Passive Activity Losses

In general, deductions from a passive trade or business activity may not be deducted from other income for the tax year to the extent that the deductions exceed income from all such passive activities. The effect of this rule is to prohibit the offsetting of passive losses against income that can be termed "nonpassive," such as compensation for services, portfolio income (interest, dividends, royalties, and gain from the sale of property held for investment), and income from a trade or business in which you materially participate.

Deductions from a passive trade or business activities for the tax year that exceed the passive activity income—the "passive activity loss"—is "suspended" and carried forward to reduce passive activity income generated in future years.

There are two kinds of passive activities:

• trade or business activities in which you do not materially participate during the year; and
• rental activities, even if you do materially participate in them, with two exceptions.

The following are not considered rental activity and, therefore, are not subject to the passive activity loss rules:

• The average period of customer use of the property is 7 days or less.
• The average period of customer use of the property is 30 days or less and you provide significant personal services with the rentals (such as cooking meals or cleaning the space that is rented, not the common areas).
• You provide extraordinary personal services in making the rental property available for customer use.
• The rental is incidental to holding the property in order to realize a gain from its appreciation or for use in a trade or business (other than property rental) and the gross rental income from the property is less than 2 percent of the smaller of the property's unadjusted basis or fair market value.
• You customarily make the rental property available during defined business hours for nonexclusive use by various customers.
• You provide the property for use in a nonrental activity in your capacity as an owner of an interest in the partnership, S corporation, or joint venture conducting that activity.

The following are two exceptions to the loss disallowance rule for rental activities:

1. rental real estate losses up to $25,000 may be deducted in full for taxpayers with modified adjusted gross income less than $100,000; and
2. qualifying real estate professionals may be able to deduct all current real estate losses.

Special $25,000 allowance. Although all real estate losses are considered passive losses and, therefore, deductible only to the extent of passive activity income, there is a special break if you actively participated in the rental activity.

Active Participation. "Active participation" means that you have significant participation in making management decisions or arranging for others to provide services. These management decisions might include approving new tenants, deciding on rental rates and terms, and approving capital or repair expenditures. But the determination of whether a taxpayer actively participates in the management of a trade or business depends on the facts and circumstances of each case. However, you're not considered to have "actively participated" if you own less than 10 percent of the property.

If you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000 of loss from the activity from your nonpassive income. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception. If you are married and file a separate return, your losses are limited either to $12,500 if you lived apart from your spouse for the entire year, or to $0 if you lived with your spouse at any time during the year.

If you have more passive losses from real estate than you have passive income, your deduction of $25,000 will shrink as your AGI rises. You'll lose $1 of the deduction for every $2 that your AGI rises above $100,000; if your modified AGI is $150,000 or more, you can't deduct any excess passive losses this year.

"Modified AGI" means your AGI as shown on Form 1040, Line 37, without taking into account any passive activity losses, taxable Social Security benefits, deductible IRA contributions, the deduction for one-half the self-employment tax, and the exclusion for amounts received under an employer's adoption assistance program. Also, if you filed Form 8815, Exclusion of Interest from Qualified U.S. Savings Bonds, you must add back the savings bond interest excluded on Line 14 of that form.

If your losses are limited under any of these rules, you must complete Form 8582, Passive Activity Loss Limitations. The allowed loss, if any, shown on the bottom of Form 8582 is transferred to Line 23 of Schedule E.

Planning Tools You can download Form 8582 and Schedule E to aid in your financial planning.

Losses that cannot be deducted in the current year are carried over to later years until they can be offset by passive income, until you can use the special $25,000 deduction, or until you sell your entire interest in the property to an unrelated third party.

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