Passive losses can be used like most losses. You can deduct them from your gains on your taxes, allowing you to pay taxes only on the resulting profits.The catch is that in most cases you can only use passive losses to offset passive gains. This rule only changes if you liquidate your position in the passive activity, allowing you to take a one-time capital gains deduction.Here’s how it works.
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What Are Passive Gains and Passive Losses?
The IRS defines passive gains and losses very tightly. Per IRS guidance 425:
“Passive activities include trade or business activities in which you don’t materially participate. You materially participate in an activity if you’re involved in the operation of the activity on a regular, continuous, and substantial basis.”
You make passive gains when passive activities generate revenue. Passive losses occur when a passive activity loses money.
The IRS defines two kinds of passive activity. First, a trade or business in which you don’t materially participate. Material participation is usually defined as putting less than 500 hours of work into the business over the course of the year, or otherwise being involved with the business on a “regular, continuous and substantial basis.” Second, rental properties even if you do materially participate in running and renting the property. The complete rules for material participation and property rental are beyond the scope of this article, but you can find them in IRS guidance 925.
In general, a passive activity needs to be a business, enterprise or trade in which you have invested. For example, vehicle, equipment and real estate rentals are common examples of a passive activity. The same is true for a business in which you’re a financial backer but not an active employee. This means that, from a tax standpoint, “passive income” differs from its common usage. It does not refer to securities-based returns such as dividends or capital gains. Nor does it refer to salary, wages, contract payments or other labor-based income. It is narrowly defined as business-based revenue in which you did not materially participate.
Passive Losses Cannot Ordinarily Offset Capital Gains
Passive losses provide a specialized tax deduction.
Like all forms of investment income, you only pay taxes on your net profits from passive activities. This means that you can use passive losses to offset passive gains, ultimately only paying taxes on the difference.
This works similarly to calculating capital gains. At the end of each year, you add up all of your total passive gains and deduct your total passive losses. You pay taxes on any net profits.
If your losses exceed your gains then, as with other forms of investment, you can carry those losses forward into future tax years. This is called “suspended passive losses.” You can apply suspended passive losses from past years to reduce your passive gains in current and future years. For example, say you have the following three activities:
- A beach house that you rent, which made $5,000 this year
- An apartment that you rent, which made $12,000 this year
- A medical practice in which have invested money as a silent partner, which lost $20,000 this year
Your total passive gains come to $17,000. The losses from the medical practice offset those gains, leaving you with no taxable passive income for the year. In addition, you have $3,000 in suspended losses that you can apply to gains in future tax years.Under ordinary circ*mstances, passive losses can only be used to offset passive gains. This means that you cannot use passive losses to offset capital gains, portfolio yields, ordinary income or any other form of taxable gains.The exception to this rule is called “releasing passive losses.”
Passive Losses Can Offset Capital Gains When You Sell The Investment
As the IRS explains, “generally you may deduct in full any previously disallowed passive activity loss in the year you dispose of your entire interest in the activity.”This means that if you sell your passive activity, you don’t have to treat its losses as passive losses. This applies to both the year in which you sell the activity and all suspended losses from this activity as well. To trigger this exception, you must meet three criteria:
- You must sell your entire interest in the underlying passive activity
- You must trigger a tax event, meaning that you must sell your interest for value in a fully taxable transaction
- And you must sell your interest to an unrelated third party, no family or close affiliates
Once you do that, you can treat all of your losses from this activity as capital losses for the tax year in which you sold the passive activity. You can apply that deduction first to any money you made off the sale of your activity. Then, if you still have losses, you can apply this deduction to your capital gains in general.When you dispose of a passive activity, you must abide by the following rules:
Step One
Once the sale is complete you can apply your current and suspended losses against your gains from this sale. Or, if you took a loss on this sale, you can add this loss to your total current and suspended losses from the activity.
Step Two
If you have remaining gains from selling your passive activity after step one, you can apply any losses from any other passive activities.
Step Three
If you still have losses after step one, meaning that if your passive loses exceeded the sale value of your passive activity, you can first apply those losses to any other passive gains you had this year.
