Passive Activity Loss Limitations US Tax On Passive Losses

Taken from article originally published 28th March 2024

As both the New Zealand media and government are currently focused on the taxation of rental properties and landlords, we’ll touch on an area of US taxation which frequently affects our US person clients, who own rental properties.

Whilst we’ve discussed areas such as depreciation recapture for rental properties, we’ll delve a little here into the Passive Activity Loss limitations, and Suspended Losses.

Passive Activity

Firstly, for those of us whom are unfamiliar with accounting and financial terms, we’ll discuss what a passive activity is for tax purposes.

A passive activity generates passive income or loss, which will affect a person’s US tax return.

Passive income is income generated without active participation of the individual earning the income.

For example, owning a rental property is widely treated as a passive income. It generally doesn’t require day to day work of the landlord, and sits quietly in the background generating passive income. Other forms of passive income include interest, dividends, capital gains or investment earnings.

Of course, there are situations whereby earning income from a rental does indeed require active participation of the individual earning the income, such as those who own and manage a number of properties in the form of a full time occupation.

Making this determination of whether rental income is actively or passively earned can be complex, and tax advice should be sought. Complicated rules exist with regards to the amount of time spent on a passive activity (including hours and input), and in some situations a passive activity such as rental income, can be considered to be “earned income”.

For the remainder of this article, we’ll make the assumption that the rental income is treated as passive income for tax purposes.

Passive Activity Loss (PAL)

A passive activity loss is a financial loss incurred as a result of a passive activity.

For example, if the expenses of a rental property (ie maintenance, agent fees, rates etc) exceeded the rental income earned, then this would generate a PAL.

This loss retains its character as a passive activity loss and means that once the individual files their US tax return, the passive activity loss can only be used to offset other passive gains.

Using another example, lets say a US person had a loss on their NZ based rental property of $5000, and they had other passive income (ie investment gains) of $3000, then they may be able to fully offset their investment gains with the loss they incurred. This may result in the $3000 of passive income being free from US taxation.

However, if the individual above also had wages of $80,000 in this period, the passive loss cannot be used to offset this (as wages are active/earned income, not passive).

The amount of the PAL which cannot be deducted becomes a Suspended Loss.

Suspended Losses

A suspended loss is a PAL which could not be used in full in a prior year, and instead gets carried forward to next year’s tax return to be used in future.

When can a Suspended Loss be used?

A suspended loss can be carried forward to future years, and used to offset future passive income. These are subject to Passive Activity Loss Limitations, and the circumstances in which it can be claimed can vary.

One of the most frequent benefits arising from a Suspended Loss, is the ability to offset income on the disposition of the passive asset which generated the loss originally.

Using the example previously of the NZ rental property generating a PAL and thus a suspended loss, this loss can be claimed against passive gains made upon the sale of the rental property.

If however the rental property was sold at a loss (however unlikely in New Zealand’s property market), then limits do apply on how much capital loss can be claimed in any one year.

Summary

Determining what passive activities are subject to the PAL rules can be complicated, and professional advice should be sought. The above only briefly touches on this subject, and there are many instances where PAL limitations can also be beneficial to a taxpayer, enabling deductions where otherwise there wouldn’t be one.

If you are considering investing in a brokerage account, rental property or any other passive activity, seeking US tax advice before investing can be a wise move.