If you’ve invested in a trade or business in which you don’t materially participate, remember the passive activity rules. Why? Passive activity income may be subject to the NIIT, and passive activity losses generally are deductible only against income from other passive activities. You can carry forward disallowed losses to the following year, subject to the same limits.
To avoid passive activity treatment, typically you must participate in a trade or business more than 500 hours during the year, or demonstrate that your involvement constitutes substantially all of the participation in the activity. Special rules apply to real estate: to qualify as a real estate professional, you must annually perform:
- More than 50% of your personal services in real property trades or businesses in which you materially participate, and
- More than 750 hours of service in these businesses during the year.
If you don’t pass this test, consider:
Increasing your involvement
If you can exceed 500 hours, the activity no longer will be subject to passive activity rules. If the business is structured as a limited liability company (LLC), proposed IRS regulations may make it easier for you to meet the material participation requirement. Check with one of our tax advisors for more information.
You may be able to group certain activities together to be treated as one activity for tax purposes, and exceed the 500-hour threshold. But the rules are complex, and there are potential downsides to consider.
Looking at other activities
Another option if you have passive losses, is to limit your participation in another activity that’s generating income, so that you don’t meet the 500 hours test, or invest in another income-producing trade, or business that will be passive to you. Under both strategies, you’ll have passive income that can absorb your passive losses.
Disposing of the activity
This generally allows you to deduct all the losses — including any loss on disposition (subject to basis and capital loss limitations). But, again, the rules are complex.
Seek the services of a legal or tax adviser before implementing any ideas contained in this blog.