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What is a Passive Loss?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 27 November 2016
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Passive loss refers to financial losses that are incurred through business transactions that qualify as passive activity. In countries where passive loss is considered grounds for tax breaks of some type, there are normally rules that define the amount of the loss that can be used to offset gains or profits that are realized from other passive activity during the same tax period. Many countries also have regulations in place that clearly determine what is considered passive activity and what is not.

For the most part, countries that recognize a passive loss as a legitimate tax break tend to define passive activity as any type of revenue generation that does not involve the direct participation of the investor. For example, salary or wages would not be classified as passive activity, since the investor would be actively engaged in the process of earning those forms of income. However, a silent partner that invests in a business but assumes no managerial control and does not participate in the operation of the business could define this type of activity as passive.

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In order to claim a passive loss, it is necessary to establish that the activity resulting in the loss was in fact passive. Only losses resulting from passive activity can be claimed under the provisions of this type of tax reduction; the losses cannot be used to offset any losses that may have taken place as a result of active involvement or earning endeavors. This means claiming a passive loss is only helpful when there is some type of profit or gain realized from other passive activities.

In the United States, the Tax Reform Act serves as the basis for evaluating the amount of passive loss that can be claimed in a single tax period. The act also helps to define the scope of acceptable passive activities while also identifying some forms of revenue generation that will remain subject to taxation even when a passive loss is claimed.

Whenever a passive loss is incurred, it is important to consult current governmental guidelines to determine how much of the loss can be claimed during any given tax period. In most instances, investors are well-advised to seek the guidance of a professional tax analyst in order to assure that the deduction is properly calculated and in full compliance with applicable laws.

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bear78
Post 3

@alisha-- I'm not sure about this and I hope you get more answers after this one. But I think the difference is that bad debt does not imply passive activity. In both passive loss and bad debt, a loan is given to a business which is then unable to pay it back. But in bad debt, the person or institution who gave the loans may be active in the business.

Otherwise, you are right, they are pretty similar. I know both are business losses than can be written off.

discographer
Post 2

I'm working on an assignment and I'm confused about passive loss and bad debt. I don't really see the difference between the two. Can anyone please explain?

ddljohn
Post 1

I think that determining whether something is a passive loss also depends on the expectation of the investor. I gave some money to my sister to use in her business, but she ended up going bankrupt that year. Now that is not a passive loss because I never expected her to give the money back to me. It was like a gift.

So I think we can say that a passive loss is not just because of passive investment. It's because of a passive investor who expects a return on their investment.

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