Question

What is the importance of the passive activity rules from the perspective of the taxpayer and U.S. Treasury?

Answer 1

Passive activity loss rules are a set of IRS rules that prohibit using passive losses to offset earned or ordinary income. Passive activity loss rules prevent investors from using losses incurred from income-producing activities in which they are not materially involved.

Being materially involved with earned or ordinary income-producing activities means the income is active income and may not be reduced by passive losses. Passive losses can be used only to offset passive income.

The key issue with passive activity loss rules is material participation. According to IRS Topic No. 425, "material participation" is involvement in the operation of a trade or business activity on a "regular, continuous, and substantial basis." If the taxpayer does not materially participate in the activity that is producing the passive losses, then those losses can only be matched against passive income. If there is no passive income, then no loss can be deducted. However, rental activities, including real estate rental activities, are considered passive activities even if there is material participation ("real estate professionals" cannot benefit from this exception).

Passive activity losses can only be applied in the current year, and if they exceed passive income they can be carried forward without limitation; they cannot be carried back.

The passive activity rules apply to:

• Individuals,

• Estates,

• Trusts (other than grantor trusts),

• Personal service corporations, and

• Closely held corporations

It helps the taxpayer not to set off the profits from business where material participation is involved with the passive losses of past years and also US Treasury is helped as tax is not avoided or reduced because of set off of passive losses against active current year income or profits.