There are two kinds of passive activities.
- Business or trade activities in which you do not materially participate for the tax year.
- Rental activities, regardless of your participation
Basically, you can only deduct passive activity losses from passive activity income. This results in a limit on loss deductions. You can carry any excess loss forward to the following year or years until it is used, or until deducted in the year you dispose of your entire interest in the activity in a fully taxable transaction.
There is an exception to the above limitation. If you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000 ($12,500 for married filing separate filers) of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income and passive activities. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under the exceptions.
The maximum special allowance of $25,000 ($12,500 for married filing separate filers and living apart at all times during the year) is reduced by 50% of the amount of your Modified Adjusted Gross income that is more than $100,000 ($50,000 if you are married filing separately). If your modified adjusted Gross income is $150,000 or more ($75,000 or more if you are married filing separately), you generally cannot use the special allowance.
Modified Adjusted Gross income for this purpose is your adjusted gross income figured without the following:
- Taxable Social Security and Tier 1 Railroad Retirement Benefits
- Deductible contributions to individual retirement accounts (IRAs) and section 501(c)(18) pension plans.
- The exclusion from income of interest from qualified US savings bonds used to pay qualified higher education expenses.
- The exclusion from income of amounts received from an employer's adoption assistance program.
- Passive activity income or loss included on Form 8582
- Any rental real estate loss allowed because you materially participated in the rental activity as a real estate professional
- Any overall loss from a publicly traded partnership (PTP)
- The deduction for deductible (one-half) of self-employment tax.
- The deduction for domestic production activities.
- The deduction allowed for interest on student loans
- The deduction for qualified tuition and related expenses (Tuition and Fees has expired for the 2018 tax year. In years prior to 2018, you must add this into the MAGI).
For further information about Passive Activity see IRS Publication 925.