Per IRS Publication 925 Passive Activity and At-Risk Rules, on page 3:
There are two kinds of passive activities.
A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional. See Real Estate Professional under Activities That Aren’t Passive Activities, later. An activity is a rental activity if tangible property (real or personal) is used by customers or held for use by customers, and the gross income (or expected gross income) from the activity represents amounts paid (or to be paid) mainly for the use of the property. It doesn’t matter whether the use is under a lease, a service contract, or some other arrangement.
On page 5:
3. The rental of a dwelling unit that you also used for personal purposes during the year for more than the greater of 14 days or 10% of the number of days during the year that the home was rented at a fair rental.
5. Rental real estate activities in which you materially participated as a real estate professional. See Real Estate Professional, later.
A trade or business activity isn’t a passive activity if you materially participated in the activity.
Material participation tests. You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.
You didn’t materially participate in the activity under test (7) if you participated in the activity for 100 hours or less during the year. Your participation in managing the activity doesn’t count in determining whether you materially participated under this test if:
Participation. In general, any work you do in connection with an activity in which you own an interest is treated as participation in the activity.
Please see the Publication for additional information about Material Participation.
Active participation. Active participation isn’t the same as material participation (defined later). Active participation is a less stringent standard than material participation. For example, you may be treated as actively participating if you make management decisions in a significant and bona fide sense. Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.
Example. Mike, a single taxpayer, had the following income and loss during the tax year.
Rental Loss ($4,000)
The rental loss came from a house Mike owned. He advertised and rented the house to the current tenant himself. He also collected the rents and did the repairs or hired someone to do them.
Even though the rental loss is a loss from a passive activity, Mike can use the entire $4,000 loss to offset his other income because he actively participated.
Special $25,000 allowance. . If you or your spouse actively participated in a passive rental real estate activity, the amount of the passive activity loss that’s disallowed is decreased and you therefore can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing the passive activity loss. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.
If you’re married, filing a separate return, and lived apart from your spouse for the entire tax year, your special allowance can’t be more than $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you can’t use the special allowance to reduce your nonpassive income or tax on nonpassive income.
The maximum special allowance is reduced if your modified adjusted gross income exceeds certain amounts. See Phaseout rule, later.
Phaseout rule. The maximum special allowance of $25,000 ($12,500 for married individuals filing separate returns and living apart at all times during the year) is reduced by 50% of the amount of your modified adjusted gross income that’s more than $100,000 ($50,000 if you’re married filing separately). If your modified adjusted gross income is $150,000 or more ($75,000 or more if you’re married filing separately), you generally can’t use the special allowance. This is because the special allowance is reduced to $0 since the modified adjusted gross income is over the $100,000 amount.
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