For the most part, passive activities are those trade or business activities in which you do not materially participate and rental activities. You materially participate in an activity if you are involved on a regular, continuous, and substantial basis in the operation of the activity. Rental real estate activities will not be passive activities if you are a real estate professional and meet certain requirements. Guidelines for determining material participation and the rules for a real estate professional can be found in Publication 925, Passive Activity and At-Risk Rules.

Income from non-passive activities includes income from employment, active participation in a trade or business, and working interests in oil and gas properties. Also included is portfolio income such as interest and dividend income. Other types of income from non-passive activities are listed in Publication 925.

Generally, losses and credits from passive activities that exceed the income and tax attributable to passive activities are disallowed. Use Form 8582, Passive Activity Loss Limitations, to summarize income and losses from passive activities and to compute the deductible losses. The disallowed losses and credits may be carried forward to the next tax year.

A special rule applies for passive rental real estate activities in which you actively participate. The rules for active participation are different from those for material participation and are discussed in Publication 925. Passive losses are first offset against any passive income; any excess passive losses are disallowed unless they arise from rental real estate. Up to $25,000 of additional passive losses from rental real estate activities in which you actively participate may be used to offset income from non-passive sources. This $25,000 amount is subject to a special phase-out rule for individuals with an adjusted gross income in excess of $100,000. For those who are married filing separately and who lived apart from their spouse the entire year, the additional passive loss allowed is limited to $12,500 and the phase-out begins at adjusted gross income in excess of $50,000.

Generally, passive losses that have previously been disallowed are allowed in full in the year the taxpayer disposes of the investment. However, unused passive credits are lost. Form 8582 is used for passive losses.

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