Material Participation and Passive Activity Losses

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Material Participation and Passive Activity Losses

Ordinarily, expenses and losses related to a passive activity are only deductible by the taxpayer to the extent of their passive activity income. There are two main types of passive activities:

  1. Trade or business activities that the taxpayer does not materially participate in during the tax year, and
  2. Rental activities.

Disallowed passive activity expenses and losses are carried forward to offset future passive activity income. In the year that the taxpayer disposes his or her entire interest in the passive activity, any remaining carryover passive activity losses attributable to that activity generally may be used as a deduction against the taxpayer's other income. A taxpayer may avoid the unfavorable treatment for expenses and losses associated with a passive activity if he or she materially participates in the activity.

To Whom Do the Passive Activity Loss Rules Apply?

1. Individuals
2. Estates
3. Trusts
4. Personal service corporations
5. Closely held C corporations

What is "Material Participation" for the Purposes of the Passive Activity Loss Rules?

There are seven ways in which a taxpayer may be considered "materially participating" in an activity:

  1. The taxpayer participates in the activity for more than 500 hours during the tax year;
  2. The taxpayer is the only participant in the activity during the tax year;
  3. The taxpayer participates for more than 100 hours in the activity and his or her participation must be more than any other person involved in the activity during the tax year;
  4. The activity is a "significant participation activity" for the taxpayer during the tax year and the taxpayer's aggregate participation in all "significant participation activity" for that tax year exceeds 500 hours.
  5. The taxpayer materially participated in the activity for any five taxable years (that need not be consecutive) during the past ten years;
  6. The activity is a personal service activity and the taxpayer materially participated in it for the past three years before the current tax year; or
  7. The taxpayer participates in the activity for more than 100 hours and based on all of the facts and circumstances the taxpayer participates on a regular, continuous, and substantial basis.

What Is a "Rental Activity" for the Purposes of the Passive Activity Loss Rules?

A rental activity usually means an activity where the taxpayer gets paid for letting someone else use his or her tangible properties. There are several exceptions to this general definition. If the activity meets any one of the following tests, then it will not be considered a "rental activity" for the purposes of the passive activity loss rules:

  1. The average rental period for customer use is 7 days or less;
  2. The average rental period for customer use is 30 days or less and "significant personal services" are provided in connection with the rental;
  3. "Extraordinary personal services" are provided in connection with the rental regardless of the average period of rental use;
  4. The rental is incidental to a nonrental activity of the taxpayer;
  5. The taxpayer customarily makes the rental property available during defined business hours for nonexclusive use by various customers; or
  6. The taxpayer provides the property for use in a nonrental activity by a partnership, S corporation, or joint venture that the taxpayer owns an interest.

Do I Need an Attorney with My Tax Problems?

Tax laws are complex and ever-changing. Although there are various tax preparation softwares on the market that can help you with filing your tax returns, they cannot give the same level of service that an experienced and knowledgeable tax attorney provides. If you are unsure about the characterization of your expenses or if you need someone to represent you before the IRS, a tax attorney can help.

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Last Modified: 12-04-2014 03:15 PM PST

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