I’m Not Your Friend—I’m a PAL! Passive Activity Loss Rules Explained
Imagine that you’ve put a significant amount of money into your business or real estate property. Now imagine that it generates loses in the first few years of operations… yet you as an owner are not allowed to deduct those losses on your tax return.
Sounds like a tax nightmare, right? Unfortunately, the situation is not uncommon. It’s the result of passive activity loss (PAL) rules, and this article will help you understand them and the tax strategies designed to minimize their impact.
What is passive activity loss?
Any business owner who is not regularly, continuously, and substantially involved in the operations of a business may be considered passive and subject to PAL rules. Under these rules, if your passive losses exceed your passive income, they are suspended rather than deducted in the current tax year.
In other words, your losses from activities classified as passive cannot offset your income from other activities such as wages, interest or dividends. Suspended passive activity losses are carried forward to future tax years and utilized when there is enough passive income to absorb them or the activity is disposed of.
In order not to be considered passive, a business owner must meet one of the following material participation tests:
- Participates in the activity for more than 500 hours during the year. That’s almost 10 hours a week of working in or on the business.
- Participates in the activity for more than 100 hours during the year as long as no other person participates more than 100 hours.
- Participates any amount of hours but no other person participates in the activity
- Materially participated in any five out of last ten years
For married taxpayers, if one spouse is considered materially participating, the other one is automatically qualified, even if individually, the spouse would not meet any of the above tests.
It is important to note that income from real estate activities is considered passive by default, and meeting the material participation tests is not enough to avoid passive classification. Taxpayers in lower income tax brackets are allowed to deduct up to $25,000 of their rental property losses; however, this deduction is phased out for taxpayers with adjusted gross income of over $100,000.
Here are a couple of easy examples to put the passive activity loss rules just described in real-life terms.
You purchase a commercial property for $500,000 and rent it out for $24,000 a year. Your annual expenses are $20,000 and you are also allowed a depreciation deduction on your property of $12,000. Accordingly, although your property earns you $4,000 in cash this year, you have a tax loss of $8,000 due to depreciation. Additionally, you also run a small real estate management company that generated $75,000 of income.
On a surface, it looks like you have an $8,000 passive loss from your rental property and $75,000 nonpassive income from your business in which you materially participate. Since your income is below $100,000, you are allowed to deduct up to $25,000 of rental loss. So only $67,000 of your income is subject to tax.
Let’s use the same scenario but add the fact that your spouse made $150,000 in wages in the same year. Now your total income is over the threshold and your $8,000 passive rental loss is no longer deductible. The entire $75,000 of your business income is subject to tax along with your spouse’s wages. The rental loss is suspended and carried forward to future years. You do not expect your rental property to generate any significantly higher income in future years, so your suspended losses will only keep growing.
Do you ever get to use those suspended passive activity losses? The good news is that you do but you may have to wait quite some time to do so. Suspended losses are released only when you have passive income in excess of passive losses (for example, if you invest in another entity that generates more passive income). Losses can also be released in the year you dispose of the property or business that generated the passive loss. This is why keeping track of your suspended passive losses is very important, as they are significant in offsetting the gain on disposition (if any) or creating a larger deductible loss.
That’s not fair! What can I do?
The only true way out of the trap of passive activity losses is to obtain a classification as real estate professional from the IRS. This requires more than possession of a real estate license; it can only be accomplished by meeting both of the following criteria:
- Spend more than half of your working time on real estate related activities in which you materially participate. This includes time spent on real estate management, maintenance, renovation and construction, development and redevelopment, acquisition, conversion, rental, leasing and brokerage. It is important to note that each activity is evaluated separately for the purpose of material participation test unless a special grouping election discussed later is made.
- Spend more than 750 hours per year on activities identified in the first test.
In our second example, you can use this strategy to prevent suspending of the losses altogether. Since you are the only person who regularly and continuously participates in running your commercial property (and there is no one else helping you), you materially participate in the activity.
Because it is a rental property, your material participation is not enough to make the loss nonpassive. However, since you are also materially participating in the real estate management business, you do spend all of your time in real estate-related activities. And if you work full time, you likely meet the 750 hours test between running the commercial rental and the real estate management business.
So congratulations—you now qualify as a real estate professional, and all of your rental loss is nonpassive and deductible! (Note that good records are very important when claiming a real estate professional status especially for taxpayers who spend time on activities other than real estate. So make sure you’re accurately recording the work you do and the hours you put in.)
There are other strategies available for taxpayers with multiple business activities. Several rental properties can be aggregated into one rental activity for the purpose of meeting the material participation test. A special election has to be filed in a timely manner with your tax return in order to utilize this strategy. Occasionally, a taxpayer may want to reduce his or her involvement in the business to intentionally make the activity passive if the income from that activity could free up some passive losses from another activity.
PAL rules are complex and should be evaluated in detail. If you expect passive activity losses or have suspended losses from prior years, consult an experienced real estate CPA to assess your activities and deploy an appropriate tax strategy.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.