What Are Passive Activity Losses and How Do They Work?

Passive activity losses (PALs) are an important tax consideration for investors and business owners. These losses occur when expenses from passive activities exceed the income generated by those activities, but tax rules limit how they can be deducted. Understanding these limitations helps taxpayers involved in rental properties or businesses where they don’t actively participate manage their tax liability.

The IRS defines what qualifies as passive, and knowing these rules allows taxpayers to optimize deductions while staying compliant.

Distinguishing Active and Passive Income

The IRS classifies income into two categories: active and passive. Active income comes from work where an individual materially participates, such as wages, salaries, and self-employment earnings. This type of income is subject to payroll taxes, including Social Security and Medicare, and allows for a broader range of deductions.

Passive income, by contrast, comes from activities where the taxpayer does not materially participate. Common examples include rental properties, limited partnerships, and businesses where the individual is an investor rather than an operator. Passive earnings are not subject to self-employment tax, but losses from these activities can only offset passive income unless specific exceptions apply.

Active income is taxed at ordinary rates, ranging from 10% to 37% in 2024. Passive income, particularly from rentals, may benefit from depreciation deductions, reducing taxable income without requiring a cash outlay. Certain passive income sources, such as qualified dividends and long-term capital gains, are taxed at lower rates of 0%, 15%, or 20%, depending on the taxpayer’s income level.

Material Participation Criteria

The IRS determines whether an activity is passive based on material participation tests outlined in Treasury Regulation 1.469-5T. Meeting any one of these seven tests qualifies an individual as materially participating, allowing losses to be treated as non-passive.

One common test requires a taxpayer to participate in the activity for more than 500 hours in a tax year. If participation is below this level, the activity is generally classified as passive unless another test applies. For example, if multiple individuals share ownership in a business, a taxpayer who spends more than 100 hours and is not outperformed by any other participant may still qualify under the “significant participation activity” test.

For those involved in multiple businesses, the IRS allows taxpayers to group activities if they form an “appropriate economic unit” under Regulation 1.469-4(c). This grouping can help meet material participation criteria by aggregating time spent across related businesses. However, once a grouping election is made, it generally cannot be changed without IRS approval, making it a long-term strategic decision.

Categories of Passive Losses

Passive losses generally come from rental activities and businesses where the taxpayer does not materially participate.

Rental losses are common for property owners who do not actively manage their investments. Under IRC 469(i), certain taxpayers can deduct up to $25,000 in rental real estate losses against non-passive income if they actively participate and have a modified adjusted gross income (MAGI) of $100,000 or less. This deduction phases out at a rate of 50 cents per dollar for MAGI above $100,000 and disappears completely at $150,000. Without this special allowance, rental losses can only offset passive income.

Losses from passive business activities, such as limited partnerships or investments in companies where a taxpayer has no operational role, follow similar restrictions. These losses can only offset passive income from other sources, such as dividends from another passive investment or gains from the sale of a passive business interest. If a taxpayer has multiple passive activities, losses from one can be used to offset income from another, but they cannot be applied to reduce taxes on salary or self-employment earnings.

Handling Carryover Losses

When passive losses exceed passive income in a given year, the unused portion is not lost. Instead, these losses are suspended and carried forward indefinitely under IRC 469(b) until they can be used to offset future passive income or until the underlying activity generating the losses is fully disposed of in a taxable transaction.

One way to unlock suspended losses is by selling or disposing of the passive activity in a fully taxable event. Under IRC 469(g), when a taxpayer sells their entire interest in a passive activity to an unrelated party, all suspended losses tied to that activity become fully deductible against any type of income, including wages and business profits. This creates a planning opportunity to time the sale of a passive business or investment in a year where it provides the greatest tax benefit, such as offsetting a large capital gain or unusually high earned income.

Real Estate Activities

Real estate investments are a common source of passive activity losses, but tax treatment depends on the investor’s level of involvement.

Real Estate Professionals

Taxpayers who qualify as real estate professionals under IRC 469(c)(7) are exempt from passive activity loss limitations. To meet this designation, they must spend more than 750 hours per year in real estate trades or businesses and ensure that this work constitutes more than half of their total working hours. If these conditions are met, rental losses are treated as non-passive and can offset other income without restriction. This classification benefits full-time real estate investors, brokers, and developers, but part-time landlords typically do not qualify. Documentation, such as time logs and business records, is essential to substantiate this status in case of an IRS audit.

Short-Term Rentals

Short-term rental properties, such as those listed on Airbnb and Vrbo, may not be classified as passive activities if they meet certain conditions. Under Regulation 1.469-1T(e)(3)(ii), rental activities where the average stay is seven days or less are not considered passive unless the taxpayer fails to materially participate. This distinction allows active short-term rental operators to deduct losses against other income, even if they do not qualify as real estate professionals. However, state and local regulations on short-term rentals can impact tax treatment, particularly if the property is subject to hotel occupancy taxes or zoning restrictions.