Who Do Passive Activity Rules Apply To?

Here's how section 469(c) of the Internal Revenue Code defines a passive activity:

In general - The term "passive activity" means any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate.

Passive activity rules apply to:

  • Individuals
  • Estates
  • Trusts (other than grantor trusts)
  • Personal service corporations, and
  • Closely held corporations.


Work you do in your capacity as an investor does not constitute participation unless you are directly involved in the day-to-day management or operations of the activity.

For example, the following work by an investor does not constitute participation:

  • Studying or reviewing financial statements or reports on the operations of the activity
  • Preparing summaries or analyses of the finances of the operations for your own use
  • Monitoring the finances or operations in a nonmanagerial capacity

Purpose of Passive Activity Rules

The passive activity rules are designed to prevent passive activity losses from being deducted from a taxpayers nonpassive income, such as wages (earned income), interest and dividends (portfolio income).

In addition, passive activity credits may only be deducted from the tax on passive activity income. Passive activity credits include the general business credit and other special business credits, such as the credit for fuel produced from a nonconventional source.

What is a Passive Activity?

There are two kinds of passive activities:

  • Trade or business activities in which you do not materially participate during the year.
  • Rental activities, even if you do materially participate in them, unless you are a real estate professional.

Exception for Real Estate Nonprofessionals

Although rental activities are always considered passive activities (except for real estate professionals), a special rule allows real estate nonprofessionals to classify up to $25,000 of rental losses as nonpassive.

This means you can deduct up to $25,000 of rental losses from your other, nonpassive income. You must actively participate in the activity. It's easy to qualify for the special $25,000 allowance. 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.

Tax Forms You May Need to File

The following tax forms apply to passive activity loss limitations and passive activity credit limitations:

  • Form 8582, Passive Activity Loss Limitations
  • Form 8582-CR, Passive Activity Credit Limitations

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