Mastering Passive Activity Losses & Maximizing Tax Savings

Summary: Explore the complexities of passive activity losses and their impact on tax planning. Learn how to optimize passive loss treatment, understand at-risk considerations, convert passive losses through disposition, qualify for material participation, and meet real estate limitations. By leveraging these strategies, taxpayers can effectively manage their passive losses and maximize tax savings.

Navigating the complexities of passive activity rules is essential for taxpayers looking to maximize their investments in rental businesses or other investments that generate passive income or losses. Passive activity losses, particularly those from rental activities, are treated differently from losses where taxpayers actively participate. Losses from passive activities are taxed at ordinary income rates but are limited in their ability to offset other income.

Generally, passive losses cannot be offset against nonpassive income, except in specific circumstances such as sale of a business. Understanding when income is considered passive and the limitations imposed by these rules can help taxpayers maximize the usage of their losses and thus potentially avoid the passive activity rules altogether. 

Optimizing Passive Loss Treatment

While passive losses have limitations to what income they can offset, their usage can fully extinguish tax liability from passive activities. If there is an allowable loss, a taxpayer can use passive losses to reduce their passive taxable income to $0 in any given year. These losses are netted against all other passive activities, meaning a diversified taxpayer can use one business that is generating losses to reduce the tax liability for other income generating activities. Any excess loss that cannot be used in the current tax year can be carried forward indefinitely until there is income to offset without being limited or reduced.

Understanding At-Risk Considerations & Suspended Losses

The primary situation that can limit the amount of passive loss allowed is related to at-risk considerations. A taxpayer’s at-risk amount is measured by the equity in an activity. In general, basis includes all contributions to the activity, increased by their share of income and reduced by any distributions. At-risk amounts generally constitute the taxpayer’s basis less any financing for which the taxpayer is not personally liable, otherwise known as nonrecourse liabilities. For those engaged in real property financing, such as real estate, Section 465(b)(6) provides a special exception that allows financing secured by real property to be considered qualified nonrecourse. Qualified nonrecourse liabilities are treated as amounts at-risk for the taxpayer.

When it comes to passive losses, the losses are tracked to the activity that generated them and can only be used if the taxpayer has remaining at-risk basis in the activity. If, in a given tax year, the passive loss for an activity exceeds the basis, then only the loss up to the basis is allowable, and the rest must be carried over or otherwise suspended until basis is increased or the activity is disposed.

Converting Passive Losses through Disposition

Leveraging a disposition not only automatically allows taxpayers to use the full loss amount in an activity, even those restricted by at-risk limits, but it is also one of the primary mechanisms to convert passive losses into nonpassive deductions. When a taxpayer sells their interest in a passive activity to a nonrelated party, all losses in that activity are released. When this happens, these losses can then be used to reduce the gain from the sale as if there was additional basis, and any excess loss can be used to offset nonpassive income.

Qualifying for Material Participation

In some cases, a taxpayer can avoid the passive categorization altogether and treat the activity as a trade or business in which the taxpayer actively participated. If a taxpayer can treat an activity in this manner, they will be able to classify their income from the activity as nonpassive. For a non-real estate activity to be considered active and avoid the passive loss categorization, the taxpayer must be considered a material participant in the business. In general, any person who is the sole worker in an activity or puts in more than 500 hours throughout the tax year can claim material participation. Alternatively, the taxpayer must have a minimum of 100 hours in the business and put in the most hours of any other person or be considered as contributing to the business activity on a regular, continuous, and substantial basis.

For the purposes of this test, hours spent managing, brokering, trading, investing, and similar work are not allowed to be considered. A taxpayer does not need to materially participate every year to claim the business income as nonpassive. If a taxpayer was considered to materially participate in the activity for five out of the last 10 years, they can claim the activity as nonpassive income, with some industries considered personal service activities having reduced requirements.

Criteria for Meeting Real Estate Limitations

Taxpayers participating in a real estate activity generally cannot apply the rules above to avoid the passive characterization. For example, even if a taxpayer materially participates in a rental real estate business, the activity is still considered passive according to Section 469(c)(7)(A) unless the activity qualifies as low-income housing, qualifies for rehabilitation of historic building credits, or the taxpayer qualifies as a real estate professional. To qualify as a real estate professional for an activity, a taxpayer must meet both of the following:

• More than 50% of hours worked in a tax year are attributable to real property trade or businesses in which the taxpayer materially participates.
• The taxpayer performs more than 750 hours of service in real property trade or businesses in which the taxpayer materially participates.

For purposes of this determination, real property trade or business includes related real estate work such as construction, development, management, leasing, brokering, and conversion. For married couples, the couple is not allowed to combine hours for purposes of meeting the requirement.

Aggregation of Real Estate Activities

Despite a taxpayer qualifying as a real estate professional, each activity is treated independently by default. Therefore, for each activity, the taxpayer must still meet material participation on a per activity basis under the standard rules. To better assist real estate professionals who may have multiple separated entities holding real estate, taxpayers are allowed to elect to aggregate all interest in real estate as if it were a single entity. However, this election does not allow the taxpayer to decide which activities are aggregated. Instead, the taxpayer must meet material participation for the aggregate of all activities; otherwise, all rental activities will be considered passive. There is a separate offset that allows certain taxpayers in real estate activities to offset up to $25,000 in passive losses against non-passive income. However, this offset is only available for taxpayers with income below a limited threshold.

Final Thoughts

Taxpayers looking to invest in passive businesses can use passive loss rules to create tax planning strategies that maximize their deductions. These strategies may include diversifying income generation with activities expected to claim losses in the same year or planning loss carryovers to offset years with income. Some taxpayers may even be eligible to recategorize their income through active participation or disposition. By leveraging these strategies, taxpayers can effectively manage their passive losses and optimize their tax planning.

How we can help: Reduce your overall tax burden through comprehensive tax planning. Aprio’s Tax advisors can help you identify tax saving opportunities and align your tax strategy with your business goals.

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