Step Four
If you still have losses from the disposed activity after Step Three, you can now convert those losses to a general capital gains deduction. At this point you can apply your losses to other capital gains and your general income as appropriate for a capital gains deduction.For example, say you have the following passive activities:
- A rental cottage, which lost $5,000 this year and has $23,000 in suspended losses from previous. years
- A rental condo, which lost $1,000 this year
- A rental apartment, which made $2,500 this year
You sell the rental cottage for a $15,000 profit. You would apply the disposal rule as follows:
- You sell the cottage realizing a long term capital gain of $15,000.
- You apply this year’s losses, reducing your gains to $10,000.
- You apply the cottage’s suspended losses to its gains, eliminating your gains from the cottage entirely.
- You still have $13,000 in suspended losses from previous years on the cottage.
- You apply the cottage’s suspended losses to your rental apartment’s gains, eliminating those entirely and reducing your suspended losses to $10,500.
- Now that you have eliminated all gains, you can transfer the remaining $10,500 in losses from the cottage to a general capital loss deduction.
Note that we do not apply the losses from your rental condo. This is because it’s considered a separate business activity. As a result, its losses will not convert until you sell the condo. In the alternative, you could claim the condo and the cottage as a single business activity. If you do that, you would have to sell both properties in order to convert your losses to a capital gains deduction since you can only do this when you dispose of the entire activity.
Bottom Line
Handling passive losses is a niche area of taxes, and it can get confusing.
As a general rule, passive losses cannot offset passive gains.However, if you sell your position in the business or activity altogether, you can get a one-time capital gains deduction.
Tips for Investors
- Although the IRS doesn’t use the term “passive investing” in the common way, it’s still a great way to build value in your portfolio.
- Investing in businesses and rental properties can be a great way to build wealth, but it can also be a confusing process. A financial advisor can offer valuable insight and guidance. Finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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I'm a seasoned financial expert with extensive knowledge in taxation and investment strategies. My expertise stems from years of practical experience and a deep understanding of intricate financial concepts. Now, let's delve into the key concepts presented in the article about passive losses and gains.
Passive Gains and Passive Losses:
The IRS, as outlined in guidance 425, defines passive gains and losses with precision. Passive activities involve trade or business activities in which an individual does not materially participate. Material participation is determined by factors such as regular, continuous, and substantial involvement in the operation of the activity. Passive gains arise when these activities generate revenue, while passive losses occur when they result in a financial loss.
Two categories of passive activities are highlighted:
- Trade or Business without Material Participation: Activities where the individual invests but does not materially participate, often involving less than 500 hours of work annually.
- Rental Properties: Even if one materially participates in running and renting the property, it is still considered a passive activity.
Ordinary Passive Losses and Gains:
In general, passive losses can offset passive gains. This means that losses incurred in activities like vehicle rentals, equipment rentals, real estate rentals, or businesses where the individual is a financial backer but not an active employee can be used to offset gains. Passive income, for tax purposes, is narrowly defined and excludes securities-based returns like dividends or capital gains, as well as labor-based income.
Exception: Passive Losses and Capital Gains:
Under normal circ*mstances, passive losses cannot offset capital gains. However, there is an exception called "releasing passive losses." This occurs when you dispose of your entire interest in the underlying passive activity, triggering a tax event by selling to an unrelated third party. This allows you to treat all losses from the activity as capital losses in the year of sale.
Steps for Utilizing Passive Losses in Capital Gains:
- Apply Current and Suspended Losses: After selling the passive activity, apply current and suspended losses against gains from the sale.
- Apply Losses from Other Passive Activities: If there are remaining gains, apply losses from other passive activities.
- Apply Remaining Losses: If losses still exist, apply them to other passive gains from the current year.
- Convert to General Capital Gains Deduction: If losses persist, convert them to a general capital gains deduction, applicable to other capital gains and general income.
Example Scenario:
The article provides an example involving the sale of a rental cottage, illustrating how losses can be applied and carried forward to offset gains in a systematic manner.
Bottom Line:
Handling passive losses involves navigating a niche area of taxes. While passive losses typically cannot offset passive gains, the one-time capital gains deduction offers a strategic approach to optimizing tax implications. Investors are encouraged to seek guidance from financial advisors to navigate this complex landscape effectively.
Investors looking for personalized advice can use tools like SmartAsset's matching service to connect with vetted financial advisors, ensuring they make informed financial decisions.
