Are Passive Losses Deductible? The Rules Explained

Passive losses, which arise from investments or business ventures where the taxpayer is not actively involved, are subject to specific rules that limit their immediate deductibility. These limitations prevent taxpayers from offsetting active income, such as wages, with losses from activities in which they have minimal engagement.

Defining Passive Activities and Income

A passive activity generally includes any trade or business in which the taxpayer does not materially participate. It also encompasses all rental activities, unless a specific exception applies, such as qualifying as a real estate professional. Material participation means involvement in the operation of the activity on a regular, continuous, and substantial basis. The IRS provides seven tests to determine material participation.

Common examples of passive activities include owning rental properties, being a limited partner in a partnership, or investing in a business where management decisions are handled by others. This contrasts with active income, which is derived from services performed, like wages, salaries, or profits from a business where the taxpayer materially participates. Portfolio income, another distinct category, includes earnings from investments such as interest, dividends, and capital gains from stocks or bonds. Differentiating these income types is important because passive losses can generally only offset passive income.

The Passive Activity Loss Limitation Rule

The passive activity loss (PAL) limitation rule states that losses from passive activities can only be deducted against income generated from other passive activities. These losses cannot offset active income, such as salaries or wages, or portfolio income like interest or dividends. This rule prevents taxpayers from sheltering primary income sources with losses from passive investments.

When passive losses exceed passive income in a given tax year, the excess losses are not immediately deductible. These disallowed amounts are referred to as “suspended losses.” Suspended losses are carried forward indefinitely to future tax years. For example, if a taxpayer has a $10,000 passive loss and only $3,000 of passive income, $7,000 of the loss becomes a suspended loss and can be used in a later year. This carryforward continues until the taxpayer has sufficient passive income to absorb the losses or disposes of the activity.

Exceptions for Real Estate Activities

Real estate activities have specific exceptions to the general passive activity loss rules. One exception applies to “real estate professionals.” To qualify, a taxpayer must meet two criteria: more than half of their personal services in all trades or businesses must be performed in real property trades or businesses in which they materially participate, and they must perform more than 750 hours of services in real property trades or businesses in which they materially participate. If these conditions are met, rental real estate activities are not considered passive, allowing losses to offset other types of income.

Another exception is the “active participation” rule for rental real estate. An individual may be able to deduct up to $25,000 of rental real estate losses against non-passive income, even if they don’t meet the real estate professional criteria. To qualify, the taxpayer must actively participate in the rental activity and own at least 10% of the property. Active participation is a less stringent standard than material participation, generally involving involvement in management decisions like approving tenants or authorizing repairs. This $25,000 special allowance is subject to a phase-out based on modified adjusted gross income (MAGI). The allowance begins to phase out when MAGI exceeds $100,000, reducing by $1 for every $2 over this threshold, and is completely eliminated when MAGI reaches $150,000.

When Suspended Losses Can Be Used

Suspended passive losses, which accumulate from prior tax years, can eventually be deducted under specific circumstances. The primary way to utilize these losses is through a “fully taxable disposition” of the entire interest in the passive activity. When a taxpayer sells or otherwise disposes of their complete interest in a passive activity in a fully taxable transaction to an unrelated party, any remaining suspended losses from that activity become fully deductible. These losses can then offset income from any source, including active or portfolio income.

If a passive activity interest is transferred due to the taxpayer’s death, suspended passive losses can be deducted on the decedent’s final income tax return. However, the deductible amount is limited to the extent the losses exceed any step-up in basis the property receives at death. If a passive activity is gifted, suspended losses are generally added to the recipient’s basis in the property rather than being deducted by the donor.

How to Report Passive Losses

Taxpayers with passive activity losses generally use IRS Form 8582, “Passive Activity Loss Limitations,” to calculate their allowable deductions. This form is used by individuals, estates, and trusts, and accounts for unallowed losses carried forward from previous years.

The process of completing Form 8582 involves aggregating income and losses from all passive activities. This includes distinguishing between rental real estate activities with active participation and all other passive activities. The form systematically applies the passive activity loss limitation rules, including the special allowance for rental real estate, to arrive at the deductible amount for the current year. Once the allowable passive losses are determined on Form 8582, these amounts are then reported on the appropriate tax schedules, such as Schedule E for rental real estate income and losses, or Schedule C for business income and losses, before ultimately flowing to Form 1040.