Passive Activity Loss Rules

The passive activity loss rules, enacted by Congress as part of the Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085.  The rules generally prohibit certain taxpayers from using losses and credits from passive activities to offset income from nonpassive activities. These disallowed losses and credits are suspended and carried forward to reduce passive activity income generated in future years. 

Luckily, these rules can often be avoided with advance tax planning.

What is a Passive Activity? 

A passive activity is any activity which involves the conduct of any trade or business in which the taxpayer does not materially participate.  It also includes any rental activity. 

Trade or Business with Material Participation

A trade or business includes any activity in connection with a trade or business or any investment activity.  These concepts are described in I.R.C. §§ 162 and 212 and court cases interpreting these Code sections.  

The term “material participation” means participating in an activity on a regular, continuous, and substantial basis.  The regulations, case law, and other guidance provide a framework of rules for determining whether this standard is met.

Rental Activity

Rental activities are also per se passive. Rental activities include activities where real or personal property is provided to customers to use in exchange for pay. This can include traditional rental activities, such as holding residential or commercial rental property for rent. It can also include other activities, such as equipment rentals.

The Exceptions

The Code includes several exceptions for activities that are not passive.  Working interests in an oil or gas property, trading activities, and rental real estate activities for a real estate professional are exceptions.  

What is a Passive Activity Loss?

The term “passive activity loss” means the amount by which the aggregate losses from all passive activities for the taxable year exceed the aggregate income from all passive activities for such year.  

Portfolio income and expense and gain or loss on the disposition of investment property that are not derived in the ordinary course of business are counted as losses or income for this purpose.  

Who is Subject to the Passive Activity Loss Rules?

Individuals, estates, and trusts; closely held C corporations; and personal service corporations are subject to the passive activity loss rules.  These rules are more nuanced than one might suspect.  

We Help With Passive Activity Losses

We are experienced tax attorneys in Houston, Texas.  We help taxpayers plan for and deal with passive activity losses and credits.

If you have a loss or credit that is limited by the passive activity loss rule, we want to hear from you.  Contact us to schedule an appointment with our tax attorneys to discuss your options.

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