Passive Activity Rules

• May 24, 2021
• Carey M. Heyman, CPA

The passive activity rules are often misunderstood, even by the savviest real estate investors. The rules were created to prevent taxpayers from using losses from passive activities to offset income from non-passive activities. Losses from passive activities may only be used to offset income from passive activities, with some exceptions. Passive losses that exceed passive income are suspended, but may be eligible to be deducted against passive income in future tax periods.

Passive activities are generally defined as any activity that involves a taxpayer’s “material participation” in a trade or business, and any rental activity. A taxpayer is considered to be materially participating in an activity if the taxpayer is involved in the regular, ongoing operations of the activity. The regulations provide a number of tests to determine whether a taxpayer has materially participated in an activity, including separate tests for individuals, spouses, investors, estates and trusts, and even special rules for limited partners. Limited partners typically are not treated as materially participating in an activity, but can be treated as materially participating if some of the aforementioned tests are satisfied, or if the taxpayer also held a general partnership interest during the partnership’s tax year.

Special Allowance for Rental Real Estate Activities

If a taxpayer actively participated in a passive rental real estate activity, the taxpayer may be eligible to deduct up to $25,000 of loss from the activity from their non-passive income. This is an exception to the general rule disallowing losses in excess of income from passive activities.

Real Estate Professional

Another wonderful exception to the passive activity loss limitations is the concept of the “real estate professional.” A rental activity is not considered a passive activity to the extent that the taxpayer is engaged in a rental real estate activity as a real estate professional. For a taxpayer to qualify as a real estate professional, the following requirements must be met annually:

1. More than half of the personal services performed in trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated, and
2. The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

For the purposes of the definition above, a real property trade or business is any real property development, re-development, construction, re-construction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Services performed by the taxpayer as an employee are not treated as performed in a real property trade or business. The exception to this is if the taxpayer owns 5% or more of the capital or profits interest, or stock, in the employer. Also, please note that not all states conform to the “real estate professional” designation.

Disposing of a Passive Activity

When a taxpayer disposes of their entire interest in a passive activity, that activity is no longer subject to the passive activity rules. If the activity is disposed of in a fully taxable transaction, suspended and current passive activity losses that were generated by that activity, including the loss on the disposition, are eligible to be deducted. If the passive activity is exchanged in a tax-deferred transaction such as a Section 721 exchange or a Section 1031 exchange, the taxpayer cannot deduct the suspended passive activity losses.

For more information on the passive activity rules, please refer to IRS Publication 925.

Sources: IRS.gov, Bloomberg Tax, RIA Checkpoint

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