Passive Activity Income

Under the 1986 tax act, is generated by:

1. Any trade or business conducted for profit in which the taxpayer does not materially participate.

2. any rental activity, whether or not the taxpayer materially participates.

Rental activities are presumed to be passive. These include all activities that generate income from payments for the use of property rather than for the performance of services. Rental activities include long-term rentals of apartments, net leased property, office equipment, and automobiles. In contrast, the rental of hotel rooms or transient apartments and short-term car rentals are not passive because of the extent of services provided.

Because rental real estate is a passive activity, owners may not use losses to shelter other types of income. These are exceptions:

1. "Qualified real estate professionals" are excluded from passive activity rules.

2. "Active" Participants in rental real estate are allowed to shelter up to $25,000 per year of losses against nonpassive income. A less stringent definition of active participation is provided as compared to Material Participation.

3. A closely held C corporation (other than a personal services corporation) may use passive losses and credits to offset its net active income, but not portfolio income. An S corporation may not apply passive losses and credits against other income.

4. Mortgage Interest on a Principal or a Second Home Residence is not subject to these rules even when the residence is rented out. Example: Paul bought an apartment complex in 2004, which generated a $30,000 tax loss. If Paul meets the test of an active investor, up to $25,000 of the loss may be used to offset active or portfolio income. If not, the entire loss remains suspended until Paul earns Passive Income.