What is Passive Activity Loss?

Passive activity loss is any type of financial loss that is sustained as a result of some passive investing or passive management strategy. Depending on the circumstances surrounding the loss, it may or may not be used to offset any gains achieved from the generation of active income or portfolio income. More often, passive activity loss is considered suspended until some type of passive income is generated to balance the loss.

In order to understand the nature of passive activity loss, it is important to define what is mean by passive management or passive investing. This particular approach to investing involves focusing more on long-term options that require little to no maintenance in order to earn a return. Sometimes referred to as a couch potato approach, passive investing makes it possible to acquire investments that are likely to post a consistent return from one year to the next. With this strategy, the investor chooses to execute new transactions when and as desired, not because circumstances demand that some sort of action be taken.

One example of passive investing would be the investment in a piece of real estate where the owner is not actively involved in the management of that property. In many countries, there are regulations that define what is meant by material participation. For example, the owner of the property may be considered passive if he or she leaves the management of the property to a co-owner, and receives a specified percentage of the monthly profits as a result of that hands-off form of participation. Should the owner become actively involved in the management of the rental property, the income generated is no longer passive.

A passive activity loss takes place when shifts in the marketplace have a negative impact on the performance of those long-term options. At the time of the loss, the investor essentially has two options. The investment that posted the loss can be maintained, in hopes that the current trend will reverse within a reasonable period of time, and the investment will regain its former profitability. As an alternative, the investor can choose to sell the asset while the price is still in decline, and use the proceeds to secure a different long-term option that shows promise of performing at acceptable levels.

When it comes to claiming a passive activity loss as a tax deduction, regulations vary from one nation to the next. Often, this type of loss can only be applied to returns that are generated by other passive investments. If there are no passive gains made during the period, it is not possible to claim the loss as a means of offsetting revenue generated by what the tax agency considers active investments. Instead, the loss is carried forward until such point that some type of passive income gains are realized, and then used to offset that amount of income.