The Internal Revenue Service places limits on passive losses -- the type that arise from activities you engage in on the side, essentially as an investor. Generally, when your losses from passive activities exceed your income from passive activities, the IRS disallows those excess losses for the current year. You then must carry forward your disallowed passive losses to the next taxable year.
Passive Activities Defined
The IRS defines a passive activity as any business or trade activity in which you do not “materially participate.” Material participation occurs when you actively, consistently, regularly and substantially partake in the operations and decision making of the business or trade. However, the rules differ for real estate. The IRS does not deem real estate a trade or business; it considers it an investment. Unless you qualify as a real estate professional, the IRS considers all rental real estate a passive activity no matter your involvement. If you take part in any business as a limited partner, the IRS deems any income you derive from that partnership as passive.
As a result of the Tax Reform Act of 1986, you can only deduct losses from passive investments from your passive income, though a few exceptions apply. For example, if you have $10,000 in losses on a limited partnership investment but achieve a $10,000 gain on the sale of stock, the two will completely offset each other. If the losses and gains total to a net passive income, you include this with your total taxable income. If your losses and gains total to a net passive loss, except for the real estate exception, you cannot deduct any of that loss against your regular income. Instead, you must carry over the remaining loss to use against passive income in future years.
Exception to the Rule
If you actively participated in real estate -- for example, you owned and managed a rental property -- you can deduct up to $25,000 of your passive real estate losses against your regular taxable income. This special $25,000 allowance decreases by 50 percent of the amount of your modified adjusted gross income that exceeds $100,000. It disappears completely if your modified adjusted gross income exceeds $150,000.
Example of How It Works
Say you sell a rental home and generate a loss of $30,000. Meanwhile, you only had $5,000 in capital gains from the sale of stock. This leaves you with a net passive loss of $25,000 for the tax year. Your modified adjusted gross income is $180,000, therefore you are wholly ineligible for the $25,000 real estate offset against regular income. You must carry over the $25,000 passive loss.
Filing for the Carry-over
In general, you may fully deduct any passive loss carry-overs in the year you sell or dispose of your investment. If you have passive income, you must complete Form 8582, Passive Activity Loss Limitations, to summarize income and losses from passive activities and compute the deductible losses.
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