Passive Activity

Passive Activity

Passive Activity means:
a term introduced by the Tax Reform Act of 1986; generally, any rental activity is considered passive, as is any other activity in which the investor does not materially participate. With certain exceptions, losses generated by passive activities may not be used to offset active income or portfolio income. Losses from passive activities are suspended until passive activity income is generated.

To determine whether a taxpayer has passive losses for a taxable year under current law, the taxpayer's operations must be organized into activities that are either trade or business activities or rental activities. In general, rental operations may not be treated as part of a trade or business activity.

A trade or business activity is passive unless the taxpayer materially participates in the activity. Treasury regulations provide that, in general, the material participation standard is satisfied if a taxpayer participates in the activity for more than 500 hours during the taxable year. Rental activities, however, are passive regardless of the level of the taxpayer's participation. Thus, in general, losses from rental activities may offset only rental income or other passive income. A limited exception to this treatment of rental activities permits a taxpayer to treat up to $25,000 of real estate rental losses as nonpassive. This exception applies, however, only to losses from activities in which the taxpayer actively participates (a lesser standard of involvement than material participation) and is phased out for upper-income taxpayers.

The passive loss limitation rules apply to individuals, estates, trusts, and personal service corporations. Closely held C corporations are exempt beginning in 1994. At that time, individuals who spend more than 50% of their time and more than 750 hours per year in real estate are exempt. IRC §469.

See also the entries Income Tax and State Income Tax in the American Encyclopedia of Law.

Description and Definition of Passive Activity

An activity in which the taxpayer does not materially participate. A passive activity is one defined in the Internal Revenue Code as one or more trade, business, or rental activities that the taxpayer does not materially participate in managing or running. Real estate rentals and limited partnerships are examples of passive activities. Passive loss rules apply to losses from passive activities. All income and losses from passive activities are grouped together on an income tax return, and generally loss deductions are limited to income or suspended until the passive activity that generated them is disposed of in its entirety.


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