26 U.S.C. § 469 — Passive activity losses and credits limited

(a) Disallowance (1) In general: if, for a tax year, the taxpayer is one of the types listed in (2), then neither the passive activity loss nor the passive activity credit is allowed for that year. (2) Persons described: (A) any individual, estate, or trust; (B) any closely held C corporation; and (C) any personal service corporation. (b) Disallowed loss or credit carried to next year Except as this section otherwise provides, a loss or credit from an activity that gets disallowed under (a) is instead treated as belonging to that same activity in the next tax year. (c) Passive activity defined (1) In general: a "passive activity" is any activity that (A) involves running a trade or business, and (B) the taxpayer does not "materially participate" in. (2) Rental activity: except as (7) provides, "passive activity" includes any rental activity. (3) Working interests in oil and gas property: (A) "passive activity" does not include a working interest in oil or gas property that the taxpayer holds directly, or through a structure that does not limit the taxpayer's liability for that interest. (B) But if a taxpayer has a loss from such a working interest that is treated as not from a passive activity, then any later net income from that same property (or property whose basis traces back to it) is also treated as not from a passive activity — and if that happens, related credits are treated as not from a passive activity too, but only up to the regular tax attributable to that income. (4) Paragraphs (2) and (3) apply whether or not the taxpayer materially participates in the activity. (5) "Trade or business" also includes research and experimentation activity, as defined in section 174. (6) Regulations may extend "trade or business," for (1)(A), to include (A) any activity connected to a trade or business, or (B) any activity for which expenses are deductible under section 212 (investment expenses). (7) Special rules for taxpayers in the real property business: (A) In general — if this paragraph applies to a taxpayer for a year, (i) rental real estate is not automatically passive under (2), and (ii) each of the taxpayer's rental real estate interests is treated as a separate activity, unless the taxpayer elects to treat them all as one activity; this does not change how material participation is judged for an interest held as a limited partner. (B) Who this applies to — it applies to a taxpayer for a year if (i) more than half the personal services the taxpayer performs in trades or businesses that year are in real property trades or businesses the taxpayer materially participates in, and (ii) the taxpayer performs more than 750 hours of services that year in real property trades or businesses they materially participate in; on a joint return, only one spouse needs to meet both tests, based on that spouse's own participation as figured under (h). (C) "Real property trade or business" means real estate development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. (D) Special rules for (B) — (i) a closely held C corporation meets the (B) test if more than 50 percent of its gross receipts for the year come from real property trades or businesses it materially participates in; (ii) work performed as an employee does not count as work in a real property trade or business, unless the employee owns more than 5 percent of the employer. (d) Passive activity loss and credit defined (1) Passive activity loss: the amount by which (A) total losses from all passive activities for the year are more than (B) total income from all passive activities for the year. (2) Passive activity credit: the amount by which (A) certain credits from passive activities allowed for the year exceeds (B) the regular tax owed on income from passive activities. (e) Special rules for determining income or loss from a passive activity (1) Certain income not treated as passive: (A) In general — when figuring income or loss from an activity, do not count (i) interest, dividends, annuities, or royalties not earned in the ordinary course of a trade or business, plus expenses (other than interest) clearly tied to that income, and interest expense tied to it, and (ii) gain or loss, not from the ordinary course of a trade or business, from selling property that produces that kind of income or that is held for investment — and for this rule, an interest in a passive activity is never treated as "held for investment." (B) Return on working capital — income, gain, or loss from investing working capital is treated as not from the ordinary course of a trade or business (so it is excluded too). (2) Passive losses of certain closely held corporations may offset active income: (A) In general — if a closely held C corporation that is not a personal service corporation has net active income for the year, its passive activity loss for that year (figured without this rule) can be deducted against that net active income instead of being disallowed under (a); the same applies to its passive activity credit. (B) "Net active income" means taxable income figured without counting passive-activity income or loss, or the items excluded under (1)(A). (3) Earned income from