Passive Activity Rules

The passive activity rules are designed to prevent you from passively investing in losing businesses and using those losses to offset income from your “real” business or businesses.

Passive Activity. There are two kinds of passive activity:1

Trade or business activities in which you do not materially participate (see Material Participation); and

Rental activities, even if you do materially participate in them, unless you are a real estate professional. (See below.)

Passive activity loss disallowed. In any Tax Year in which you own a passive activity, you can use losses from that activity only as an offset against income from other passive activities. If you have a net loss from all passive activities, you have a passive activity loss, which you must carry forward to the following year or years until:2

You have enough passive activity income to absorb the loss; or

You dispose of your entire interest in the passive activity in a fully Taxable Transaction. When this occurs, you can then deduct the entire loss from that passive activity against your other (nonpassive) income.3

Real estate professionals. Real estate rental activities are not passive activities (and therefore losses can offset other business income) in any given Tax Year if:4

More than one-half of the personal services you perform in all your businesses are in real property trades or businesses in which you materially participate; and

Your perform more than 750 hours of personal services in those real property trades or businesses.

A Real Property Trade or Business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage business.5

For articles in our Tax Reduction Letter on tax strategies for dealing with the passive activity rules, click on Passive income and losses in our Browse by Topic finding tool.