Passive Activity and At-Risk Rules
There are two rules that limit the amount of a business loss you may deduct from your other sources of income in any given tax year:
- Passive Activity Rules
- At-Risk Rules
Passive Activity Rules
The passive activity rules (Section 469, Passive Activity Losses and Credits Limited) were enacted into law with the passage of the Tax Reform Act of 1986
Passive activity rules deal with participation in a business. Passive activity rules target investors who do not materially participate in the businesses they invest in. Such investors simply expect a return on their investment.
A business you merely invest in but do not materially participate in is a passive activity for tax purposes. Rental activities are considered passive activities regardless of your participation in the activity unless you're a real estate professional.
See the special $25,000 allowance for real estate non-professionals (the Small Landlord Exception).
Passive activity rules prevent investors from deducting passive activity losses from their nonpassive sources of income. In other words, passive activity losses may only be deducted from passive activity income.
For example, your share of the loss from a partnership in which you're a limited partner may not be deducted from the salary you earned at some company in which you are an employee.
If passive activity losses exceed passive activity income, the excess must be carried over to future tax years and may be deducted from passive activity income of those years.
Generally, if you participate at least 500 hours per year (10 hours per week) in your business, you're not subject to the passive activity rules.
Real Estate Non-Professionals: If you're not a real estate professional and you rent out property that you own, such a your condo, you don't need to count hours of participation to determine active participation. For real estate rental purposes, active participation means actively participating in the management of the property, such as setting the terms of the lease, approving repair and maintenance expenses, approving prospective tenants, using a property management company to collect your rent.
The Tax Reform Act of 1986 also extended the at-risk rules to property placed in service after 1986.
At-risk rules deal with your investment in a business and not your participation. This means, your share of the loss that the business passes through to you and that you may deduct from your other sources of income is limited to the amount of your investment in the business. In other words, you may deduct the loss up to amount you actually stand to lose.
For example, say you started an S corporation in 2015 with an investment of $15,000 and you're the only stockholder/employee. The business suffers a $20,000 loss in 2015. Your deduction for 2015 is limited to only $15,000, the amount of your investment (the amount you actually stand to lose).
You may deduct the $15,000 from your other sources of income reported on your individual income tax return (e.g., wages you earned from a job, your spouse's wages, interest, dividends, etc.). The nondeductible portion of the loss, $5,000, is called a suspended loss and may be carried over to future years indefinitely, until there is sufficient basis to absorb the loss.
During the 1980s, a variety of speculative and questionable tax shelters were created offering passive investors the lure of significant tax incentives in the form of tax deductions (write-offs).
These tax shelters were generally set up as limited partnerships and were involved in highly leveraged real estate activities that tended to attract high-income taxpayers.
Losses and deductions would be passed through these partnership entities to the investors who could then deduct their share of the losses and deductions (i.e. depreciation) from their other sources of income reported on their personal income tax returns.
Over time, the tax savings for investors from these write-offs tended to be greater than the amount of their original investment in the activity.
In other words, rather than real economic incentives being the motivating factor for investing in these real estate partnerships, such as the profitability and economic substance of the activity, it was the lure of tax write-offs, touted by savvy promoters, and the potential for substantial tax savings that was the primary motivating factor.
Consequently, Congress concluded that since these tax shelters were not designed to produce real economic benefit but only as vehicles to generate tax savings, the tax incentives had to be limited. As a result, the at-risk rules were created limiting loss deductions only up to the amount of a taxpayer's investment that the taxpayer personally has at risk.
At-Risk Rules vs Passive Activity Rules
The at-risk rules deal with your investment in an activity while the passive activity rules deal with your participation in an activity.
At-risk rules limit the amount of a business loss you may deduct in any given tax year. You may only deduct up to the amount of your investment in an activity that you stand to lose (have at risk). If a loss exceeds your at-risk investment, the excess is a suspended loss and may be carried to future years indefinitely and deducted when there is sufficient at-risk basis to absorb the loss.
Passive activity rules restrict the deduction of passive activity losses. You may only deduct passive losses from passive income.
The passive activity and at-risk rules are intended to have the effect of directing capital investment into viable, economic activities, where profit is the motivating factor and getting a return on investment, and not merely generating tax savings via sham businesses (i.e. "tax shelters") and financial finagling.