personal services is not counted when figuring income or loss from a passive activity. (4) Dividend income is reduced by the dividends-received deduction under section 243 or 245 before applying (1) and (2). (f) Treatment of former passive activities (1) In general: if an activity is a "former passive activity" for a year, (A) any unused deduction tied to it under (b) first offsets that activity's income for the year; (B) any unused credit tied to it under (b) first offsets the regular tax attributable to that activity for the year; and (C) any deduction or credit left over after (A) and (B) is still treated as arising from a passive activity. (2) If a taxpayer stops being a closely held C corporation or personal service corporation, this section keeps applying to its old passive losses and credits as if it still were one. (3) "Former passive activity" means an activity that is not passive for the taxpayer this year, but was passive for the taxpayer in an earlier year. (g) Dispositions of entire interest in passive activity If a taxpayer sells or disposes of their entire interest in a passive activity (or former passive activity) during the year: (1) Fully taxable transaction — (A) if all the gain or loss on the sale is recognized, the amount by which that activity's loss for the year (after applying (b)) is more than the taxpayer's net income or gain from all other passive activities for the year (after applying (b)) is treated as a loss that is not from a passive activity. (B) That treatment is delayed if the buyer is related to the taxpayer under section 267(b) or 707(b)(1) — it doesn't apply until the year an unrelated person eventually acquires the interest. (C) Regulations may pull income or gain from earlier years into account under (A)(ii), to prevent taxpayers from avoiding this rule. (2) Disposition by death — if the interest passes because the taxpayer died, (A) the free-up rule in (1)(A) applies only to the part of the loss that is more than the step-up in basis the new owner received (the excess of the property's basis to the new owner over its basis right before the taxpayer's death), and (B) losses equal to that step-up amount are never allowed as a deduction. (3) Installment sale of entire interest — for an installment sale of an entire interest, only the share of the losses that matches the ratio of the gain recognized that year to the total gross profit expected on the sale gets the treatment in (1). (h) Material participation defined (1) In general: a taxpayer materially participates in an activity only if involved in its operations on a basis that is regular, continuous, and substantial. (2) A limited partnership interest held as a limited partner generally does not count as material participation, except as regulations provide. (3) Certain retired individuals and surviving spouses are treated as materially participating in a farming activity for a year if the special rules in section 2032A(b)(4) or (5) would have satisfied section 2032A(b)(1)(C)(ii) for that farmland, had the taxpayer died during the year. (4) A closely held C corporation or personal service corporation materially participates in an activity only if (A) one or more shareholders owning more than 50 percent (by value) of its stock materially participate in the activity, or (B) for a closely held C corporation that is not a personal service corporation, the requirements of section 465(c)(7)(C) (without its clause (iv)) are met for that activity. (5) A taxpayer's spouse's participation counts toward the taxpayer's material participation. (i) $25,000 offset for rental real estate activities (1) In general: for a natural person, the disallowance in (a) does not apply to the part of the passive activity loss (or the "deduction equivalent" of the passive activity credit, defined in (j)(5)) that comes from rental real estate activities the person actively participated in for the year — including amounts carried over from an earlier year. (2) Dollar limitation: this cannot total more than $25,000 for a year. (3) Phase-out of exemption: (A) In general — that $25,000 shrinks, but never below zero, by 50 cents for every dollar the taxpayer's adjusted gross income is above $100,000. (B) Special phase-out for the rehabilitation credit — for the rehabilitation credit under section 47, use $200,000 in place of $100,000 in that phase-out. (C) Exception for the low-income housing credit — the phase-out in (A) does not apply to the part of the passive activity credit attributable to the credit under section 42. (D) Ordering rule — the $25,000 (as reduced) is applied, in order, first to the passive activity loss, second to the part of the passive activity credit not covered by (B) or (C), third to the part covered by (B), and fourth to the part covered by (C). (E) Adjusted gross income for this paragraph is figured without counting certain Social Security income under section 86, certain excluded income under sections 85(c), 135, and 137, certain deductions under sections 219, 221, and 250, or any passive activity loss, or any loss allowed under (c)(7) for oil and gas working interests. (4) Special rule for estates: (A) for an estate's tax years ending less than 2 years after the decedent's death, this offset