Passive activity expenses and losses are those attributable to passive activities that generate income. Such expenses and losses can only be used to offset income from passive activities with one exception. Expenses and losses that exceed passive activity gross income may be applied retroactively or carried forward until such excess is used up. Passive activity rules apply to individuals, trusts, estates, personal service corporations, and closely held C corporations, but not S corporations or partnerships although they apply to partners and shareholders at the individual level respectively. Note: a taxpayer who owns an interest in an activity as a limited partner is not treated as materially participating in the activity by definition.
Generally, a passive activity is any activity that may be considered a trade or business where the taxpayer does not materially participate. Material participation means that a taxpayer is involved in the operations of the activity on a regular, continuous and substantial basis. Moreover, it is determined for each tax year. Typically, passive activities will include rental activities, irrespective of whether the taxpayer materially participates or not. A taxpayer usually cannot deduct a loss from a rental activity even if he materially participates in the activity. Nonetheless, a taxpayer’s rental real estate activity is not a passive activity if the taxpayer: 1) materially participates in the activity, and 2) performs qualifying services in real property trade or business. To determine this, a facts and circumstances test is used.
One exception to the definition of a passive activity is a working interest in any oil and gas property that a taxpayer holds directly or through an entity that does not limit the taxpayer’s liability for the interest, regardless of whether there is material participation or not.