Code Section 469 defines passive activities as “any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate.” This section was enacted in 1986 in an effort to reduce the prevalence of tax shelters.
You hear a lot of talk about tax shelters, especially during election season. Back when Sec. 469 was enacted, tax shelters commonly involved real estate, where businesses owned property and generated losses for the investors. The investors were able to offset- or shelter- their other income with these losses. For example, if someone had $100,000 in wages and $20,000 in real estate tax shelter losses, they would only be taxed on $80,000. Real estate activities were specifically identified by Sec. 469 as passive (unless the taxpayer qualifies as a real estate professional-to be discussed in a different post).
How Passive Activity Income Works
Classifications and Buckets
Income can be classified as passive or non passive (there are other classifications as well, but we will ignore those for this discussion). Losses of a particular type can only offset income of the same type. You can think of different types as being in different buckets, not able to mix with each other. So the losses for passive activities can only offset the income for passive activities. The exception to this grouping is when a passive activity is disposed, then it becomes non passive- meaning that when you sell a passive activity any losses generated can be used to offset other income.
Passive Activity Income Examples
The most basic example is a passive loss from a rental property. Any losses generated CANNOT offset non passive income. It is the opposite of the tax shelter example above.
Say you have two rental properties, one generates a loss and the other generates income. The income and loss from two properties will net against each other. BUT if there is a net loss, that CANNOT be used to offset other non passive income.
Now say you sell the rental property that has been generating losses. In the year of the sale, those losses are “freed up” and can be used to offset other non passive income.
Summary and Conclusion
The basic thing to remember is that passive and non passive income don’t mix. Same nets against same in their buckets, except in the year of a sale of a passive activity. This was a simplified explanation of passive activity rules and an extremely simplified explanation of rental properties. Please if you own real estate speak with a tax expert- every individual situation is different!