A passive activity loss can occur when a business or individual is involved in a business activity, but not actively. If so, and the activity generates a loss, the business or person may be able to claim on their tax return a passive activity loss. This situation arises when:
- There is no material participation in the business activity during the tax year; or
- The business activity involves rentals.
Conversely, a business or person is judged an active investor in any of the following situations:
- At least 500 hours are spent in the activity per year
- All of the activity in the venture is by the business or person in question
- The business or person has materially engaged in the activity in at least five of the past 10 tax years
- There has been material participation by the investor in any of the preceding three tax years in a personal service business
- There have been as many hours of participation in the activity as by any other participant, as long as there were at least 100 hours of participation by the investor
Some additional rules that may have a bearing on the ability to use passive activity losses are:
- If the business or person is designated as a limited partner in an activity, then any participation is not considered to be material
- Such losses cannot be claimed by S corporations, partnerships, or grantor trusts
- Such losses can be claimed by closely-held C corporations, trusts, estates, individuals, and personal service corporations
When passive activity losses arise, they can only be used to offset corresponding amounts of passive activity gains. If, after such an offset, there is a residual credit, the credit can be rolled forward to the next tax year for offsetting against later passive activity gains. If the investor elects to liquidate the investment in the activity, then all remaining unused passive losses can be recognized at that time.
In general, the investor's use of a passive activity loss is limited to the grand total amount that the investor has at risk in an activity. Thus, if an investor's investment is $10,000, then that is the total amount of passive activity losses that can be offset against the investment.