Passive Activity Losses (PAL) are tax losses generated from business or investment activities in which the taxpayer does not materially participate. Under the Internal Revenue Code, passive activities generally include rental real estate and businesses in which the taxpayer is not actively involved on a regular, continuous, and substantial basis.
The concept was introduced to prevent taxpayers from using losses from passive investments to offset income from wages, self-employment, or portfolio sources. Instead, passive losses can only offset passive income, with limited exceptions.
The rules apply to individuals, estates, trusts, personal service corporations, and closely held C corporations. Passive activity losses are reported on tax forms such as Schedule K-1 for pass-through entities, and their treatment is a key consideration in tax planning for investors and business owners.
The PAL rules, codified in IRC Section 469, were enacted to curb tax shelter abuses and ensure that only losses from active participation could offset nonpassive income. The IRS defines a passive activity under the passive activity rules as any trade or business in which the taxpayer does not materially participate, as well as most rental activities regardless of participation. The PAL limitations mean that losses from passive activities can only be used to offset income from other passive activities. If passive losses exceed passive income in a given year, the excess is suspended and carried forward indefinitely. These rules were further clarified and expanded by the Tax Cuts and Jobs Act Changes, but the core limitation remains: passive losses cannot reduce ordinary income, such as wages or self-employment earnings.
Rental real estate is generally considered a passive activity, but there are two important exceptions. First, real estate professionals who meet strict material participation and time requirements can treat rental losses as nonpassive. Second, for non-professional investors, the IRS provides a special $25,000 allowance. Taxpayers who “actively participate” in rental real estate (such as making management decisions or approving tenants) and own at least 10% of the property may deduct up to $25,000 of passive losses against nonpassive income. This allowance phases out for taxpayers with modified adjusted gross income (MAGI) above $100,000, disappearing entirely at $150,000. The active participation standard is less stringent than material participation, making this a valuable exception for many small landlords.
When passive activity losses exceed passive income in a tax year, the excess losses are not lost; they are suspended and carried forward indefinitely. These suspended losses remain attached to the specific activity that generated them. They can be used in future years to offset passive income from the same or other passive activities. The most significant opportunity to use suspended losses occurs when a taxpayer disposes of their entire interest in a passive activity in a fully taxable transaction to an unrelated party. In that year, all suspended losses from the activity are released and can be deducted against any type of income, including wages and capital gains. This “unlocking” of losses can provide substantial tax savings in the year of sale.
The at-risk rules (IRC Section 465) limit the amount of loss a taxpayer can claim to the amount they have at risk in the activity. Generally their cash investment plus recourse debt. For real estate, qualified nonrecourse financing secured by real property is also considered at-risk. The PAL rules apply after the at-risk rules: a loss must first be allowed under the at-risk rules before it is subject to PAL limitations. In real estate investing, this means that even if a taxpayer has a large paper loss from depreciation, they can only deduct the portion for which they have sufficient at-risk basis, and only to the extent allowed by the PAL rules. Depreciation strategies can create large passive losses, but their deductibility is ultimately governed by both the at-risk and passive activity loss limitations .
Additionally, these limitations can indirectly affect taxable income calculations, which may in turn influence items such as the Qualified Business Income deduction and, in certain cases, exposure to the Alternative Minimum Tax. Because these rules are complex and fact-specific, taxpayers should consult a qualified tax professional to understand how they apply to their individual situation.
How does the IRS define a passive activity and a passive activity loss?
A passive activity is any trade or business in which the taxpayer does not materially participate, as well as most rental activities. A passive activity loss is the amount by which the total deductions from all passive activities exceed the total income from those activities in a given year.
Why can’t passive activity losses generally offset wages, self-employment income, or portfolio income?
The IRS restricts passive losses from offsetting nonpassive income to prevent taxpayers from using investment or business losses to reduce taxes on earned income or investment returns. This rule was enacted to curb tax shelter abuses and ensure losses are only used to offset similar types of income.
How does the $25,000 special allowance for rental real estate work, and who qualifies for it?
The $25,000 allowance lets qualifying taxpayers deduct up to $25,000 of passive rental real estate losses against nonpassive income. To qualify, you must actively participate in the property’s management and own at least 10%. The benefit phases out for MAGI above $100,000 and is eliminated at $150,000.
What happens to disallowed passive activity losses, and when are suspended losses released?
Disallowed passive losses are suspended and carried forward indefinitely. They can be used to offset future passive income or are fully released and deductible against all income when the taxpayer disposes of their entire interest in the passive activity in a taxable transaction to an unrelated party.
How do passive activity loss rules interact with at-risk limitations and depreciation strategies in real estate?
Losses must first pass the at-risk rules, which limit deductions to the amount the taxpayer has at risk in the activity. Only then do the PAL rules apply. Depreciation can create large paper losses, but their deductibility is limited by both the at-risk and passive activity loss rules, especially in leveraged real estate investments.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Trey Webb, partner in charge of Bennett Thrasher’s Real Estate and Hospitality Tax Group, or call us at 770.396.2200.
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