Passive Activity Loss Rules: Understanding At-Risk Rules

Businesses often end up losing money, and from a tax perspective, the consolation prize is that you can often use those losses to offset other income and reduce your tax bill. Unfortunately, however, this rule does not apply to all losses. The Internal Revenue Service (IRS) has very strict rules about claiming losses that exceed your risk in a business, and the agency also limits the losses you can claim from passive activities. Here is an overview of the essentials.

What Are the IRS's At-Risk Rules?

At-risk rules state that you cannot claim a loss that exceeds your risk in a business activity. Your risk is the money and property you contribute to the activity. It also includes money you borrow for the activity if you're personally liable for the loan or if you use personal property as collateral.

To give you an example, imagine that you own a liquor store as a sole proprietorship. When you file your tax return, the liquor store has a loss of $30,000. You paid for all of the business's expenses which means that you contributed the $30,000 for the loss. Based on the at-risk rules, you may be able to claim this loss against other income on your return.

Now, here's another example. Say that a brother and sister have a partnership with a $30,000 loss. Theoretically, they should each be able to claim a $15,000 loss from the partnership. However, the brother took out a loan to cover the business's expenses, and the sister did not contribute any money to the business. Based on the at-risk rules, the sister cannot claim this loss on her tax return, but her brother may be able to claim the loss.

However, the at-risk rules are just the first rules you need to consider. Next, you need to consider the passive activity loss rules.

What Are Passive Activity Loss Rules?

Passive activity loss rules restrict you from claiming passive losses against other income. To illustrate, return to the example above. The sister was not allowed to claim her partnership losses due to the at-risk rules, but these rules did not prevent the brother from claiming his losses.

If the brother materially participated in the business, he can claim his losses against his regular earned income. Imagine, for example, that he is a nurse who earned $100,000 in wages. The $15,000 loss reduces his earned income to $85,000 on his tax return.

However, if he did not materially participate in the partnership, he has passive losses. In that situation, he can only claim those losses against other passive income on his tax return. He cannot use the passive losses to offset the income he earned as a nurse.

However, he can roll the passive losses to the following tax year. Then, he can claim them against profits from that same passive activity. Say for example, that the following year, the partnership earns $50,000 in profit. He reports $25,000 on his tax return, but once he rolls forward the passive loss from the previous year, he reduces his profits to $10,000 on paper.

How Do Passive Activity Loss Rules Apply To Investments?

Passive losses don't apply to investments in real estate, stocks, bonds, or other items that you buy and sell in hopes of making a profit. These types of investments either generate capital gains or losses. Instead, passive losses come into play when you invest in businesses in which you don't materially participate or when you earn rental income.

You cannot use passive losses to offset capital gains from investments. For instance, if you have a $15,000 passive loss and $30,000 in capital gains from selling stocks, you cannot use the passive loss to reduce the gains from those investments. However, you can use passive losses to offset gains from other passive activities.

Passive Activity Loss Rules and Rental Real Estate Activities

The passive activity loss rules specifically apply to rental real estate activities. All rent income is considered a passive activity unless you are a real estate professional. Then, it is considered active income.

However, you can consider the activity active if one of the following applies:

1. The average rental period is seven days or fewer.
2. The average rental is 30 days or fewer and you provide significant personal services.
3. You provide extraordinary personal services and the customer's use of the property is incidental to the services.

There is a special $25,000 allowance if you or your spouse actively participate in a rental real estate activity. Active participation includes activities like making management decisions, and it is a much lower standard than material participation. In this case, you can claim up to $25,000 of these passive losses against your ordinary income. Note that you can only claim up to $12,500 if you file married filing separately.

How Passive Activity Loss Rules Affect Business Owners

Passive activity loss rules can lead to unnecessarily high tax liabilities because they prevent you from using losses to reduce other income. In contrast, if you materially participate in an activity, you are not subject to these rules, and by extension, you can leverage your losses to reduce your tax liability.

If you meet any of the following criteria, you meet the IRS's material participation rules.

• You participate in the business for more than 500 hours during the year.
• You provide all of the participation in the activity (even if it is less than 500 hours).
• You participate at least 100 hours, and you participate at least as much as anyone else involved in the activity.
• You materially participated in the activity for at least five of the last 10 years.
• The activity is a personal services activity, and you materially participated in any three previous years.

In other words, if you’re thinking “my business lost money this year, will I be able to reduce my personal taxable income for this” or if you anticipate having a loss, you may want to ensure that you meet the material participation rules so that you are not subject to the passive activity loss limits.

This is a high-level overview of the at-risk and passive activity loss rules. The Internal Revenue Code detailing these rules has countless subsections and caveats. To ensure that you're optimizing your business and investment tax situation, you should consult with a tax specialist.

To get answers now, contact us today. At Flynn & Company, we offer business advisory services designed to help you optimize your tax and financial planning.