Passive income is a special type of income that not everyone will be involved in. It is also different from wage income. Passive income is generated from a partnership, a business the investor is not involved in, rentals, or other flow-through entities.
Given its differences, can passive losses be used to offset capital gains? Let’s find out.
Passive losses occur when losses are greater than income in passive activities. A passive investment is one that an investor puts money into but has no further involvement. The money-making part is left to someone else. This makes the investments basically hands-off.
The investor can still manage their investment by adding/removing funds but doesn’t have any other influence on how much money the investment will make. Some of these investments are securities. The technical definition of a passive investment is an investment in which you are not directly or materially involved.
If an investment is a security, they generally require the sponsor/manager of the investment to register with securities authorities/regulators.
When a passive investment incurs a loss, can the investor offset it against other income, specifically capital gains?
Capital gains are profits on capital assets. Capital assets are investment property, stocks, bonds, and even art.
Capital gains are taxed at two primary rates — short and long-term. Short-term rates are taxed at the investor’s ordinary income tax rate. Long-term rates are taxed much lower, which is also dependent on the investor’s income.
With those definitions out of the way, we can dive into whether passive losses can offset capital gains.
When we talk about offsetting capital gains with passive losses, we’re referring to realized losses. Unrealized losses aren’t taxed and don’t offset income.
Unfortunately for, passive losses, they can only offset passive income. Wages, capital gains, retirement income, and investment income can’t be offset with passive income. You might look at investment income, such as stock appreciation, and say it is passive income. However, it depends on how the IRS categorizes the income. Stock appreciation is considered capital gains rather than passive income.
You have a net passive loss if your passive losses overwhelm your passive income. But we already know there is nothing that it can offset. So, does that loss go away?
No, but passive losses can be carried forward into future years and used against future passive income. These losses are called suspended passive losses.
There are some exceptions to the rule. Those with a modified adjusted gross income (MAGI) of $100,000 or less can deduct up to $25,000 of passive losses against their ordinary income (i.e., wages). This deduction phases out up to $150,000, where it can no longer be used.