Passive Activities

Some investment activities are defined as “passive” to prevent their use as tax shelters for other types of income. Passive activities are of two types:

  1. the owner (often limited partnerships or S Corporations) does not “materially participate” and
  2. any rental activity (irrespective of the level of participation) for which payment is mainly for the use of tangible property. (There are a few exceptions.)

Passive activity investments do not include stocks and bonds. There is an exception to the passive-loss restrictions for those who actively participate in renting real estate.

Calendar year filers must report new groupings or changes in how passive activities are grouped. The reporting rules are intended to keep filers from playing games to deduct losses. The grouping rules are important because if two or more activities are grouped as one, the disposition of an activity will not trigger any suspended passive losses until all the others are disposed of.

Passive losses you can't deduct this year can be carried forward and deducted when you dispose of the entire activity or have passive income to offset them. Any interest owners receive on loans to passive activities is treated as portfolio income, and can’t be used to offset passive losses—except that interest earned on loans owners make to partnerships or S Corporations with passive activities (such as rental realty) is passive income to the owners. The owners need not have a 10% share in the S Corporation or partnership to use this break.

To reduce your passive-activity interest expense, reduce your debt in a rental activity or convert the debt to home-equity debt, the interest on which may be deductible. (Use the proceeds from a home-equity loan to repay passive-activity loans.)