Passive Activity Loss Rules

See: Passive Activity.

According to the IRS, we can make (or lose) money in two ways: actively or passively. When our passive activities end up losing us money, we might be tempted to offset those losses by deducting them from our active income (like our salary), but this is a big IRS no-no. How do we know? Because it says so in the IRS’s passive activity loss rules. “Passive activity loss rules” are exactly what they sound like: they’re rules about what we can—and can’t—do with losses from passive activities. They’re designed to keep people from doing the whole shady-tax-shelter thing to unfairly reduce their tax debt. And these rules don’t just apply to individuals, FYI. They apply to businesses too.

Anyway, here’s what we can do: we can deduct passive losses from our passive income. For example, if we earn $5,000 in dividends but somehow manage to lose $1,000 on a rental property we own, we can subtract the rental loss from the dividend amount, and then we only have to pay taxes on the $4,000 profit. Also, if our passive losses are more than our passive income—let’s say we lost $5,000 on the rental property and only received $1,000 in dividends—then we can carry the excess loss forward to next year.

Here’s what we can’t do: as mentioned before, we can’t claim the $1,000 rental loss against our $60,000 teaching salary. And while we can carry excess passive losses forward to future years, we can’t apply them to years that have already come and gone. If we’re not sure what this all means for us come tax time, we should consult a tax professional and get the passive loss skinny.