Question: What’s a “passive activity” loss?
Answer: The complicated “passive activity rules” were created to curb a growing abuse by taxpayers who were using tax-shelter losses to offset ordinary income (wages, interest, dividends, etc.). Passive investments include real estate, limited partnerships, and other businesses in which a taxpayer doesn’t play an active role.
The rules create a tax “basket” for passive activities. The gains and losses from various passive activities are netted against each other. If the net result is a loss, the loss is generally suspended or carried forward to the next year where the process is repeated. In other words, the law generally eliminates the ability to offset ordinary income with passive losses until you dispose of an investment.
Question: What is a passive activity in tax law?
Answer: A passive activity is a business activity in which a taxpayer does not “materially participate.” So just what is “material participation”? In general, material participation requires a taxpayer to be involved in the operation of the activity on a regular, continuous, and substantial basis.
Any rental activity is generally a passive activity except for some very specific ones defined by a complicated calculation of hours spent in the activity. A limited partnership is generally considered to be a passive activity unless personal involvement meets a specified number of hours.
Proper tax planning dictates that you determine early on how your business activities will be viewed by the IRS. Passive activity losses cannot be deducted against regular or nonpassive income such as wages and dividends. These excess losses are suspended and carried forward to future years or until the property is sold.
