out of the last 10 year then taxpayer would qualify.
5) If taxpayer participated in a personal service activity in the past three years then taxpayer would qualify.
6) If taxpayer has multiple businesses in which the total hours in all activities exceed 500 hours then the taxpayer would qualify.
Most taxpayers try to achieve one of these requirements so that they do not fall under the passive loss rules.
Rental real estate exception
There is an exception to the material participation rules as it relates to rental real estate. Taxpayer’s that have losses that are from rental real estate are always passive unless the taxpayer is considered a real estate professional. However, the losses from rental real estate can be deducted up to $25,000 per year and can be offset against all types of income. However, this loss is phased out as the taxpayer’s AGI exceeds $100,000 and is completely phased out once the taxpayer’s AGI exceeds $150,000.
What happens to unused losses?
Any passive losses that are not used in a tax year can be carried forward to future years. These losses can be deductible in future years if there is either offsetting passive income, the property is disposed of, or the AGI of the taxpayer drops below $150,000 in the case of rental real estate.
Conclusion
The bottom line with passive losses is that in most cases you want to satisfy the material participation rules so that the loss becomes active. With a little tax planning and adhering to the material participation rules there is chance that you can bypass the passive loss rules and have an active loss from your business.