Gary M. Kaplan, C.P.A., P.A.

The IRS classifies income producing activities as two different types.

1. Nonpassive – Income or losses generated from trade or business activity in which a taxpayer materially participates. Examples include wages and self-employed income.
2. Passive – Income or losses generated from activities in which a taxpayer does not materially participate. Examples include most rental activities and limited partnership interests.

What does it mean to “materially participate”?

According to the IRS, you materially participated in a trade or business activity for a tax year if you satisfy any of the following tests:

1. You participated in the activity for more than 500 hours, or
2. You are the only one who substantially participates in the activity, or
3. You spend more than 100 hours participating in the activity and no one else spends more hours, or
4. You met “material participation” requirements for any 5 of the 10 prior tax years.
5. The activity is considered a “personal service activity” (i.e. a trade or business where capital is not an income-producing factor such a health, law, or architecture business) and you materially participated for any 3 (whether consecutive or not) preceding tax years, or
6. The activity is considered a “significant participation activity” (an activity you participated more than 100 hours during the tax year) and your participated more than 500 hours in all significant activities during the tax year, or
7. Based on all facts and circumstances, you participated in the activity on a regular, continuous and substantial basis during the tax year.

If you are married, participation of both spouses is combined to meet material participation requirements.

What are the passive activity loss rules?

Passive activity loss rules prevent investors (those who do not materially participate) from using passive losses to reduce current year non-passive taxable income. Under Internal Revenue Code Section 469, passive activity losses are limited to passive activity income for the current tax year. Losses not allowed in the current year are carried forward to the following tax years.

Example: In 2011, a taxpayer has $7,000 net passive losses. No loss is deducted in 2011. The $7,000 net passive loss is carried forward to 2012 when the taxpayer has $10,000 passive income for the year. The taxpayer will apply the prior year passive activity loss and will report $3,000 net passive income subject to taxation in 2012.

Are there exceptions for rental activities?

Of course; after all it’s the IRS! Here are special rules for taxpayers renting real estate:

• $25,000 special allowance for rental real estate: The taxpayer (or spouse) must “actively participate” in the rental activity. This means they must own at least 10% of the property and have substantial involvement in managing the rental. Net income & losses from all of the taxpayer’s rental estate activities with active participation must be combined to determine the net overall loss. If the taxpayer has more than $100,000 Adjusted Gross Income (AGI), the $25,000 loss allowance will begin a 50% reduction and will be reduced to $0 when AGI reaches $150,000.

• Real estate professionals:  The $25,000 special allowance does not apply to these taxpayers. They would treat their rental activities as nonpassive if they meet both conditions:

  a. More than 50% of their personal services during the tax year are performed in real property trades or businesses in which they materially participate, and
  b. They spend more than 750 hours of service during the year in real property businesses in which they participate.

Passive activity rules are not easy, particularly if you own rental property and/or have multiple investment interests. Gary Kaplan has worked with many clients facing these issues. Call him with your questions.