Limiting passive activity losses began with the Tax Reform Act of 1986 as a means of discouraging economic activity undertaken strictly as a tax shelter.
Passive activity losses can only be offset by passive activity income. Exceptions apply for certain rental real estate activities, and additional limitations apply to a publicly traded partnership (PTP).
If a taxpayer's passive losses are limited in the current year, the losses can be carried forward until fully applied against passive gains or until the activity that generated the passive loss is sold or otherwise disposed of. TaxSlayer Pro will automatically carry forward any unused passive loss until used.
There are two kinds of passive activities.
- Trade or business activities in which the taxpayer did not materially participate during the year.
- Rental activities, even if the taxpayer actively participates in them, unless the taxpayer is a real estate professional.
If the taxpayer actively participated in the rental activity they are permitted to use a limited amount of any passive losses based on the their modified adjusted gross income.
Modified AGI equals AGI adjusted as follows:
- Passive income or loss included on Form 8582.
- Rental real estate loss allowed to a real estate professional.
- Any overall loss from a PTP.
- The taxable amount of social security and tier 1 railroad retirement benefits.
- Deductible contributions to traditional IRAs and section 501(c)(18) pension plans.
- The deduction allowed for the deductible part of self-employment taxes.
- Interest from series EE and I U.S. savings bonds used to pay higher education expenses.
- The exclusion of amounts received under an employer's adoption assistance program.
- The student loan interest deduction.
- The deduction allowed for foreign-derived intangible income and global intangible low-taxed income.
- Any portfolio income and any expenses that are clearly and directly allocable to portfolio income.
- Any income that’s treated as nonpassive income, such as overall gain from a PTP and net income from an activity or item of property subject to the recharacterization of passive income rules.
- Any overall loss from the entire disposition of a passive activity (considered a nonpassive loss).
If the taxpayer is not a real estate professional, no passive loss will be allowed if their modified AGI is $150,000 or more ($75,000 or more if married filing separately).