Definition
A passive activity is one in which you do not physically participate
in.  Examples of passive activities are renting out a house,
investing in a partnership where other people do the work, or
owning a farm where someone else plants the crops.  Special rules
apply to whatever your earn, or lose, in these passive activities. 


Passive Activity Background
The IRS passive activity laws were intended to discourage
tax-shelter investments, but their reach goes beyond tax shelters to
cover all real estate investors and persons who invest in businesses
as "silent partners" or who are not involved full time in the business.

The passive activity rules prevent an investor from deducting a
passive "loss" from salary, self-employment income, dividends,
sales of investment property, interest, or retirement income.  Such
losses are deductible only from income from other passive activities.


Passive Activities
There are two kinds of passive activities defined by the IRS:

Passive Income / Passive Loss
In general, all rental activities are passive activities. 
Deductions for losses from passive activities is limited.  If
rental expenses exceed rental income, the resulting loss is subject
to passive activity loss restrictions.  The amount of rental loss that
exceeds rental income is not deductible for the current year; it can
be carried forward to the next tax year though.  You cannot deduct
rental losses against other non-passive income either.  Examples
of non-passive income would be earned income (income from your
job) and portfolio income (dividend payments, interest payments,
profits on the sale of investment property, etc...).


Rental Activities
A rental activity is a passive activity even if you materially participated
in that activity, unless you materially participated as a real estate
professional (see below).  An activity is a rental activity if tangible
property is used by customers or held for use by customers, and the
gross income (or expected gross income) from the activity represents
amounts paid (or to be paid) mainly for the use of the property.  It
does not matter whether the use is under a lease, a service contract,
or some other arrangement.


Exceptions to Passive Activity Loss
There are two exceptions to this passive activity loss limitation. 
The exceptions apply in the following scenarios:

Passive Loss Limit
If you meet the "real estate professional" exception, there is no
limit to the amount of losses you can deduct.  The real estate
losses are deductible against any other form of income.

If you meet the "material participation" requirements you may
deduct up to $25,000 of loss from your non-passive income.  This
amount is phased out, however, if your modified adjusted gross
income is between $100,000 and $150,000. 

To see examples of the phaseout limit, click here.





Click here to leave passive activity and return to rental
property main