When can passive activity losses be used to offset other taxable income?

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A passive activity is generally a trade or business in which the taxpayer does not materially participate, and rental activities are generally treated as passive regardless of participation unless an exception applies under section 469(c).

So when can passive activity losses be used to offset other taxable income? There are several principal situations. First, passive losses can always offset passive income from other passive activities in the same year. Second, individuals may qualify for the special $25,000 allowance for rental real estate activities if they actively participate and meet the modified adjusted gross income phaseout rules under section 469(i). That exception is often the main path for passive activity losses real estate to offset nonpassive income. Third, if the taxpayer qualifies as a real estate professional under section 469(c)(7) and materially participates in the rental real estate activity, the activity is not passive, so the loss is not limited by the passive activity loss rules.

Fourth, suspended losses may become deductible when the taxpayer disposes of the entire interest in the passive activity in a fully taxable transaction to an unrelated party under section 469(g)(1). Fifth, if an activity becomes a former passive activity, prior suspended losses may offset current net income from that activity under section 469(f). Otherwise, disallowed losses are carried forward as a passive activity loss carryover to future years under section 469(b). Taxpayers commonly track these amounts through Form 8582 and, for passthrough investments, information reported on Schedule K-1.

What is At-Risk Considerations & Suspended Losses

Requirements for Qualifying Under Real Estate Activity Rules

Rental real estate activities are generally treated as passive under Internal Revenue Code Section 469, even when the taxpayer is actively involved in the operations. Material participation alone is usually not enough to avoid passive activity treatment unless the taxpayer qualifies as a real estate professional or meets one of the limited statutory exceptions, such as certain low-income housing or historic rehabilitation activities.

To be treated as a real estate professional, the taxpayer must satisfy two separate tests during the tax year. First, more than half of the individual’s total working time must be spent in real property trades or businesses in which they materially participate. Second, the taxpayer must perform more than 750 hours of qualifying services in those real estate activities. Qualifying work may include construction, property development, leasing, brokerage, management, or real estate operations. Married taxpayers generally cannot combine their hours to satisfy these requirements.

At-Risk Rules and Suspended Passive Losses

The amount of passive loss a taxpayer may deduct can be limited by the at-risk rules under Section 465. A taxpayer’s at-risk amount generally reflects the money and adjusted basis invested in the activity, including contributions and income allocations, reduced by distributions and certain financing arrangements.

Passive losses are tied directly to the activity that generated them and are often reported through a Schedule K-1 for partnerships and S corporations. If losses exceed the taxpayer’s available at-risk basis, the excess losses become suspended and carry forward until additional basis is created or the activity is disposed of. Taxpayers should also consider how the Excess Business Loss Rules may further limit deductible losses at the individual level.

How BT Can Help

For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Trey Webb, partner in charge of Bennett Thrasher’s Real Estate and Hospitality Tax Group, or call us at 770.396.2200.

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