A passive activity, according to the IRS, is a trade or business activity where the taxpayer does not materially participate in operations. This typically includes rental properties and investments where the individual is not regularly, continuously, and substantially involved. Understanding passive activity rules is critical because they affect how taxpayers can deduct losses generated by these activities.

The IRS instituted passive activity loss (PAL) rules under the Tax Reform Act of 1986 to prevent taxpayers from using losses from businesses where they had little involvement to offset income from active sources, like salaries. If you own a business and are heavily involved day-to-day, such as owning and running a pizza shop, your participation is active. But if you just invest money and do not engage in management or operations, your activity is passive.

Classification of Passive Activities

Passive activities generally fall into two categories:

  1. Trade or business activities where you do not materially participate.
  2. Most rental activities, even if you spend time managing properties, unless you qualify as a real estate professional.

Activities that do not count as passive include active businesses where you materially participate, portfolio income like dividends or interest, and wages from employment.

Material Participation Tests

Material participation determines whether your involvement in an activity is active or passive. The IRS defines seven tests to measure this. Meeting any one of these means the activity is active (not passive):

  • Participate more than 500 hours in the year.
  • Your involvement is substantially all the participation in the activity.
  • You participate more than 100 hours and more than anyone else.
  • Combined significant participation activities exceed 500 hours.
  • Material participation in the activity for five of the prior ten years.
  • Material participation in a personal service activity for any three prior years.
  • Based on facts and circumstances, participation is regular, continuous, and substantial.

Failing all tests means the activity is passive. For detailed criteria, see our Material Participation guide.

Passive Activity Losses and Tax Impact

The IRS restricts how passive losses can be used. Losses from passive activities generally can only offset income from other passive activities, not active income (like wages) or portfolio income (dividends, interest).

If you have passive losses that exceed passive income for the year, those losses are suspended and carried forward indefinitely until you generate passive income or sell the activity.

There are exceptions:

  • Real estate professionals who meet tight requirements may deduct rental losses against active income.
  • Taxpayers with AGI under $100,000 who actively participate in rental real estate can deduct up to $25,000 in rental losses against active income (phasing out at $150,000 AGI).

Practical Examples

  • Owning a rental property managed by a company is usually passive.
  • Being a limited partner in a business without involvement results in passive activity income/loss.
  • Investing in a friend’s business but not participating in operations is passive.

Reporting and Compliance

Passive activity income and losses are reported on IRS Form 8582. Maintaining detailed records of your participation hours is vital for substantiating your status with the IRS if questioned.

Summary

Understanding passive activities helps taxpayers navigate complex IRS rules and optimize tax outcomes on rental and investment income. For more on related topics, check our glossary entries on Material Participation and Passive Income.

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