What is passive activity loss?

A passive activity loss is a loss from a trade or business in which the taxpayer does not materially participate, which generally cannot be deducted against ordinary income and must be carried forward to offset future passive income. For professional service firm owners with side investments, passive loss rules limit the deduction of losses from those activities.

Key characteristics

• Loss from passive activity

• Limited deductibility

• Cannot offset active income

• Carried forward

• Material participation determines status

• Released upon disposition

Why it matters for professional service firms

Passive loss limitations prevent using losses from activities you do not actively participate in to shelter your professional income. Understanding these rules affects investment decisions. Professional service firm owners should consider passive loss implications when evaluating investments.

Real-world example

Chris invested in a rental property, generating a $28,000 loss. His consulting practice generated $320,000 income. Passive loss limitation: rental loss is passive, consulting income is active (material participation). Cannot deduct $28,000 rental loss against consulting income. Losses are carried forward until: rental generates passive income, or the property is sold, releasing suspended losses.