A passive activity is generally an income-producing activity in which you do not materially participate on a regular, continuous, and substantial basis.
For federal tax purposes, there are two main types of passive activities:
- A trade or business in which you do not materially participate during the tax year
- Most rental activities, regardless of how much time you spend managing them
These rules matter because passive activity losses are usually subject to special limitations.
How Do Passive Activity Loss Limits Work?
In most cases, you can deduct passive activity losses only against passive activity income. For example, if your rental property generates a loss but you do not have any passive income, you may not be able to deduct the entire loss on your current tax return. Instead, any disallowed loss is generally carried forward to future tax years. You can use those suspended losses when:
- You have passive income in a later year, or
- You dispose of your entire interest in the activity through a fully taxable transaction
This rule prevents taxpayers from using certain passive losses to offset wages, self-employment income, and other nonpassive income.
Special Allowance for Rental Real Estate Losses
There is an important exception for many rental property owners.
If you or your spouse actively participated in a rental real estate activity, you may be able to deduct up to:
- $25,000 of rental real estate losses against nonpassive income
- $12,500 if you are Married Filing Separately and lived apart from your spouse for the entire year
Active participation is generally a lower standard than material participation. For example, approving tenants, setting rental terms, or authorizing repairs may qualify as active participation.
Income Limits for the Special Allowance
The maximum special allowance begins to phase out when your Modified Adjusted Gross Income (MAGI) exceeds:
- $100,000 for most filing statuses
- $50,000 for Married Filing Separately taxpayers
The allowance is reduced by 50% of the amount your MAGI exceeds the applicable threshold.
If your MAGI is:
- $150,000 or more, the special allowance is generally eliminated
- $75,000 or more for Married Filing Separately taxpayers, the special allowance is generally eliminated
What Is Modified Adjusted Gross Income (MAGI) for Passive Activity Rules?
For passive activity loss limitations, Modified Adjusted Gross Income (MAGI) starts with your Adjusted Gross Income (AGI) and adds back certain deductions and exclusions.
Your MAGI is generally your AGI without including the effects of:
- Taxable Social Security benefits and Tier 1 Railroad Retirement benefits
- Deductible contributions to traditional IRAs and section 501(c)(18) pension plans
- The exclusion of interest from qualified U.S. savings bonds used for qualified higher education expenses
- The exclusion for employer-provided adoption assistance
- Passive activity income or loss reported on Form 8582
- Rental real estate losses allowed because you qualified as a real estate professional and materially participated
- Any overall loss from a publicly traded partnership (PTP)
- The deduction for one-half of self-employment tax
- The student loan interest deduction
Because several adjustments are involved, tax software can help calculate your MAGI automatically and apply the correct passive loss limitations.
Material Participation vs. Active Participation
These terms sound similar, but they are not the same.
- Material participation generally means you are regularly, continuously, and substantially involved in the activity.
- Active participation is a less demanding standard and is often used to determine eligibility for the special rental real estate loss allowance.
A taxpayer may actively participate in a rental property without meeting the stricter material participation requirements.
How Tax Software Handles Passive Activity Limitations
When you enter income and expenses from a rental property or other passive activity, the software will determine whether passive activity limits apply and calculate any suspended losses that must be carried forward.
If you qualify for the special rental real estate allowance, the allowable deduction will be calculated automatically based on your filing status and Modified Adjusted Gross Income.
For further information about Passive Activity see IRS Publication 925.