Things don’t always go the way we plan in business. We all want to make money, but sometimes we lose money. We know that when we make money, we report the income on our tax return and we owe Uncle Sam. But what about when we lose money? Do we report the loss on our tax return? The answer is (like with most things involving tax law) … it depends.
Various tax rules may prohibit losses from an activity from being deducted in the current tax year. Losses may be limited, suspended, non-deductible, carried forward, unjustly denied to you because you lost real money!!!! due to:
- capital loss limitations,
- S corporation basis limitations,
- Partnership basis limitations,
- At-Risk Limitations,
- Passive Activity Loss Limitations.
And this is a partial list.
Let’s talk about the Passive Activity Loss rules. These rules provide that losses from a passive activity are generally not deductible.
What is a passive activity?
There are two types of passive activities – a trade or business in which you don’t materially participate and a rental activity unless you’re a Real Estate Professional.
So, if you have a loss from any activity, you need to first determine if the activity is a trade or business or a rental activity.
It’s not always that easy to determine if an activity is a trade or business or a rental activity.
What is a rental activity
An activity is a rental activity if tangible property is used by customers and the income from the activity represents amount paid mainly for the use of the property.
But, there’s always exceptions. An activity is not a rental activity if–
- The average period of customer use of the property is 7 days or less.
- The average period of customer use of the property is 30 days or less and you provide significant personal services with the rentals.
- You provide extraordinary personal services in making the rental property available for customer use.
- The rental is incidental to a non-rental activity.
- You customarily make the rental property available during defined business hours for nonexclusive use by various customers.
- You provide the property for use in a non-rental activity in your capacity as an owner of an interest in a pass through entity.
Those are quite a few exceptions for your CPA (including yours truly) to have to remember! Luckily, the rules of tax law usually make sense. The exceptions above all tend to make an activity more like a business than a passive sit back and let money collect rental activity. (Try telling someone who’s ever rented out property that renting property is a passive activity!)
So if you lease a house to a tenant for 12 months, it’s a rental activity. The house is used by the customer and the customer pays you to use the property. None of the exceptions apply.
So if you’re Redbox, and you rent movies or video games to customers, well that business model is a bit different than renting out the spare bedroom above your garage! It’s more like an actual trade or business. The average period of customer use of the property is 7 days or less, so that activity is not a rental activity.
So it’s not a rental activity, that means it’s a trade or business
Not necessarily. If you sell stock at a loss, that’s not a rental activity and it surely isn’t a trade or business. So what is a trade or business?
A trade or business is an activity that involves the activity conduct of a trade or business or is conducted in anticipation of starting a trade or business. :-|. Someone once told me that you’re not supposed to use the term in a definition. The technical definition is a bit more jargon filled than that, but practically speaking, if an activity seems like a trade or business, and not investment and not rental, then it is a trade or business.
So I have the next Redbox. It’s a trade or business. Is it a passive activity?
A trade or business is a passive activity if you do not materially participate in the activity. You materially participate in a trade or business activity if any of the following are true–
- You participated in the activity for more than 500 hours
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated as much as any other individual for the tax year
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours.
- You materially participated in the activity for any 5 of the 10 immediately preceeding tax years.
- The activity is a personal service activity in which you materially participated for any 3 preceding tax years.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Again, the entire list is probably too much for the average CPA to remember. But look at number 7. Again, tax law generally makes sense. If you are engaged heavily in a trade or business, and you simply don’t pass it on to someone else to manage, then you materially participate in the activity, and it won’t be a trade or business.
Great. Now i’m an expert at the Passive Activity Loss rules.
I can’t say that I know anyone who is an expert at the passive activity loss rules. These are only the basics. We didn’t touch on other fun passive activity loss topics, such as –
- Real Estate Professionals
- Spouse’s participation
- Active Participation Exception
- Pass through entities
- Other exceptions to the general rules
- What happens to passive losses
- What happens if an activity changes from passive to nonpassive
- Converting passive activities to nonpassive activities
- Self-rental rules
- Grouping of Activities Rules
There’s a lot to cover, but at a minimum, if you’re going to have losses, you have to understand and need to plan for the fact that losses could be limited if you have a rental activity or if you don’t participate in a business activity.