8695 / What are the passive loss rules?

The passive loss rules are a set of rules that are generally intended to prevent losses from passive activities from offsetting salaries, interest, dividends, and income from “active” businesses. They apply to individuals, estates, trusts, closely-held C corporations, and personal service corporations (see Q 8696).

Under the passive loss rules, aggregate losses from “passive” activities (see Q 8697) may generally be deducted in a tax year only to the extent they do not exceed aggregate income from passive activities in that year. Similarly, credits from passive activities may be taken against tax liability allocated only to passive activities.¹ (In the case of certain publicly traded partnerships, aggregation is not permitted. See Q 8701 for details.) The passive loss rules generally apply to losses incurred in tax years beginning after 1986.

An individual can also deduct a limited amount of losses (and the deduction-equivalent of credits) arising from certain rental real estate activities against nonpassive income. A closely-held C corporation (other than a personal service corporation) can deduct its passive activity losses against its net active income (other than its investment, or “portfolio,” income) and its passive credits can be applied against tax liability attributable to its net active income.²

Generally, a corporation is considered to be closely-held if it has five or fewer shareholders who own more than 50 percent of the value of its stock.³ A personal service corporation is a corporation the principal activity of which is the performance of personal services and these services are substantially performed by employee-owners.⁴

A taxpayer may elect to treat investment interest (see Q 8705) as a passive activity deduction if the interest was carried over from a year prior to 1987 and is attributable to property used in a passive activity after 1986.⁵ However, the interest deduction is not treated as being from a pre-enactment interest in a passive activity.⁶