What is a Passive Activity
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.
Renting property is considered a passive activity and income derived from a rental property is considered passive income. A rental property loss of income is considered a Passive Loss. Deductions for passive activities on real estate are limited. Rental losses can never exceed rental income with the exception of TWO exclusions.
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.
There are two kinds of passive activities defined by the IRS:
- 1. A “rental activity”, including both equipment and rental real estate, regardless of the level of participation.
- 2. A “trade or business activity” in which the taxpayer does not materially participate on a regular, continuous, and substantial basis.
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…).
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.