What Are Suspended Losses and How Do They Work?

Losses from investments or business activities don’t always provide immediate tax benefits. In some cases, they are classified as suspended losses, meaning they cannot be deducted right away and must be carried forward to future years. This can impact an investor’s ability to offset taxable income and requires careful planning to maximize deductions.

Understanding how these losses accumulate, when they can be used, and what events trigger their release is essential for managing tax liabilities effectively.

Reasons Suspended Losses Arise

Tax laws often restrict when certain losses can be deducted, leading to suspended losses. One primary cause is the passive activity loss (PAL) rules under Section 469 of the Internal Revenue Code (IRC). These rules prevent taxpayers from using passive activity losses to offset non-passive income, such as wages or business profits. If a taxpayer lacks sufficient passive income in a given year, the losses are suspended and carried forward until they can be applied against future passive income or when the activity is fully disposed of.

The at-risk rules under Section 465 also contribute to suspended losses by limiting deductions to the amount a taxpayer has at risk in an investment or business. If losses exceed this amount—such as when financing is nonrecourse—the excess losses are suspended. This prevents taxpayers from deducting more than their actual financial exposure.

Basis limitations further restrict deductions, particularly for shareholders in S corporations and partners in partnerships. Under Section 1366(d), an S corporation shareholder can only deduct losses up to their stock and loan basis in the company. Similarly, partnership losses are limited to a partner’s adjusted basis in the partnership under Section 704(d). If losses exceed these thresholds, they are suspended until additional basis is created, often through capital contributions or income allocations.

Income Activities That Create Such Losses

Suspended losses typically arise from investments or business ventures with uncertain income or restrictions on deductibility. Understanding the types of activities that generate these losses can help taxpayers anticipate limitations and plan accordingly.

Passive Investments

Investments in businesses where the taxpayer does not materially participate often generate passive losses. Material participation generally requires significant, regular, and continuous involvement in the business. If a taxpayer does not meet these criteria, any losses from the activity are considered passive and can only offset passive income.

For example, if an individual invests in a limited partnership that operates a restaurant but does not take part in daily management, any losses from the business are classified as passive. If the investor has no other passive income, the losses are suspended and carried forward until the investor either generates passive income from another source or sells their interest in the partnership.

The passive activity loss rules apply to various investments, including private equity funds, hedge funds, and other limited partnerships. Investors should track their participation levels and income sources to determine when they can utilize these losses.

Rental Arrangements

Rental real estate is another common source of suspended losses due to its classification as a passive activity. Even if a taxpayer actively manages a rental property, the IRS generally considers rental income passive unless the individual qualifies as a real estate professional under Section 469(c)(7). To meet this designation, a taxpayer must spend more than 750 hours per year in real estate activities and have real estate-related work constitute more than half of their total working hours.

For most rental property owners who do not meet these criteria, rental losses can only offset passive income. If rental expenses—such as mortgage interest, property taxes, depreciation, and maintenance—exceed rental income, the excess loss is suspended. However, individuals with adjusted gross income (AGI) below $150,000 may deduct up to $25,000 of rental losses against non-passive income, with the benefit phasing out between $100,000 and $150,000.

If a taxpayer’s AGI exceeds this threshold, any unused rental losses are carried forward. These losses can be used in future years when rental income increases or when the property is sold, at which point all suspended losses become deductible.

Flow-Through Entities

Businesses structured as partnerships, S corporations, or limited liability companies (LLCs) often generate suspended losses due to ownership rules that limit deductions. Since these entities do not pay taxes at the corporate level, income and losses pass through to individual owners, who must meet specific requirements to deduct losses on their personal tax returns.

For S corporation shareholders, losses are limited by stock and loan basis. If a shareholder’s share of losses exceeds their basis in the company, the excess is suspended until additional basis is created, either through new capital contributions or income allocations. Similarly, partners in a partnership can only deduct losses up to their adjusted basis, which includes their initial investment, share of income, and any personally guaranteed debt.

For example, if a partner has a $10,000 basis in a partnership and their share of losses is $15,000, only $10,000 can be deducted in the current year. The remaining $5,000 is suspended until the partner increases their basis, such as by contributing additional funds or receiving an income allocation.

Owners of flow-through entities should monitor their basis carefully to determine when losses can be deducted. Proper tax planning, such as making timely capital contributions or restructuring debt, can help maximize the use of suspended losses.

How They Are Carried Forward

Once losses are suspended, they accumulate for future use when conditions allow for their deduction. The mechanics of carrying forward these losses depend on the type of limitation that caused them to be deferred. Taxpayers must track these amounts carefully, as they remain tied to the specific activity that generated them and cannot be freely applied to other income sources.

For tax reporting purposes, suspended losses must be documented each year on the relevant tax forms, such as Form 8582 for passive activity losses. The IRS does not automatically apply suspended losses; taxpayers must claim them when eligible by including them in their tax filings. Maintaining detailed records, including prior-year tax returns and supporting schedules, ensures compliance and maximizes deductions.

Changes in financial circumstances, such as increased income from the same activity or modifications in ownership structure, can affect when and how suspended losses are applied. If additional income is generated from the same passive investment or business, the losses may be used to offset that income. Similarly, if a partnership or S corporation undergoes restructuring, the ability to use suspended losses may depend on whether the taxpayer retains ownership or receives additional basis through capital contributions or debt financing.

Events That Trigger Loss Release

Suspended losses remain unusable until a triggering event allows them to be deducted. One of the most common ways this happens is when a taxpayer generates sufficient income from the same activity that originally produced the losses. If a previously unprofitable business begins generating taxable earnings, the accumulated losses can be applied against this income, reducing overall tax liability.

A complete disposition of the underlying investment or business interest also triggers the release of suspended losses. When a taxpayer sells or otherwise disposes of their entire interest in a passive activity to an unrelated party in a fully taxable transaction, all remaining suspended losses tied to that activity become deductible in full. This applies even if the taxpayer does not have passive income in the year of sale. However, if the disposition is structured as a gift or transfer to a related party, the losses do not become deductible and instead carry over to the recipient.

Debt forgiveness can also impact the availability of suspended losses. If a taxpayer’s business undergoes a debt restructuring where a portion of liabilities are forgiven, the resulting cancellation of debt (COD) income may allow suspended losses to be used. However, under Section 108, COD income may be excluded from taxable income in certain circumstances, such as insolvency or bankruptcy. In these cases, the taxpayer may be required to reduce certain tax attributes, including suspended losses, before applying them against future income.