Let’s say you’ve dipped your toe into the real estate game and flipped a house. Instead of making a killing on it, you took a big financial hit. When tax time comes around, can you take that loss against your regular income to reduce your taxes?
Generally, no. That’s because of passive activity loss rules.
In short, passive activity loss rules are anti-tax shelter rules. They prohibit taxpayers from using financial losses from passive activity to offset active income and thereby reduce their taxable income and pay less in taxes.
If you own rental property or are otherwise involved in any passive activity trade or business, you need to know about passive activity loss rules. We’ll look at these rules more closely along with the important definitions and exceptions you should know.
Passive Activity Loss Rules: Definitions and Overview
Below is a summary of some key points of the passive activity loss rules along with definition of terms (in bold). Note that this blog is not intended to be exhaustive, but just to familiarize you with the topic. We’ll be discussing rules from the IRS, specifically Topic No. 425 and Publication 925 (2021), which are derived from 26 U.S. Code § 469. The IRS rules are detailed and contain multiple exceptions, which we won’t go into here, as this is an overview. If you believe you’re subject to passive activity loss rules, speak with an accountant to help you with your taxes.
Passive activity loss rules prohibit a taxpayer from taking a deduction of losses incurred from passive activity to offset active (ordinary/earned) income.
While passive activity losses can’t be used to offset active income, they can be used to offset passive activity income. Losses that exceed passive activity gains in the same year can be carried over to the following tax year.
Passive activity rules apply to:
- Individuals
- Estates
- Trusts (other than grantor trusts)
- Personal service corporations, and
- Closely held corporations
The IRS notes that grantor trusts, partnerships, and S corporations are not directly subject to these rules, but the individuals who own them are.
Active income includes wages, salaries, commissions, and any other income “that comes from performing a service.” This is the money you make from your job or business, whether you’re a W2 employee, 1099 contractor, or business owner actively involved in your business.
In contrast, passive income is income from a passive activity in which you’re not “materially” involved. The IRS defines two kinds of passive activity: 1) rental activities, and 2) trade or business activities the taxpayer did not actively contribute to.
Material participation means being involved in the business activity on a “regular, continuous, and substantial basis.” The IRS lays out seven “material participation tests” to help determine whether involvement is passive or active. The taxpayer only needs to satisfy one of the seven for their participation to be considered material and thus not have the activity considered “passive.”
To see all seven tests, go to IRS Publication 925, linked above; here are three:
- Participation in the activity for more than 500 hours in the tax year
- Participation in the activity for more than 100 hours in the tax year, and at least as much as any other individual (including individuals who don’t own any interest in the activity)
- “Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year”
These material participation tests do not apply to rental activity (discussed below) or to working interests in oil and gas property, which have separate rules.
Active participation is a lower standard to meet than “material” participation. For example, taking decisions with regard to management of the business activity would qualify as active participation.
Passive Activity and Rental Activities
If you earn income from a rental property, then you know that it only takes a few major repairs or renovations or a couple months without tenants to put you in the red for the year.
That’s where passive activity loss rule comes in. These rules apply to you because the income from your rental property is considered passive activity, even if you are “materially” involved in the activity, as described above – unless you are a real estate professional.
To be considered real estate professional by the IRS, you must meet both of the following requirements:
- “More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.”
- “You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.”
Under the IRS’s definition, you do not need to be a licensed real estate agent, contractor, or other certified real estate professional to meet these requirements. Conversely, the IRS definition means that some people who are licensed in the field, like a part-time real estate agent, would not be considered a real estate professional, and their rental activity would be considered passive.
Real property trades or businesses include not only renting out a real property, but development, construction, acquisition, management, and more.
Special $25,000 allowance
If you are not a real estate professional, then your income is considered passive. Any loss you derive from rental activities may be “trapped” (meaning, you can’t take the loss on your taxes) unless you can offset gains from other passive activities – most of the time.
But there is one big exception to know about. The IRS allows up to $25,000 in passive losses to be used to offset ordinary income such as salary or wages as long as you are “actively participating.” In this specific context, active participation may include things like determining rental terms, approving new tenants, and making repairs or hiring someone to do them.
The full amount up to $25,000 is available for taxpayers whose modified adjusted gross income (MAGI) is $100,000 or less. It begins to phase out above a MAGI of $100,000 and is completely phased out at a MAGI of $150,000, meaning that you cannot offset any ordinary income from passive losses if your MAGI is over $150,000.
There are several facets to this special allowance that we won’t go into here, including different allowance amounts depending on filing status and exceptions to the phaseout rules; again, read more on IRS.gov for more detail.
Estate Planning and Trusts
Passive activity loss rules apply to trusts and estates, too. Remember to work with an accountant if you have questions about how passive activity loss rules affect your taxes. If you have questions about trusts and estate planning, or are the personal representative of someone who recently died and need advice, call estate planning attorney Gem McDowell.
Gem and his team at the Gem McDowell Law Group help individuals and families in South Carolina with trusts, wills, powers of attorney, and other estate planning documents to ensure they’re in control of their assets now and in the future. Call Gem and his team at his Mt. Pleasant office at 843-284-1021 today to schedule your free consultation.
