Under The Tax Reform Act of 1986, a taxpayer is no longer allowed to deduct losses in full from rental activities and trades or businesses regardless of his or her participation. IRC § 469. For businesses reportable on IRS Form Schedule C, Profit or Loss From Business (Sole Proprietorship); Schedule F, Profit Loss From Farming; or Schedule E, Supplemental Income and Loss, as well as flow through income and losses from partnerships, S Corporations, and trusts, a taxpayer can deduct losses if he or she materially participates. Losses generated by passive activities can only be used to offset income generated by passive activities.
According to the IRS, the two types of passive activities are rentals, and businesses in which the taxpayer does not materially participate. Generally, income and losses from the following activities are passive:
- Rental real estate by a nonprofessional real estate agent,
- Equipment leasing,
- Sole proprietorship or farm the taxpayer does not materially participate in,
- Certain limited partnership interests, and
- A partnership, S corporation, and limited liability company in which the taxpayer does not materially participate.
Participation is determined separately for each activity. If a taxpayer works on a business regularly, continuously, or has a substantial participation in how the business operates, the participation is generally considered material. IRC § 469(h)(1). With real estate activities, if the taxpayer makes management decisions, he or she can generally deduct up to $25 thousand in losses against non-passive income, subject to the $150,000 MAGI limitation.
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