Being an investor, especially when you invest in things that can incur some initial losses, often comes with some pretty solid tax benefits. One such perk is the ability to deduct passive losses when you go to square up with Uncle Sam come tax time. While you generally can deduct these passive losses when you go to file taxes – depending on the investment and your participation in it – there are rules that apply to determine how and when you can do so.
Passive loss carryover occurs when you do not have enough passive income by which to offset these losses for a given tax year. You can carry over these losses until you sell the asset or realize enough passive gains.
Understanding Passive Loss
Passive losses are financial losses stemming from passive activities, such as renting properties or losses from interest in limited partnerships where the investor does not play a material participant role. Rental losses are not uncommon at all, particularly during the early years of owning a property. And, to further muddy the waters, different rules and requirements apply when you are offsetting real estate activities and losses than when you are offsetting other forms of passive income.
As to be expected, the IRS is quite clear on the definition of a material participant, and provides a series of several tests to determine whether or not an investor is a material participant. But, if you are the owner of a rental property or a limited partner, you can claim some of the losses you incur during the course of investing. However, you can only do so against any passive gains you have realized based on your proportional share of interest. Any losses that exceed the amount of passive gains you had for any given year can be carried over to future years to be deducted against future passive income gains. But, there are requirements that must be met first before doing so.
Passive Activity and Material Participant
If you are an investor, and you are not active in any day-to-day decisions or operations regarding that activity, then the IRS considers this passive activity. An example of a passive activity would be any interest you may have in a start-up company where you have no say or control over the daily business dealings of the start-up. If you are solely funding the operating (in part or in whole) yet have no active role in the company, then this would be considered a passive activity as far as the IRS is concerned.
This rule, however, is different for real estate investors. And as a result, all real estate dealings fall under passive activity – regardless of your activity or involvement – unless it has been determined that you are a real estate professional. You are considered a real estate professional only if more than half of the personal services you performed were in the real estate trade or business where you were a material participant, and if you performed more than 750 hours of services in the real estate trade for the tax year in question. The rules for determining activity are less restrictive than the rules for determining material participation, which is why you can play an “active” role in renting your real estate and still not qualify as a real estate professional or material participant.
There are seven material participant tests that are used to determine a taxpayer's level of participation, activity or involvement in an investment, trade or business. For a complete list of all seven material participant tests, and to find out whether or not you qualify as a material participant, visit the IRS website for more information. When you materially participate in an activity, this means you have regular, continual and substantial influence in the decision-making or operations of the activity or company. If you fail to meet one of the material participation tests, then there are other rules that apply which determine how you either offset or carry over your losses. These rules are known as passive activity loss rules, or PAL. When you are a passive participant, even if the activity is income-producing, then your involvement is not continual or substantial, so passive activity rules would then apply.
What Is Passive Activity Loss Limitation?
A passive activity loss limitation occurs when your total losses (including any carried-over losses) from all of your passive activities are more than the amount of passive gains you've realized from all your passive activities for a given year. The IRS deems activities in which you do not materially participate in the operation or daily decision-making of said activity to be passive. Generally, you cannot, for instance, use passive activity loss to offset any non-passive activities or interests you have.
There is, however, a real estate exception that allows you to offset losses for rental activities in which you actively participate – as long as you have not been deemed to be a real estate professional – against non-passive income gains. For the 2017 tax year, the amount of passive income that you can offset against non-passive income is $25,000 if you are single or married filing jointly, and $12,500 for married filing separately taxpayers who lived apart from their spouse during the tax year. If you are married and filing separately – but lived with your spouse during any point in the year – then you are disqualified for this special $25,000 allowance.
