Passive Income and Losses

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.

Suspended Losses

Passive losses are only deductible up to passive income. Passive losses that exceed passive income in any given year are not deductible in that year and are called suspended losses. You may carry suspended losses forward indefinitely.

A suspended loss may be deducted when you have sufficient passive income or you dispose of the activity.

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.

Example: Passive loss and nonpassive income

  • You invest in Company T but do not participate in its operations (you're a passive investor).
  • You invest in Company X, in which you do materially participate.
  • You have no investment in any other activities.
  • Company T has a loss of which your share is $5,000. It is a passive loss.
  • Company X has a profit of which your share is $2,000. It is nonpassive income.

Result:

In this example, you have the following situation:

  • A passive loss
  • A suspended loss
  • A nonpassive loss

Passive loss:

  • You may deduct any of the $2,000 loss in the current year.
    • The $2,000 loss is a passive loss, however, you have no passive income to offset it against.
    • Therefore, since it is not deductible in the current year it is a suspended loss.

Suspended loss:

  • You may carry a suspended loss over to the following year or other future years indefinitely, until you either have passive income to offset the loss against or you dispose of the activity.
    • You can deduct any remaining suspended loss when you dispose of the activity.

Nonpassive Income:

  • You have nonpassive income of $2,000.
    • It must be included in your gross income.
    • Enter the $2,000 on Schedule E, Part II in the Nonpassive Income and Loss section (located to the right of the passive income and loss section).
    • Carry the $2,000 from Schedule E to the front of Form 1040.

Tip: Don't forget to keep tract of suspended losses!

You don't want to overlook deducting a suspended loss from passive income of a future tax year. To remind you, staple a note to the front of the tax return for the year the suspended loss was originally created.

Example:

Passive loss limited to passive income.

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

Result:

In this example, you have the following situation:

  • Passive income
  • A passive loss
  • A suspended loss

Passive losses may only be deducted from passive income.

Passive income:

  • You have passive income from Company B of $6,000.

Passive loss ($6,000 is deductible)

  • Since your passive income is only $6,000, you can only deduct $6,000 of the $10,000 passive loss.
  • The remaining $4,000 is a suspended loss.

Suspended loss

  • Your excess loss of $4,000 is a suspended loss.
  • You may carry a suspended loss over to the following year or other future years indefinitely, until you either have passive income to offset the loss against or you dispose of the activity.
    • You can deduct any remaining suspended loss when you dispose of the activity.

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