Passive vs. Non-Passive: The § 469 Framework

Passive vs. non-passive is the gateway classification of § 469, and the entire passive activity loss regime turns on it. Get it right and losses flow against active income; get it wrong and they suspend.

The statutory framework

Under § 469(c)(1), a passive activity is any trade or business in which the taxpayer does not materially participate. § 469(c)(2) makes rental activity per se passive regardless of participation (subject to the § 469(c)(7) real estate professional exception). § 469(h)(1) defines material participation as involvement that is regular, continuous, and substantial; § 469(h)(2) presumptively treats limited partnership interests as passive.

The loss limitation mechanic

§ 469(a) disallows the passive activity loss for the year, the excess of aggregate passive losses over aggregate passive income. Losses are aggregated across all passive activities: a loss from one passive activity offsets income from another. The disallowed remainder carries forward and is treated as a deduction from that activity in the succeeding year.

Disposition releases suspended losses

The key relief valve: under § 469(g)(1)(A), when a taxpayer disposes of the entire interest in a passive activity in a fully taxable transaction, suspended losses (after netting against other passive income) are freed and become non-passive, deductible against any income. A foreclosure on recourse debt comprising the taxpayer's entire interest qualifies as a fully taxable disposition (CCA 201415002).

Recharacterization traps

Several items that look passive are recharacterized as non-passive: significant participation activity income, self-rented property to a business in which the taxpayer materially participates, rental of nondepreciable property (<30% depreciable basis), and former passive activities under § 469(f). Earned income is excluded from passive income computations by § 469(e)(3).