What is passive activity loss? It’s what happens when the sale of or expenses related to “passive” business activity exceed profit or revenue. So, the issue is defining passive. So, we have to start with what a passive activity is.
If a person owns a commercial property as part of their portfolio and that person is not involved in the business, upkeep, or use of the property, then that’s a passive activity.
That might be a lot of information to take in, especially if you’re not well-versed in passive activity. That’s okay. Let’s go one step at a time as we walk through what passive activity loss is, exactly, and how it impacts your tax situation as an investor or business owner.
A passive activity is a business activity that you don’t participate in actively.
Passive activity is not about how much money you’ve contributed to a project. Instead, it’s defined by the amount of time and effort you’re putting in. If you own a stake in a business but aren’t involved in the management on a regular basis, then as far as the Internal Revenue Service (IRS) is concerned, you’re a passive participant.
There are two types of passive activity, according to the IRS:
- Trade or business activities in which you don’t materially participate during the year.
- Rental activities, even if you do materially participate in them, unless you’re a real estate professional.¹
When those activities result in net losses, you’ve got passive activity loss. That’s different than selling investment property that you have an active role in at a loss; in that case, there are deductions and options available.
The IRS has rules on how and when these losses can be deducted.
If you engage in any passive activities, it’s important to understand how to deduct losses to maximize tax benefits and comply with tax regulations.
Nonpassive losses occur for active participants.
Nonpassive activities require you to participate “actively and materially.”² If you’re actively managing an LLC, running a sole proprietorship, or engaging in an S corporation’s operations, your activities are nonpassive.
There are six common sources of passive losses.
I mentioned earlier that the IRS has two broad types of passive activity. That’s true, but when we burrow down into the weeds, there are really six forms of passive losses you should be aware of.
1. Equipment leasing
If you lease equipment to others without actively managing the operation, losses from leasing are passive.
2. Real estate rental
If you’re a real estate professional or actively managing the property, then rental losses are active, as well as associated real estate taxes. If not, then losses will be considered passive and not open to deductions.
3. Limited partnerships
If you invest in a partnership but don’t participate in its day-to-day operations, then your income and losses are passive.
4. S corporations
Similarly, if you invest in an S corp without involving yourself materially, you may experience passive losses.
5. Limited liability companies (LLCs)
For an LLC member who isn’t actively involved in business operations, losses are passive.
6. Sole proprietorships
Lastly, for those of you with sole proprietorships who don’t materially participate — for example, you hired a manager to handle operations — your business losses are considered passive.
The IRS uses seven material participation tests.
You’ve seen the phrase “material participation” a few times now. But what does that mean specifically? The IRS uses a seven-step participation test to determine the active or passive status of an activity.
To be active, you must meet at least one of these criteria:
- You participated for more than 500 hours.
- Your activity substantially constituted all participation.
- You participated for more than 100 hours, and no less than any other individual.
- You participated in the activity, along with all significant participation activities, for more than 500 hours.
- You participated in the business or activity during any five of the preceding 10 taxable years.
- The activity is a personal service activity, and you participated in it for any three prior taxable years.
- You participated for more than 100 hours (based on all the facts and circumstances) on a regular, continuous, and substantial basis.¹
Losses not allowed in the current year are carried forward to future years.
In any given year, if your passive losses are greater than your passive income, you can’t deduct the excess right away. Instead, the IRS requires you to carry those losses forward to offset passive income in future years.³
Use IRS Form 8582 to claim passive losses.
Form 8582: Passive Activity Loss Limitations is where you’ll report passive activity losses for the current year and any carried forward from the previous year.
Follow these five steps to figure out your total passive losses on Form 8582.
Step 1: Identify all your passive income sources.
Step 2: Calculate your total expenses, including costs like mortgage interest, property taxes, maintenance, and any other deductible costs.
Step 3: Determine your net loss by subtracting the total passive activity expenses from total passive income.
Step 4: Document your losses.
Step 5: If your passive expenses exceed your passive income, you’ll have a passive activity loss to carry forward to future tax years.
Get a plan for more tax-efficient investment strategies.
If you have questions about anything in this article, schedule a discovery call with us today.
Talk soon,
Jeremy A. Johnson, CPA
References
- Internal Revenue Service. Publication 925 (2023), passive activity and at-risk rules [Internet]. Irs.gov. Available from: https://www.irs.gov/publications/p925
- Internal Revenue Service.Topic no. 425, Passive activities – Losses and credits. November 2024. [Internet]. Irs.gov. https://www.irs.gov/taxtopics/tc425
- Internal Revenue Service. Form 8582, Passive Activity Loss Limitations, December 2024. [Internet]. Irs.gov. https://www.irs.gov/forms-pubs/about-form-8582