Large losses may not be considered deductible in the current year, depending on if the losses stem from passive activities. A passive activity is any activity where the taxpayer does not materially participate, such as a rental activity or owning interest in an entity that the taxpayer does not participate. Material participation is defined as participating on a regular, continuous, and substantial basis.
Losses on passive activities are deductible up to passive income; any losses over passive income will be carried over indefinitely and taken once positive income exists or you dispose of the investment. However, losses on trade or business activity can be deducted if the taxpayer is able to satisfy one of seven material participation tests. The seven tests are as follows:
- Participate more than 500 hours in a given tax year
- Participation that constituted substantially all participation for the activity
- Participate more than 100 hours and not less than any other individual
- Significant participation in a business in which the taxpayer participates, without qualifying for any of the other six tests, for more than 100 hours
- Participation during any 5 of the preceding 10 taxable years
- Participating in a personal service activity (activities in which capital is not a material income-producing factor such as health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) for any 3 preceding tax years
- Participating for more than 100 hours and based on all of facts and circumstances, on a regular, continuous, and substantial basis
Limitations exist for certain activities and for taxpayers involved in Limited Partnerships. Time spent as an investor will not count unless the taxpayer can show direct involvement in the day to day management of the activity. Work undertaken for the primary purpose of avoiding the disallowance of losses under the passive loss rule is not considered material participation. General partners in a Limited Partnership are limited by the fact that they cannot exceed their investment in losses and would have to carryforward their losses even if they materially participate. Limited partners can only be considered material participants if they satisfy tests 1, 5, or 6.
Claiming material participation on a rental activity is slightly different. The IRS considers the rental of real estate to be a passive activity even if you materially participated in the activity (unless you are a real estate professional). To be considered a real estate professional, at least half of the taxpayer’s work in trades/businesses must be in real estate and the taxpayer must spend at least 750 hours in these trades/businesses.
If you have any questions regarding this or any other tax matters, please do not hesitate to contact your L&B professional at (858) 558-9200.