Passive Activity Losses

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Many individuals and some businesses passively participate in business activities that result in income or losses. They can claim passive activity losses on their tax returns based on these financial results. Passive participation is defined as having a trade or business activity in which one does not materially participate during the tax year, or participating in a rental activity (even if there is evidence of a substantial level of activity in the venture). One is considered to be an active investor if any of the following tests are true:

One annually expends more than 500 hours of participation in the activity.
One’s participation comprises essentially all of the activity for a business.
More than 100 hours of annual participation, which was at least as much as any other participant in the business.
Materially participated in the business in any five of the last ten tax years.
Materially participated in a personal service business for any three previous tax years.

A limited partner is generally not considered to be materially involved in a business. A closely held corporation or a personal service corporation is considered to materially participate in a business if shareholders owning more than 50% of the corporation’s shares materially engage in the business. Also, an investing entity is considered to be materially engaged in a business if it has an interest in an oil or gas well that is held directly or through an entity that does not reduce its liability.

Passive activity losses can only be claimed by individuals, estates, trusts, personal service corporations, and closely held “C” corporations. Conversely, passive activity losses cannot be claimed by grantor trusts, partnerships, and “S” corporations.

If passive activity losses have occurred, they can only be offset against passive activity gains. Activities that are defined by the IRS as not passive are gains on sale of property that has not been used in a passive activity, investment income, and personal services income. If there is an excess credit from a passive loss after all offsets have been made against passive income, then the credit can be carried forward to the next tax year for a later offset. However, all passive losses that are carried forward can be recognized at the time when the passive investor liquidates the investment.

The total amount of a passive loss will be limited to the total amount to which a passive investor is at risk. For example, if an entity invests $1,000 in a business venture, then it is only at risk for $1,000, and cannot deduct more than that amount under any circumstances as a passive loss.