If your losses do not stem from real estate, then you cannot use this active loss to offset the non-passive gains you realize. For example, if you had $20,000 of passive loss stemming from your interest in an investment that is not a real estate rental investment, you cannot, in turn, use these passive losses to offset a $40,000 earned or active salary from working a day job. However, if you are a single taxpayer, with passive losses stemming from rental real estate, you would be able to deduct up to $25,000 of these losses against your non-passive, or active, salaried day job. It is worth noting, this special allowance is subject to phase-out for modified adjusted gross incomes over a certain amount. To see what this phase-out threshold is for a particular year, head over to the IRS website and review IRS Publication 925, Passive Activity and At-Risk Rules
Understanding Passive Loss Carryover
When you own rental real estate as an investor, you are likely to experience some losses involved with owning or selling it. The passive activity loss rule allows you to deduct these losses against passive activity income from other sources such as property rentals with positive cash flow or income from the sale of other properties, even if you are an active participant. You cannot, however, deduct more in passive losses than you have realized in corresponding passive income gains – unless the activity involves real estate, then the exception applies. This means that the losses in excess of what you realized in gains are suspended or carried over until you either have enough qualified income gains to write these losses off against, or you sell your interest in the property responsible for the losses. Strictly speaking, if you have losses, you need to have sufficient passive income or you will need to carry them over for deducting against future gains, regardless of your activity or participation levels.
Suspended Passive Activity Loss
There are only two situations in which you can deduct suspended passive activity losses. The first scenario is when you have sufficient passive income by which to offset these losses against, and the second is when you choose to dispose of the passive activity in question to an unrelated party in a fully taxable transaction. For example, if you have a rental property with $10,000 in suspended losses, you can only deduct this loss to the extent that you have at least $10,000 in passive gains or you sell your interest in the property to an unrelated third party. In this example, you would only break even because your passive gains equaled your passive losses. But, if you do not sell the property (or your interest in the property), you can continue to carry over this loss to future years until you find yourself in one of the two aforementioned situations.
The good thing about carrying over passive losses is that you are able to do so indefinitely until you have passive gains to offset them with or until you dispose of your interest in the investment that generated the losses. At this point, you're then able to deduct any unused, suspended losses you have in that activity or property against any fully taxable transaction with an unrelated third party. If you do not have sufficient passive gains or do not sell your interest in the passive activity, then you must continue to carry over or suspend these losses.
Can You Carry Back a Passive Loss?
Carrying losses back is similar to carrying losses forward, but rather than applying the losses to offset future gains, they are used to offset past income or past net gains. While you can carry passive losses forward to future years, you cannot carry passive or active losses back to previous years when you had more income to offset the losses by. Sometimes businesses may experience a net operating loss, and apply that year's loss to a previous year's tax return. While it is entirely legal and can result in a business receiving a tax refund or reduction of tax liability, you cannot do this with passive losses.
Who Must File IRS Form 8582?
As of 2011, IRS Form 8582 must be filed by taxpayers who have a net gain from business or passive rental activities. Non-corporate taxpayers will need to use IRS Form 8582 to determine the amount of passive activity losses for a given tax year. Also, you will need to report any previously suspended losses from prior years on this form. There is an exception for needing to file an IRS Form 8582 if you are involved in renting real estate, and you meet all of the conditions for this exception set forth by the IRS. Some of the conditions are that the total loss from your real estate rental activities was not more than $25,000 for individuals and those who are married and filing jointly (or $12,500 if you are married and filing separately.)
For example, if you actively engage in the rental of real estate, but this activity is your only passive income, then you do not have to file a Form 8582. If you have no previous suspended losses from this or any other passive activity, then you also are not required to file Form 8582. Because IRS rules and requirements often change, it is best to check with the agency's website or consult with a qualified tax professional prior to filing.
- Publication 925 (2019), Passive Activity and At-Risk Rules | Internal Revenue Service
- IRS: Topic Number 425 - Passive Activities – Losses and Credits
- IRS: About Publication 925, Passive Activity and At-Risk Rules
- NOLO: What Happens to Suspended Passive Losses When You Sell (Or Lose) Your Rental Property?
- NOLO: Can You Deduct Your Rental Losses?
- IRS: 2017 Instructions for Form 8582