Individuals, trusts, estates, personal service corporations, and closely held C corporations may only deduct passive activity losses from passive activity income. The rules do not apply to S corporations and partnerships but do apply to their respective shareholders and partners. In general, limited partners are not deemed to materially participate in partnership activities. Thus, a limited partner’s share of partnership income is passive income. However, general partners or acting general partners may hold limited partnership interests and materially participate in the partnership.
Closely held C corporations and personal service corporations are treated as materially participating in an activity if shareholders owning 50% or more by value of the outstanding stock materially participate in the activity. Closely held C corporations can also satisfy the material participation standard under an alternative rule based on the participation of full-time employees in the activity.
A passive activity is trade or business activity in which the taxpayer does not materially participate. Passive activities generally include rental activities, regardless of whether the taxpayer materially participates in the activity. However, a taxpayer’s rental real estate activity is not a passive activity if the taxpayer materially participates in the activity and performs qualifying services in the real estate industry. A facts and circumstances test should be applied in determining whether the taxpayer’s other activities are combined or treated as separate for purposes of the passive loss rules.
Individuals who own and actively participate in the management of rental real estate may offset up to $25,000 of passive activity loss from rental real estate against active income in any tax year. The offset amount is reduced by 50% of the amount by which the taxpayer’s adjusted gross income exceeds $100,000, phasing out completely at $150,000 of adjusted gross income. More liberal rules apply to the offset of rehabilitation and low-income housing credits.
Deductions and credits that are disallowed under passive activity rules may be carried forward and used as passive activity deductions and credits in succeeding years. Remaining passive activity deductions are deductible against nonpassive income when a taxpayer disposes of the passive activity. Passive activity credits may only be applied to taxes on passive income.
A major exception to the definition of a passive activity is a working interest in any oil and gas property that the taxpayer holds directly or through an entity that does not limit the taxpayer’s liability for the interest, regardless of whether the taxpayer materially participates in the activity. A taxpayer’s passive activity loss for the tax year is disallowed and is carried forward until the taxpayer has available passive activity income. Passive activity loss is the amount by which passive activity deductions from all passive activities exceed passive activity gross income from all passive activities for the tax year.
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