What Are Passive Activity Loss Limitations?

The Internal Revenue Service (IRS) has regulations known as the passive activity loss (PAL) limitations, which govern how losses from certain investments can be used on a tax return. These rules prevent taxpayers from using losses from ventures where they are not actively involved to reduce taxable income from other sources, such as salaries or business profits. This framework, established under Internal Revenue Code Section 469, primarily affects investors in businesses and real estate.

The purpose of the PAL rules is to align loss deductions with the economic substance of an investment. They create a boundary by separating income and losses into categories, ensuring the financial results of passive investments are largely self-contained for tax purposes. This system applies to individuals, estates, certain trusts, and some corporations.

Defining a Passive Activity

A passive activity falls into one of two categories. The first is any trade or business in which a taxpayer does not “materially participate” during the tax year. The second category is any rental activity, which is considered passive by default, although specific exceptions exist. The determination of whether an activity is passive depends on material participation, a standard that measures a taxpayer’s involvement.

To be considered a material participant, a taxpayer must satisfy at least one of seven tests established by the IRS:

• Participating in the activity for more than 500 hours during the year.
• Having participation that constitutes substantially all of the participation in the activity for the year. For instance, a sole owner and operator of a small business would meet this standard.
• Participating for more than 100 hours, provided that this is not less than the participation of any other individual.
• Participating in multiple “significant participation activities” for a combined total of more than 500 hours. A significant participation activity is a business where an individual participates for more than 100 hours but does not otherwise meet the material participation tests.
• Materially participating in the activity for any five of the ten preceding tax years.
• Materially participating in a personal service activity, such as law or health, for any three prior tax years.
• Participating on a regular, continuous, and substantial basis during the year for more than 100 hours, based on all the facts and circumstances.

Calculating Allowable Passive Losses

The primary rule is that passive activity losses can only be used to offset passive activity income. These losses cannot be deducted against non-passive income, which includes wages, salaries, portfolio income like interest and dividends, or income from a business in which the taxpayer materially participates.

The calculation requires taxpayers to aggregate all income and losses from their passive activities for the year. If total passive income exceeds total passive losses, the net income is included in gross income. If total passive losses are greater than total passive income, the excess loss is disallowed for the current year. This netting process is performed on IRS Form 8582, Passive Activity Loss Limitations, which serves as the worksheet for this calculation.

For example, consider a taxpayer with two passive activities. Activity A is a limited partnership that generates a $15,000 loss, while Activity B is a rental property that produces $5,000 in net income. The taxpayer would use the $5,000 of passive income from Activity B to offset an equal amount of the loss from Activity A, leaving a $10,000 disallowed loss.

The final allowed loss amount from Form 8582 is then transferred to the appropriate schedule of the taxpayer’s return, such as Schedule E for rental real estate. It is necessary to maintain detailed records for each passive activity to properly allocate any disallowed losses.

Understanding Suspended Losses

When passive activity losses exceed passive income in a given year, the disallowed portion is not permanently lost. Instead, this excess loss is categorized as a “suspended passive loss” and is carried forward indefinitely to future tax years. These suspended losses are tracked on a per-activity basis.

These carried-over losses are most commonly used to offset passive income that arises in the future. If a taxpayer generates net passive income in a later year, the suspended losses from prior years can be used to offset that income, reducing the taxpayer’s tax liability for that year. This carryforward process continues until the suspended losses are fully used.

To continue the earlier example, the $10,000 disallowed loss from Activity A becomes a suspended loss. If, in the following year, Activity A generates a $3,000 profit and Activity B generates a $4,000 profit, the taxpayer would have $7,000 of passive income. The $10,000 suspended loss from the prior year could then be used to offset this entire $7,000 of income, and the remaining suspended loss of $3,000 would be carried forward.

Special Rules for Real Estate Activities

The tax code provides specific exceptions to the PAL rules for certain real estate activities. One of the most significant is the special allowance for rental real estate activities with active participation.

This allowance permits eligible taxpayers to deduct up to $25,000 in passive losses from rental real estate against their non-passive income, such as wages. To qualify, a taxpayer must “actively participate” in the rental activity. Active participation requires making management decisions, such as approving tenants, setting rental terms, and approving expenditures. The taxpayer must also own at least a 10% interest in the property.

This $25,000 allowance is subject to a phase-out based on the taxpayer’s modified adjusted gross income (MAGI). The deduction begins to decrease once MAGI exceeds $100,000 and is completely phased out when MAGI reaches $150,000. For married individuals filing separately who lived apart for the entire year, the allowance and phase-out thresholds are halved.

Another exception is for individuals who qualify as “real estate professionals.” To qualify, an individual must spend more than half of their personal service time in real property trades or businesses and perform more than 750 hours of service in those businesses during the year. If these tests are met and the taxpayer also materially participates in their rental activities, the losses from those rentals are not subject to the passive loss limitations.

Disposing of a Passive Activity

The disposition of a passive investment has significant tax consequences, particularly for any accumulated suspended losses. When a taxpayer disposes of their entire interest in a passive activity in a fully taxable transaction, such as a sale to an unrelated party, any suspended losses from that specific activity are released.

Once released, these losses can be used to offset other income. The losses are first applied to offset any gain from the sale of the activity itself. If losses still remain, they can then be used to offset any net income from other passive activities for the year. Any remaining loss can be deducted against non-passive income, such as wages, interest, and dividends.

For example, a taxpayer sells a rental property with $30,000 in accumulated suspended losses, and the sale results in a $10,000 capital gain. The $30,000 in released suspended losses would first offset the $10,000 gain to zero. The remaining $20,000 loss could then be used to offset the taxpayer’s other income for the year.

The disposition must be complete and fully taxable to trigger the release of suspended losses. Transactions with related parties or non-taxable exchanges, such as like-kind exchanges, do not qualify. In those cases, the losses remain suspended and attach to the new property acquired in the exchange.