This article deals with the nuts and bolts of passive activities and specifically the deductibility of their losses. This is a subject that should be important to people because more and more individuals have investments that qualify as passive activities, and as such could use an introduction into what they are, how their losses are limited, and how to report their gains or losses on a tax return.
First, passive activities are not capital gains, dividends, interest, wages, salaries, tips, or Schedule C or other active business income. So, what are passive activities? Passive activities can be thought of as investments that are in business and real estate in which your only role is one of an investor, as opposed to an owner that also provides significant work, direction, and management to that company. For example, if you are a shareholder in an S corporation and you don’t provide any labor or guidance to that company, then you are almost certainly a passive investor, and therefore from a tax perspective that S corporation is a passive activity to you.
Now let me clarify. If the income that you receive from a company that you are invested in but don’t work for is specifically deemed a certain kind of income categorically, then that’s what it is. I know how vague that sounds, but here’s my point, dividends are not passive activities, neither are capital gain distributions from S corporations. These examples hold true even if the activity is passive from a colloquial perspective, meaning that you don’t actively participate in the labor or management of the company. So if you receive a Schedule K-1 that has amount in box 5a, qualified dividends, then those are unequivocally dividends. Same example, if there’s an amount in box 8a, net long term capital gain (loss), then that’s a long-term capital gain or loss. The point is, if income is labeled as something that is by definition not a passive activity, then take that designation for granted because it has nothing to do with passive activities, as that term is defined in the tax code.
Generally, passive activity losses can only be deducted to the extent that they are not greater than passive activity gains. These are the passive activity loss limitation rules. For example, if in a given tax year you had passive activity gains of $5,000 from Investment A, but Investment B spun off a $2,000 loss in your direction, then under passive activity loss limitation rules, the $2,000 loss is completely deductible because it is overshadowed by gains. In other words gains are greater than losses, so losses are completely deductible. If it were the other way around, and the loss was $5,000 and the gain was $2,000, then only $2,000 of the loss would be deductible because passive activity losses are only deductible to the extent of gains in any given year. But all losses not allowed in the current year are carried forward and deductible in future years where there are passive activity gains to soak up.
Let’s take note of residential real estate in the context of passive activities. Traditionally, residential rental activity is considered a passive activity, regardless of whether you do all the work in managing your rental home, and as a result, the passive activity loss limitation rules would apply. However, there is an exception where you can deduct up to $25,000 if you actively participate in your residential real estate activities. What is active participation? Well, it basically means that you are making core decisions pertaining to the rental property, such as deciding who rents the property or deciding what companies you hire to perform the maintenance work.
Despite the general rule limiting passive activity losses, if you actively participate in your residential rental real estate activity, then you can deduct up to $25,000 of net losses generated from such enterprise. Notice that the loss exception only exists in the context of residential rental property, and not other passive activity losses, and it’s worth keeping that straight. Also, before you get too excited here, the $25,000 net loss exception does phase out using the following formula: one half of the difference between modified adjusted gross income and $100,000, then subtract this difference from $25,000. Used in an example, if my modified adjusted gross income is $112,000, then the phase out formula would look something like this: $25,000 – [.5($112,000 – $100,000)] = $19,000. Therefore, the deduction for active participation in the rental activity would be available to me up to a $19,000 net loss, when I have a modified adjusted gross income of $112,000.
There’s another exception, sort of. I say sort of because as you’ve probably surmised passive activities never include an occupation that you actively work at. In this vein however, if you are a real estate professional, then your losses associated with your investment in residential rental property are not limited, assuming you materially participate in the activity, meaning you manage or do labor for your rental property to a significant extent. The definition of significant in this context varies, but 500 hours of management/labor for the year regardless, or at least 100 hours of management/labor as long as someone you’ve hired with no ownership interest in the property didn’t work in your rental business more.
Parts I, II, and III of Schedule E are where you report passive income, both gains and losses. However, keep track of and figure the deductibility of passive activity losses on Form 8582, Passive Activity Loss Limitations.
Be careful. There are also at-risk and basis rules that generally apply before passive activity loss rules. While these other rules are outside the scope of this post, suffice it to say that if you’re having problems with this topic, it’s best to seek the help of a tax professional. That tax professional can be me at Dino Tax Co, so give me a call today at (713) 397-4678 or email firstname.lastname@example.org. The first phone consultation is always free. Also, like Dino Tax Co on Facebook here.