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Do You Have Investments Subject to the Passive Activity Rules?

November 25, 2014

Passive activity rules could have a significant impact on your tax bill.

It’s important to know the answer to this question, because it could have a significant impact on your tax bill. First, income from passive activities may be subject to the 3.8% net investment income tax. Second, losses from passive activities generally can be deducted only from passive activity income. If you don’t have income from other passive activities, or your passive activity losses exceed such income, you’ll have to carry the unused losses forward until you have passive income to absorb them or you sell the investment.

You’ll be subject to the passive activity rules if you’ve invested in a trade or business in which you don’t “materially participate.” Material participation generally requires participating more than 500 hours during the year. Alternatively, you may be able to meet the material participation standard if you can show that you were essentially the sole participant; no one else substantially participated.

If you don’t meet the standard, there may be steps you can take to do so. For example, you may be able to increase your involvement to exceed 500 hours. Or perhaps you participate in activities that could be grouped together to be treated as one activity for tax purposes, making it easier for you to exceed the 500-hour threshold.

If it’s not possible to avoid passive activity treatment and you have passive losses — and insufficient income from other passive activities to absorb them — consider taking steps to create passive income.

For example:
• Reduce your participation in an income-producing activity to the point that it will become passive
• Invest in an income-producing trade or business in which you won’t materially participate

Keep in mind that the rules are complex and there are other tax and nontax factors to consider. In addition, special rules apply to real estate.

So if you hold investments that might be subject to the passive activity rules, please contact us. We can help you sort through the complexities and determine the strategy that’s right for your particular situation.

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