What it means
Imagine owning a rental flat that costs more to run than it earns once mortgage interest, repairs and depreciation (the yearly write-down of an asset's cost) are included. On paper the flat has made a loss.
Because the owner does not work in the activity day to day, that loss is classed as passive. The restriction exists to stop high earners from using paper losses to wipe out the tax on their salaries.
By limiting where the loss can be used, the tax authority keeps relief tied to the activity that created it. The exact rules differ by country and are updated from time to time.
If there is passive income from other sources, the passive loss is set against it first. Any remaining loss is not wasted, but is carried forward until there is enough passive income.
In many systems it is released in full when the owner sells the whole activity in a fully taxable sale. Some systems give limited exceptions.
For instance, certain small landlords who are actively involved and have modest income may be able to use a limited amount against other income. These exceptions depend on income and involvement tests set by the tax authority.
Finance staff should track passive losses carefully across years. A schedule showing the loss each year, the amount used and the balance carried forward is essential, because the benefit may arise many years after the loss was made.
Timing is the practical issue. A loss that is suspended does not help cash flow in the year it arises, so owners of new rental projects should expect to fund the early losses from their own money.
Advisers therefore build the delay into the investor's forecasts, so the cash cost of the project is not underestimated.
In practice
Real-world examples.
Example
A teacher buys a rental flat that makes a $6,000 tax loss in its first year. Because she does not manage the flat actively, she cannot offset the loss against her salary. She carries it forward to be used against future rental profits. Her accountant records the carried-forward amount in a schedule for next year.
Example
A business consultant is a limited partner in a restaurant that makes a $20,000 loss. He has another passive investment that earned $8,000. The loss uses the $8,000 and the remaining $12,000 moves to next year. The consultant keeps a note of the balance so that it can be claimed when the partnership next makes a profit.
Example
An investor sells her entire interest in a loss-making rental company after several years. In many systems, the suspended losses from earlier years can now be used in full. The release lowers her tax bill in the year of the sale. She keeps the sale documents, because the release depends on a complete disposal to an unrelated buyer.
Formula
Calculation
Passive loss carried forward = passive loss - passive income used
An investor's rental property earns $30,000 of rent and has costs of $42,000, so the passive loss is 42,000 - 30,000 = $12,000. The investor has $5,000 of passive income from a separate partnership. She uses $5,000 of the loss against it, so the amount carried forward is 12,000 - 5,000 = $7,000. Her salary of $90,000 is not reduced by the loss.Case study
Seen in the real world.
Calloway Property Partners is an illustrative, fictional group that owned several small apartment blocks. In its first three years, the blocks made combined passive losses of $60,000 because of high interest and renovation costs.
The owners were frustrated that the losses did not reduce the tax on their other income. Their accountant built a schedule showing $60,000 of suspended losses and explained that they would be used as rents rose.
In year five the blocks made a passive profit of $45,000, so $45,000 of the suspended loss was used. In the illustrative result, the owners paid no tax on that profit and still had $15,000 of loss to use later. The accountant now updates the schedule of suspended losses each year and sends a copy to the owners, so that nothing is forgotten when the properties are eventually sold.
Watch out
Common mistakes.
- Trying to deduct a passive loss from salary, when it can generally be used only against passive income.
- Losing track of carried-forward losses, which makes it impossible to claim them later.
- Assuming the rules are the same in every country, when each tax authority sets its own definitions and limits.
Questions
People also ask.
Can a passive loss expire?
In many systems it does not expire and can be carried forward indefinitely, but this depends on local rules. If the rules change, the schedule of balances should be reviewed so that the carryforward is still correct.
What happens when I sell the activity?
In many systems, a full sale to an unrelated party releases the suspended losses so they can offset other income.
How do I know if my loss is passive?
It depends on whether you take a regular and substantial part in running the activity, so check the definition used by your tax authority and keep records of your involvement. When the facts are unclear, a qualified tax adviser can review the case before the tax return is filed.
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