Passive Income and Passive Activity Loss Rules

Passive Income and Passive Activity Loss Rules

What Is Passive Income?

Income from activities in which you don't materially participate:

• Most rental income
• Limited partnership income
• Business income from businesses you don't work in

What Is Material Participation?

You materially participate if you meet one of these tests:

1. 500+ hours per year in the activity
2. Substantially all of the participation is yours
3. 100+ hours AND more than any other individual
4. Significant participation in multiple activities totaling 500+ hours
5. Materially participated in 5 of the last 10 years
6. Personal service activity: material participation in any 3 prior years
7. Facts and circumstances (catch-all)

Passive Activity Loss Rules

• Passive losses can only offset passive income
• Excess losses are suspended and carried forward
• When you sell or dispose of the passive activity, all suspended losses become deductible

Rental Activity Exception

• Rental activities are generally passive regardless of participation
• Exception: If you actively participate and AGI < $100,000, deduct up to $25,000 against ordinary income (phases out to $150,000)

Real Estate Professional Exception

• If you qualify as a real estate professional, rental activities are treated as non-passive
• Requirement: More than half of personal services in real property trades, AND 750+ hours

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Real estate investor with losses? Understanding the passive activity rules is essential.