covers all rental real estate activities the decedent actively participated in before death. (B) That $25,000 is reduced by the amount of the offset the surviving spouse is allowed for the same tax year. (5) Married individuals filing separately: (A) except as (B) provides, substitute $12,500 for $25,000, $50,000 for $100,000, and $100,000 for $200,000, wherever those figures appear in this subsection. (B) This subsection does not apply at all to a taxpayer who files a separate return and does not live apart from their spouse at all times during the year. (6) Active participation: (A) a taxpayer is not treated as actively participating in a rental real estate interest for any period when that interest — combined with the taxpayer's spouse's interest — is less than 10 percent (by value) of all interests in the activity. (B) The active-participation requirement does not apply to the low-income housing credit under section 42 or the rehabilitation credit under section 47. (C) Except as regulations provide, an interest held as a limited partner does not count as active participation. (D) A taxpayer's spouse's participation counts toward the taxpayer's active participation. (j) Other definitions and special rules (1) "Closely held C corporation" has the meaning given in section 465(a)(1)(B). (2) "Personal service corporation" generally has the meaning given in section 269A(b)(1), but substituting "any" for "more than 10 percent," and "any" for "50 percent or more in value" in the related ownership test in section 318(a)(2)(C) — except that a corporation is not a personal service corporation unless more than 10 percent of its stock (by value) is held by employee-owners. (3) "Regular tax liability" has the meaning given in section 26(b). (4) Passive activity losses and credits (and the $25,000 amount in (i)) are allocated to activities, and within activities, on a pro rata basis, as Treasury regulations prescribe. (5) The "deduction equivalent" of a passive activity credit is the deduction amount that, if allowed, would reduce the regular tax by the same amount as the credit. (6) Special rule for gifts: if an interest in a passive activity is given away, the interest's basis right before the transfer is increased by the amount of any passive losses tied to it that were not allowed as a deduction under (a), and those losses can never be deducted afterward. (7) Passive activity loss is figured without regard to qualified residence interest (home-mortgage interest under section 163(h)(3)). (8) "Rental activity" means an activity where payments are mainly for the use of tangible property. (9) A taxpayer may elect, when figuring gain or loss on a disposition covered by (g)(1), to increase the property's basis right before the transfer by any unused credit that had reduced that basis in the year it arose; if the taxpayer makes this election, that part of the passive activity credit is never allowed. (10) If a passive activity involves a dwelling unit covered by section 280A(c)(5) (a vacation home also used personally), income, deduction, gain, or loss tied to that use is ignored under this section for that year. (11) Except as regulations provide, all members of an affiliated group filing a consolidated return are treated as one corporation. (12) Special rule for distributions by estates or trusts: if an interest in a passive activity is distributed out of an estate or trust, its basis right before the distribution is increased by the passive losses tied to it, and those losses can never be deducted. (k) Separate application of section in case of publicly traded partnerships (1) In general: this section applies separately to items from each publicly traded partnership (and the $25,000 offset in (i) does not apply to them) — except this separate treatment does not limit the low-income housing credit or the rehabilitation credit from that partnership beyond the regular tax attributable to income from it. (2) "Publicly traded partnership" means a partnership whose interests are (A) traded on an established securities market, or (B) readily tradable on a secondary market (or its substantial equivalent). (3) For the disposition rule in (g), a taxpayer is not treated as having disposed of their entire interest in one of the partnership's activities until they dispose of their entire interest in the partnership. (4) A regulated investment company (as defined in section 851) that holds an interest in a "qualified publicly traded partnership" (as defined in section 851(h)) is treated as a taxpayer described in (a)(2) for items tied to that interest. (l) Regulations The Secretary must write the regulations needed to carry out this section, including regulations that (1) define what counts as an activity, material participation, or active participation for this section; (2) say which gross income items are left out when figuring an activity's income or loss, and how to treat related expenses; (3) require net income or gain from a limited partnership or other passive activity, in certain cases, to be treated as not from a passive activity; (4) determine how to allocate interest expense for this section; and (5) address changes in marital status and switches between joint and separate returns.