California Passive Activity Loss Limitations: What You Need to Know

California has specific tax rules that limit the ability to deduct losses from passive activities, affecting real estate investors, business owners, and partnership participants. These rules prevent taxpayers from using losses from passive investments to offset other income, potentially increasing overall tax liability. Understanding these restrictions is essential for managing tax obligations effectively.

Types of Passive Activities

California categorizes certain income-generating endeavors as passive, meaning they are subject to restrictions on how losses can be deducted. These activities typically involve investments where the taxpayer does not materially participate in the operation or management.

Rental Properties

Owning and leasing real estate is a common passive activity. In California, rental income is classified as passive unless the taxpayer qualifies as a real estate professional under specific criteria. Even if a rental property operates at a loss, the ability to deduct that loss depends on income levels and participation. Taxpayers with an adjusted gross income (AGI) below $100,000 may deduct up to $25,000 in passive rental losses under federal rules, but California imposes additional restrictions. Losses exceeding allowable limits are carried forward.

Short-term rentals, where tenant turnover is frequent or the owner uses the property personally for a significant number of days, may not qualify as passive activities. Proper record-keeping, including tracking rental days and management activities, is necessary to substantiate tax claims.

Limited Partnerships

Investing in a limited partnership can generate passive income or losses. Limited partners typically do not participate in daily operations, making their income or losses subject to passive activity rules. Losses from a limited partnership cannot offset wages or other active income unless specific exceptions apply.

Certain partnerships, such as those involved in real estate development or private equity funds, may have different tax implications based on their operating agreements. Investors should review partnership agreements to understand how income and losses will be treated and whether any special allocations could impact tax liability.

Other Passive Ventures

Beyond real estate and partnerships, other investments can be classified as passive. Owning shares in an S corporation without materially participating, investing as a silent partner, or earning income from royalties, licensing agreements, or oil and gas interests may be subject to passive activity limitations.

California closely examines participation levels—minimal involvement generally results in passive classification, restricting loss deductions. Businesses structured as pass-through entities, such as LLCs, have additional considerations depending on the investor’s management role. Taxpayers should assess their involvement in each venture and consult a tax professional to ensure compliance.

Special Real Estate Considerations

California’s passive activity loss rules are particularly restrictive for real estate investors due to the treatment of depreciation, suspended losses, and income classification from property sales. Depreciation deductions, which allow property owners to recover building costs over time, can generate substantial paper losses. While these losses can offset passive income, they often exceed what is currently deductible under state law, leading to suspended losses carried forward.

When a property is sold, suspended passive losses tied to that property may be released and used to offset gains. However, California does not always conform to federal rules regarding the full release of losses upon disposition. If a taxpayer sells only part of a rental portfolio or retains an interest in a partnership, some losses may remain suspended rather than being fully deductible.

Installment sales, where payments are received over multiple years, can further complicate the timing of loss deductions. California may limit the ability to apply suspended losses against future installment gains.

Like-kind exchanges under Section 1031 allow real estate investors to defer capital gains taxes by reinvesting proceeds into a similar property. Suspended passive losses from the relinquished property do not automatically transfer to the replacement property. Instead, these losses remain tied to the original investment and can only be used when that property is fully disposed of in a taxable transaction. This can result in investors holding onto suspended losses for extended periods, making it difficult to realize their tax benefits without a strategic exit plan.

Differences From Federal Law

California’s approach to passive activity loss limitations differs from federal tax law in several ways, particularly in defining passive income and applying phase-out thresholds.

One key distinction is the treatment of nonresident taxpayers. While federal law allows passive losses to offset passive income regardless of where it is earned, California only permits nonresidents to deduct passive losses against California-source passive income. A taxpayer residing in another state with passive losses from an out-of-state investment cannot use those losses to reduce California taxable income, even if they have other passive income generated within the state.

California also applies stricter rules regarding passive income from business activities. Under federal law, an owner of an S corporation or LLC may reclassify certain income as non-passive if they materially participate in the business. California does not always follow the same criteria for determining material participation, which can lead to additional restrictions.

Publicly traded partnerships (PTPs) are another area where California differs. Under federal tax law, losses from PTPs can only offset income from the same PTP, a rule that California generally follows. However, California does not always conform to federal adjustments related to basis calculations and at-risk rules. These differences can complicate determining allowable losses, particularly for taxpayers with multiple PTP investments.

Carryovers of Unallowed Losses

When passive losses exceed the allowable deduction for a given year, they are suspended and carried forward indefinitely until they can be applied against future passive income or when the related investment is fully disposed of in a taxable transaction. This can create long-term tax planning challenges, especially for investors who consistently generate passive losses but lack sufficient passive income to offset them.

California’s treatment of carryovers follows federal guidelines in many respects, but differences exist in how losses are applied when taxpayers experience changes in income levels or investment structures. If a taxpayer’s AGI fluctuates, the ability to deduct previously suspended losses may shift from year to year, delaying the benefit. Additionally, if an investor converts a passive activity into an active one—such as by materially participating in a previously passive business—California does not automatically allow the release of suspended losses, whereas federal law may permit this in certain circumstances. This is particularly relevant for taxpayers who transition from limited partners to general partners or take on greater operational roles in a business.

Reporting on Tax Returns

Properly reporting passive activity losses on California tax returns requires careful attention to state-specific forms and compliance requirements. While federal passive losses are reported on IRS Form 8582, California taxpayers must also complete FTB Form 3801, which calculates allowable passive losses and tracks any suspended amounts carried forward.

For taxpayers with multiple passive activities, each investment must be reported separately, with losses allocated based on California’s rules. If an activity generates both passive income and losses, only the net amount is considered when determining deductibility. Taxpayers with passive losses from rental real estate must ensure they meet the state’s income limitations before claiming deductions. Errors in reporting can lead to audits or adjustments, making it important to maintain detailed records of income, expenses, and participation levels.