Passive Activity Loss Rules by Karla Hopkins

The "passive activity loss rules" have developed into a complicated set of guidelines since their inception in the mid-1980s. However, if you keep in mind the general principles that drive loss limitations in this area, you will have a good foundation for selecting investment strategies that take full advantage of, rather than solely reacting to, the current tax rules.

A passive activity is one that involves the conduct of any trade or business in which the taxpayer does not materially participate. Any rental activity is a passive activity whether or not the taxpayer materially participates. However, there are special rules for real estate rental activities and real estate professionals.

Losses and credits that are attributable to limited partnership interests are generally treated as arising from a passive activity. However, losses from working interests in oil and gas property are not subject to the limitation.

Material Participation:
Generally, to be considered as materially participating in an activity during a tax year an individual must satisfy any one of the following tests:

(1) he participates more than 500 hours;
(2) his participation constitutes substantially all of the participation in the activity;
(3) he participates for more than 100 hours and this participation is not less than the participation of any other individual;
(4) the activity is a "significant participation activity" and his participation in all such activities exceeds 500 hours.  A significant participation activity is one in which the taxpayer participates more than 100 hours during the tax year but does not materially participate under any of the other six tests.
 (5) he materially participated in the activity for any five years of the 10 years that preceded the year in question;
(6) the activity is a "personal service activity" and he materially participated in the activity for any three years preceding the tax year in question;

or

(7) he satisfies a facts and circumstances test that requires him to show that he participated on a regular, continuous, and substantial basis.

How losses are deducted:
In most cases, losses from passive activities may not be deducted from other types of income (for example, wages, interest, or dividends). Therefore, to the extent that the total deductions from passive activities exceed the total income from these activities for the tax year, the excess (the passive activity loss) is not allowed as a deduction for that year.

Losses that are not deductible for a particular tax year because there is insufficient passive activity income to offset them (suspended losses) are carried forward indefinitely and are allowed as deductions against passive income in subsequent years. Unused suspended losses are allowed in full upon a fully taxable disposition of the taxpayer's entire interest in the activity.