Passive Losses and Their Role in Your Tax Planning

If you are diving into the topic of passive activity losses (PALs) for tax purposes, you have likely been cautioned about being “passive” concerning an investment. This tax domain can seem complex, but let’s simplify it for better understanding. 

Background 

This area of taxation was established by the Tax Reform Act of 1986. There have been few changes to the law since then, so much of the guidance you have found has been generated from that law and the IRS regulations developed from it and subsequent court cases. 

What are Passive Activity Loss Rules? 

In general, the passive activity loss rules limit the deduction of losses from passive activities to offset the income generated from other passive activities. These rules apply to individuals, including partners and S corporation shareholders, trusts, estates, closely held C corporations and personal service corporations. This article emphasizes the rules related to individuals, trusts and estates. 

What Qualifies as a Passive Activity? 

A passive activity is an activity which involves the conduct of a trade or business in which the taxpayer does not materially participate. Rental activities are treated as per se passive activities by the regulations, except to the extent that the taxpayer is engaged in rental real estate activities as a materially participating real estate professional. The material participation rules and the related rules for a materially participating real estate professional can be quite detailed and are outside the scope of this article. To help you navigate this complex landscape, stay tuned for a detailed article in the coming months that will delve deeper into this topic. 

Material participation requires a taxpayer to be involved in the operations of the activity on a regular, continuous and substantial basis. Under the regulations, taxpayers will be treated as materially participating in an activity if they satisfy one of several “safe harbor” tests. Limited partners in limited partnerships are not generally treated as materially participating in an activity unless those limited partners satisfy specific material participation tests. 

What Happens if my Passive Losses Exceed my Passive Income? 

Losses from passive activities, to the extent that they exceed income from other passive activities, may not reduce nonpassive income such as salaries, wages, working interests, self-employment earnings, interest, dividends and other nonpassive investments. These excess passive activity losses are “suspended.” Suspended losses from a passive activity can reduce your passive income in future years and are allowed in full when the taxpayer disposes of the entire interest in the passive activity in a fully taxable transaction. 

Determining what constitutes an “activity” can be a key tax planning tip. The term “activity” refers to a method that assesses the facts and circumstances of one or multiple business or rental activities. If these activities form a suitable economic unit for measuring gain or loss, they are treated as a single activity. It is important for you and your tax advisor to review the pros and cons of keeping a passive business or rental property as a separate “activity” or combining two or more into one “activity.”  

Congress provided limited relief to moderate-income taxpayers who actively participate in rental real estate; allowing the use of up to $25,000 to offset nonpassive income. Taxpayers must meet various qualifications and stay under a maximum income level in addition to proving active participation in the rental activity. Given the intricacies and potential benefits, we will be releasing an article soon to delve deeper into the strategic opportunities arising from correctly defining your “activity” and the associated rules. 

Questions? 

Navigating the intricacies of passive activities and their tax implications can be challenging, but with the right guidance and understanding, you can make informed decisions to optimize your tax position. Tax services are not just about keeping in compliance with filing requirements; they are also about leveraging opportunities. An experienced tax advisor can help you not only understand the rules but also how to capitalize on them to your advantage. Whether it’s finding ways to utilize suspended losses or determining how best to categorize your investments, a proactive approach can yield significant benefits. Contact an Adams Brown advisor today to request a tax planning meeting.