Are You Subject to the Passive Activity Rules?
posted Jun 15, 2017 by Sean Kelly, CPA in the Global Tax Blog
Attention investors...you’ll be subject to the passive activity rules if you’ve invested in a trade or business in which you don’t “materially participate”. How do you know if your participation is passive or material? The IRS has prescribed seven tests to help individuals classify income, gains and losses from activities. Below is a summary of the PAL basics as well as the seven tests for material participation.
What exactly is a PAL? A passive activity loss, or PAL is any rental activity or any business in which the taxpayer does not materially participate. If you do not participate in the activity on a regular, continuous and substantial basis, the activity is likely a passive activity. Passive business or rental income is subject to the 3.8% net investment income tax. Losses from passive activities generally can only be offset by income from other passive activities. One exception on rentals: You may be allowed to deduct up to $25,000 of rental property passive losses if you actively participate (different than material participation) in a rental activity. The deduction begins to phase-out when your Modified Adjusted Gross Income (MAGI) hits $100,000 and is fully phased-out at $150,000.
So, you’ll be subject to the passive activity rules if you cannot prove your material participation.
The seven tests for material participation (you only need to pass one of the following tests)
- You participate in the activity for more than 500 hours during the year.
- Your participation in the activity constitutes all the participation by all individuals (including those who’re not owners of interests in the activity).
- You participate more than 100 hours and as much or more than any other person.
- You participate more than 100 hours but you participate less than one or more people. Nonetheless, your participation in all of your significant participation activities for the year totals more than 500 hours.
- You materially participated in the activity for any five of the preceding ten tax years.
- The activity is a “personal service” (Your Company qualifies as a personal service corporation if your employee-owners perform personal services in the health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting industries) in which you materially participated in any three of the previous tax years.
- You participate on a regular, continuous and substantial basis (with certain exceptions)
Need more help with your rental activities?
Rental activities are generally classified as passive by default under the PAL rules. In order to avoid passive treatment, as well as the 3.8% net investment income tax, you must qualify as a real estate professional. If you are considering this election, check out a couple of my past blogs for more information:
How do the Passive Activity Rules Apply to Rental Real Estate?
The Pros and Cons of Making the Grouping Election for Your Rental Real Estate Activities
With the right planning, you may be able to minimize or perhaps eliminate the harmful effects of the PAL rules. Contact our Tax Services Team for more information.