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Passive Income and Losses

Your level of participation in an activity is used to determine whether the activity is classified as a passive activity or a nonpassive activity.

Seven Material Participation Tests:

There are seven material participation tests. You only have to meet one of them EACH YEAR to qualify for nonpassive treatment of income and losses.

The seven tests include:

  1. You work in the activity for more than 500 hours per year, or
  2. You worked at least 100 hours, if no other shareholder worked more than that.
  3. If you have several activities, and spend more than 100 hours in each activity and the total hours for all activities add up to more than 500 hours, you are treated as a material participant in each activity. This is called the significant participation test.
  4. Your participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals, including non-owners, for the year.
  5. The facts and circumstances show that you worked on a regular, continuous, and substantial basis (IRC Section 469 and Reg. 1.469).
  6. You materially participated in the activity for any five tax years during the 10 tax years preceding the tax year in question. The five tax years do not have to be consecutive.
  7. In a personal service activity, you materially participated for any three tax years preceding the tax year in question. The three years do not have to be consecutive. Personal services include, accounting, law, health, engineering, actuarial science, architecture, the performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.

If you do not meet at least one of the material participation tests for the activity each tax year, income or loss passed through to you from the activity in which you have an ownership interest is classified as passive.

However, if you do meet any one of these tests, income or loss passed through to you is classified as nonpassive and is not subject to the passive activity rules.

Passive Losses and Nonpassive Income

Passive losses may only be offset against passive income. You may not offset passive losses against nonpassive income.

So, if you have a passive loss from a passive activity and nonpassive income from a nonpassive activity, such as a sole proprietorship that you own and run, you would not be allowed to deduct a loss from the passive activity from a net profit of the sole proprietorship.

Suspended Losses

Passive losses are only deductible up to the amount of passive income. Any excess loss is called a suspended loss. You may carry suspended losses forward indefinitely. If you dispose of the activity you may deduct the full amount of the suspended loss remaining for that activity at that time.

For example, if you have a passive loss of $5,000 and passive income of $2,000, you would have a suspended loss of $3,000 ($5,000 minus $2,000). If you end up carrying the suspended loss over for three years and decide to dispose of this activity, you may now deduct the full $3,000.

At-Risk Rules

Losses from an activity in which you materially participate, although not subject to the the passive activity rules, are subject to the at-risk rules.

The at-risk rules deal with your investment in an activity. They are designed to prevent you from claiming losses in excess of amounts you actually stand to lose (your investment). Only the amount of your investment that is at risk counts towards your at-risk basis ( also called your tax basis).

Example: Passive loss and passive income.

  • You invest in two companies:
    • Company A
    • Company B.
  • You do not materially participate in either of them.
  • Therefore, they are both passive activities and any income or loss you derive from these activities is passive income or loss.
  • Your share of Company A's loss is $10,000 (a passive loss).
  • Your share of Company B's net profit is $6,000 (passive income).

Result:

  • You offset the $10,000 passive loss against the $6,000 passive income.
  • The remaining loss of $4,000 is a suspended loss.

You may carry a suspended loss over to the following year and to other future years indefinitely until you have passive income to offset the loss against or you dispose of the activity.

If you dispose of the activity, you may deduct the full amount of any remaining suspended loss at that time.

How To Report Your Passive Activity Loss

More than one form or schedule may be required for reporting your passive activities. The actual number of forms depends on the number and types of activities you must report. Some forms and schedules that may be required are:

  • Schedule C (Form 1040), Profit or Loss From Business
  • Schedule D (Form 1040), Capital Gains and Losses
  • Schedule E (Form 1040), Supplemental Income and Loss
  • Schedule F (Form 1040), Profit or Loss From Farming,
  • Form 4797, Sales of Business Property
  • Form 6252, Installment Sale Income
  • Form 8582, Passive Activity Loss Limitations,
  • Form 8582-CR, Passive Activity Credit Limitations
  • Form 8949, Sales and Other Dispositions of Capital Assets.

Regardless of the number or complexity of passive activities you have, you should use only one Form 8582.

If you need additional lines for any of the Form 8582 worksheets, you can either use copies of Form 8582 page 2 or page 3, whichever is applicable, or your own schedule that is in the same format as the worksheet.