These glossary posts are intended to be an expansion on the brief definitions given in this website’s “Glossary of Tax Terms.”
Unfortunately, when talking about passive activities, it’s hard to expand on the topic without making a reader’s head spin.
But here goes. As stated in the Glossary: “A passive activity is an investment activity in which a taxpayer doesn’t ‘actively participate.’ In overly simplified terms, this means the taxpayer doesn’t work in the business day-to-day. There are limits on the amount of losses a taxpayer can deduct from passive activities.”
Here’s an example: a taxpayer invests in an ethanol plant that is taxed as a partnership. The taxpayer is taxed on their share of the income generated by the plant. Chances are, the taxpayer is just an investor and doesn’t participate in the day-to-day operations of the ethanol plant. That’s a passive activity.
It gets more complicated if the taxpayer is involved a little bit in the day-to-day operations. There are various factors to look at in that situation and it’s too complicated to get into in this blog post.
Why is this a big deal?
Because tax law places limitations on deducting losses from passive activities.
Let’s go back to our taxpayer who invests in an ethanol plant. The plant suffered an operating loss for the year, and some of that loss passes through to the taxpayer. Tax law says the taxpayer can only deduct that loss if they also had positive income from passive sources. If they had no other income from passive sources, then they wouldn’t get to take ANY of their passive loss from the ethanol plant this year. Instead, the loss would carry forward to a future year when the taxpayer either 1) had income from passive sources or 2) sells their entire investment in the plant.
As you can imagine, passive activities can be EXTREMELY complicated, even for those of us who work with things like this all the time.
Oh and by the way, I didn’t even mention the rules relating to rental properties. Rental properties are also considered passive activities, but a different set of rules apply relating to deducting rental losses.
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