Once the Tax Reform Act of 1986 was passed, taxpayers were no longer allowed to deduct non-economic losses from passive activities from wage and investment income. While the law did not ban such activities, it severely restricted taxpayers’ ability to deduct losses from what is termed “passive activities.”
A passive activity is defined as a rental activity or trade or business in which one does not materially participate. Rental activities are defined as passive regardless of the level of participation, although certain exceptions to deducting losses have been carved out of the rules. The two major exceptions are for: 1) real estate professionals and 2) individual taxpayers with active participation and adjusted gross income below a certain dollar threshold.
The passive activity rules apply at the individual level. Passive activities are reported on Schedules C, D and F; on Partnership Form 1065; S-Corporation Form 1120S; and Form 1041 Trusts. The rules are also applied to personal service corporations and closely held C-Corporations.
How do you “materially participate” in a rental activity? There are seven tests in Reg 1.469-5T(a) (see below), and only one test must be met for the taxpayer to be considered to be a material participant. If you are a married couple, the time tests are measured using the time devoted by both spouses. Material participation is measured on a year-by-year basis.
- Work 500 or more hours in the activity.
- Perform “substantially all” the work on the activity in a given year. Substantially all includes work of non-owner employees or more than 70% of hours worked on the activity during the year.
- Work 100 or more hours and no one else does more.
- Work 500 or more hours in all passive activities owned.
- Materially participate in the activity for five of the immediately preceding ten years.
- If it is a personal service activity with three years material participation prior to the current activity.
- Prove material participation based on fact and circumstances, demonstrating activity on a regular, continuous and substantial basis during the year.
Maintaining a time log on the activities performed is a good procedure to establish proof of time spent on the activity. If there are passive activities that can’t be deducted in the current year, they become suspended and may be deducted in future years against passive gains. When the property is sold in a fully taxable transaction, any leftover suspended losses may be deducted at that time.