FAQ: What are passive losses?

Individuals, trusts, estates, personal service corporations and closely held C corporations may only deduct passive activities losses from passive activity income. The rules do not apply to S corporations and partnerships but do apply to their respective shareholders and partners. In general, limited partners are not deemed to materially participate in partnership activities. Thus, a limited partner’s share of partnership income is passive income. However, general partners or acting general partners may hold limited partnership interests and materially participate in the partnership.

Closely held C corporations and personal service corporations are treated as materially participating in an activity if shareholders owning 50 percent or more by the value of the outstanding stock materially participate in the activity. Closely held C corporations can also satisfy the material participation standard under an alternative rule based on the participation of full-time employees in the activity.

A passive activity is any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate. Passive activities generally include rental activities, regardless of whether the taxpayer materially participates in the activity. A taxpayer’s rental real estate activity is not a passive activity, however, if the taxpayer (1) materially participates in the activity, and (2) performs qualifying services in real property trades or businesses. A facts and circumstances test applies in determining whether other activities are combined or treated as separate for purposes of the passive loss rules.

Individuals who own and actively participate in the management of rental real estate may offset up to $25,000 of passive activity loss from rental real estate against active income in any tax year. The offset amount is reduced by 50 percent of the amount by which the taxpayer’s adjusted gross income exceeds $100,000, phasing out completely at $150,000 of adjusted gross income. More liberal rules apply to the offset of rehabilitation and low-income housing credits.

Deductions and credits that are disallowed under passive activity rules may be carried forward and used as passive activity deductions and credits in succeeding years. Remaining passive activity deductions are deductible against nonpassive income when the taxpayer disposes of the passive activity. Passive activity credits may only be applied to taxes on passive income.

A major exception to the definition of a passive activity is a working interest in any oil and gas property that the taxpayer holds directly or through an entity that does not limit the taxpayer’s liability for the interest, regardless of whether the taxpayer materially participates in the activity.

A taxpayer’s passive activity loss for the tax year is disallowed and is carried forward until the taxpayer has available passive activity income. Passive activity loss is the amount by which passive activity deductions from all passive activities exceed passive activity gross income from all passive activities for the tax year.

For more on passive activity losses, please contact our office.

Written by

Steve Moss, CPA is a partner at Holden Moss CPAs and loves helping businesses and their owners grow to be the very best they can be. Our other offices include Raleigh, Oxford and Warrenton. We are a little different at Holden Moss CPAs. While we still provide traditional tax and accounting services, years ago we realized many clients wanted help in running their businesses and were hungry for ideas, solutions, strategy, and execution. In response, we expanded our skill set and joined Ran One, a global network of business consulting firms. Our membership with Ran One gives us access to proprietary resources and analytical software to help our clients grow, become more profitable and valuable, and have the lifestyle they desire. Now, blended into the fabric of our normal tax and accounting needs, we are focused on our clients’ businesses in a very different way. While our approach is not right for everyone, for those whom it is, incredible results may be obtained. Whether you have a new, or established, business, or for those in transition of selling or retiring, or for those who simply need to develop an exit strategy or succession plan, our unique approach to client service may be the edge you need.

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