Passive Activity Loss Rules

In the realm of real estate, there are many property owners, particularly rental property owners, who incur losses as per tax regulations. Many activities, such as renting out a property, are covered under the definition of a passive activity.

The loss in passive activities is a recurring phenomenon due to the use of different operating expenses and depreciation. Earlier, many high-income individuals used passive activity losses to reduce their tax liabilities. To prevent the misuse of losses incurred from passive activities, the IRS has set out specific rules. These rules are known as the Passive Activity Loss Rules. The rules got first introduced in the US in the year 1986.

What is Passive Activity?

Passive activity means an activity undertaken with the motive of investing money in a venture without material participation in its day-to-day operations throughout a tax year. As per the IRS, Material Participation means being involved in the operations of a business or trade in a regular, continuous, and substantial manner.

IRS has defined Passive Activities as activities that include:

  • Trade or business where a taxpayer is not actively involved on a regular, continuous, and substantial basis
  • Rental activities

Many people who invest in real estate do not actively play a role in the frequent buying and selling of their properties. Hence, many investments in the real estate sector are a passive investment.

What is Passive Loss (PAL)?

Loss from passive activity refers to the case where the amount of passive activity deductions during a tax year is greater than the passive activity gross income. A special allowance may be available to reduce the amount of loss from passive activities. In most cases, passive activity loss or PAL is not allowed against regular income. However, there are certain exceptions.

What are the different types of Passive Activities?

The term “passive activities” covers activities related to inactive businesses and rental properties. It covers:

  1. Renting out real estate properties
  2. Equipment Leasing
  3. Any Sole proprietorships or farms where there is no material participation from the taxpayer
  4. Any partnerships, limited liability companies, S-corporations without any material participation of the taxpayer in a given tax year

What is the meaning of Passive Activity Loss Rules?

Passive Activity Loss Rules refer to the set of rules which the IRS has introduced to govern the process of setting of passive activity losses of a taxpayer against the income earned. They aim to discourage economic activities considered as a tax shelter. It disallows the offset of passive losses against ordinary earnings of a taxpayer.

Who is covered under the provision of the Passive Activity Loss Rules?

As per the IRS’s tax regulations, the passive activity loss rules apply to the following persons:

  1. Individuals
  2. Estates
  3. All Trusts (excluding the Grantor Trusts)
  4. Closely Held Corporations
  5. Personal Service Corporations

Special allowance of $25000 for passive activity losses

IRS has specified exceptional cases where the passive activity losses can be set off. There is the availability of a special allowance of $25000.

It is allowed in situations where the individual or his spouse actively participated in a passive activity related to renting real estate property. Due to the special allowance, the passive activity loss that is disallowed gets reduced to a maximum of $25000. Hence, a taxpayer who satisfies the special allowance conditions can set off a loss of up to $25000 from his non-passive income. At the same time, a person can even offset credits from the passive activity against tax payable till the limit of $25000 of non-passive income after considering the losses allowed as per special allowance.

A passive activity credit showcases the amount by which the total of all credits which fall under the passive activity rules exceed the regular tax liability attributable to the passive activities in the given tax year.

Only half of the special allowance is available to a married individual who files a separate tax return and is living apart from his spouse throughout the tax year. Such a person cannot offset more than $12500 of his passive activity losses.

However, a person who lived with his spouse at any point in the tax year, but files a separate tax return will remain ineligible from using the entire special allowance of $25000. He cannot reduce any amount of taxable non-passive income or lower the tax liability payable on his non-passive income.

In the case where the Modified Adjusted Gross income exceeds the specified limits and is subject to phase out, the maximum amount of special allowance available will fall below $25000.

Passive Activity Deduction

A person can avail of a passive activity deduction only if the deduction falls in any of the two criteria in a taxable year:

  1. It arises due to the conduct of a passive activity in the given tax year, or
  2. The deduction is available for the given tax year as it was disallowed in the preceding year and is brought forward in the current tax year. Disallowance is a result of the applicability of Passive Activity Loss rules.

Which Tax Form is used for the determination of Passive Activity Loss?

IRS has brought the Form 8582 for non-corporate taxpayers to enable them to estimate the amount of passive activity loss for the relevant tax year. It is also used for reporting the application of previous years’ disallowed passive activity loss. The form can be easily filled up with the necessary details and submitted online to the IRS.

What are the provisions for the Carryover of Disallowed Deductions?

Taxpayers have the facility to carryover deductions disallowed due to the Passive Activity Rules. When any deductions or credits are not allowed to offset taxable income during a tax year, the deductions that are not allowed will be allocated among the different passive activities. The allocation shall be made so that it reasonably reflects the extent to which every activity continues the loss activity.

What is the applicability of Passive Activity Loss Rules to Real Estate Professionals?

The provisions of passive activity loss rules differ for real estate professionals. There is no upper limit on the rental losses that a real estate professional can offset against his regular income.

A real estate professional is a person who spends a minimum of 750 hours to conduct any real estate trade or business. More than 50 percent of his total working hours should be attributable to the real estate business.

Where any of the spouses qualify the 750-hour test, the total time for both the spouses shall be covered under material participation activities. Either of the spouses can use the losses to lower his income.

A person who elects to get treated as a real estate professional must keep the log of his working hours in the real estate business. It is advisable to maintain the records for the working hours for non-real estate businesses if any.

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