Understanding Passive Activity Loss Rules And Limitations

Understanding Passive Activity Loss Rules And Limitations

If you invest in real estate, it’s crucial to pay attention to your property’s financial and physical aspects. And understanding tax regulations is one of those financial considerations.

An often misunderstood tax law is how the passive activity loss rules (PAL rules) work.

New Passive Investor Circle members often inquire about these rules and how they impact their active and passive incomes.

The passive activity loss rules are a set of IRS regulations designed to limit the use of losses from income-producing activities in which the taxpayer does not materially participate. These rules prevent taxpayers from using passive losses to offset earned or ordinary income, thereby reducing their tax liability.

Understanding these rules is crucial for taxpayers with investments or businesses that generate passive income, as they may directly impact their tax returns.

Due to depreciation deduction and other operational costs, it’s not unusual for rental properties to have a net loss for tax purposes.

Investors often misunderstand the treatment of these losses for various reasons, so we’ll use this article to clear up common misconceptions of this particular internal revenue code (IRC). 

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Understanding Passive Activity Loss Rules

What is the definition of passive activities?

Passive activities are income-producing activities in which an individual does not materially participate, such as rental properties or a business.

The IRS created passive activity loss limitations to limit individuals from using passive losses to offset earned or ordinary income. 

IT WAS CONFUSING when I first began learning about using passive losses to offset my dental income. 

For that reason, I created a video that should help explain the process:

What Is Passive Income?

Passive income includes income from trade or business activities in which the taxpayer does not materially participate and income from rental activities, regardless of participation level.

Examples include:

  • Real estate rental income
  • Business income from a limited partnership
  • Dividends, interest, and royalties from investments

What Are Passive Losses?

Passive losses are losses incurred in passive activities. To determine whether an activity is passive, the IRS uses material participation tests (more detail below), which assess the level of involvement an individual has in the activity. Some criteria for material participation include the following:

  • The individual participates in the activity for more than 500 hours during the year
  • The activity constitutes substantially all of the individual’s participation in all activities during the year
  • The individual participates in the activity for more than 100 hours during the year, and no other individual participates for more hours

How Passive Activity Loss Rules Work

Under the Internal Revenue Code, losses from active efforts, like running a practice, can only be deducted from active income. Likewise, losses from passive activities, like rental properties, can only be deducted from passive income.

In other words, you can’t use losses from passive sources to reduce taxes on active income. These rules apply until you sell your complete stake in the passive rental real estate activity, after which you can fully claim any remaining losses exceeding your passive income.

Under the passive loss rules, taxpayers can deduct up to $25,000 in passive losses against ordinary income (e.g., W-2 wages) if their modified adjusted gross income (MAGI) is $100,000 or less. This deduction phases out at a rate of $1 for every $2 of MAGI above $100,000 until it is completely phased out at $150,000. 

Here’s an example: If your MAGI was $95,000 for the year and you experienced a $25,000 loss from rental properties, you could deduct the full $25,000 from your taxable income, given that you were actively involved in the rental activities.

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What Is Material Participation?

Material participation and Active participation are two essential concepts to understand regarding passive activity loss rules (PAL). These terms help determine the tax treatment of losses and credits generated from various activities, notably businesses and rental properties.

Material Participation refers to a taxpayer’s involvement in the day-to-day operations and decision-making of a business venture. A taxpayer is considered to be materially participating if they meet at least one of the following tests annually:

  1. 500-hour Participation: The taxpayer participates in the activity for at least 500 hours during the tax year. This is the most straightforward test, as it solely relies on the number of hours dedicated to the business.
  2. Primary participant: The taxpayer’s involvement in the activity is more substantial than any other individual during the tax year. In other words, they must have participated in managing the business more than anyone else.
  3. 100-hour Participation and no one more: The taxpayer participates in the activity for at least 100 hours during the tax year, and no one else, including non-owners, participates more hours than the taxpayer.
  4. Significant Participation and 500-hour total: The taxpayer significantly participates in the activity for at least 100 hours during the tax year, and their total Participation in all significant participation activities is more than 500 hours.
  5. Material Participation in past years: The taxpayer materially participated in the activity in any 5 of the 10 preceding tax years.
  6. Personal service activity: If the activity is a personal service activity such as law, accounting, or consulting, the taxpayer materially participated for any 3 prior tax years.
  7. Facts and Circumstances: If a taxpayer fails to meet any of the previous six tests but wants to claim material Participation, they may provide facts and circumstances to demonstrate their involvement. This would require at least 100 hours of Participation in the activity during the tax year and must prove that their Participation was regular, continuous, and substantial.

What Is Active Participation?

Active Participation relates explicitly to the real estate industry. A taxpayer is considered actively participating in a rental property if they have made management decisions or arranged for someone else to provide services such as repairs, rent collection, and tenant selection.

Active Participation allows taxpayers to deduct up to $25,000 of rental losses against their non-passive income.

What Is a Trade or Business Activity?

Trade or business activities refer to enterprises that individuals might engage in to earn income or profit. To classify an activity as a trade or business, the taxpayer must materially participate in it.

In general, material Participation helps to distinguish between active and passive income for tax purposes.

What Are Rental Real Estate Activities?

As the name suggests, rental real estate activities involve renting out residential or commercial property. These activities, too, can generate either active or passive income, depending on the taxpayer’s level of involvement.

In most cases, rental real estate activities are considered passive, even if the taxpayer materially participates in them.

However, there’s an exception: if the taxpayer qualifies as a real estate professional (explained in the next section), their rental real estate activities in which they materially participate are not considered passive.

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Real Estate Professionals and Passive Activity Loss

Real estate professionals can avoid some limitations imposed by the passive activity loss rules. To qualify as a real estate professional, a taxpayer must meet specific requirements outlined in the Internal Revenue Code (IRC) Secs. 469(a), (c)(2), and (c)(7).

A taxpayer must fulfill two main criteria to be considered a real estate professional (REPS):

  • More than 50% of the taxpayer’s personal service time during the tax year must be spent on real property, trade, or business activities in which they materially participate.
  • The taxpayer must spend more than 750 hours per year on these activities.

Some key points about real estate professionals and passive activity loss include:

  • Being a real estate professional does not automatically guarantee that rental losses can be offset against nonpassive income. A taxpayer still needs to establish material participation in each rental activity.
  • Making an election to group all rental real estate activities under one activity simplifies material participation determination and provides greater tax benefits in offsetting nonpassive income.

Suppose you’re a doctor or other high-income earner and obtain REPS status. In that case, you’re able to offset rental losses against nonpassive income and potentially achieve significant tax savings.

Applicable Tax Forms and Filing Requirements

When filing taxes and accounting for passive activity loss rules, several forms are crucial for reporting income, gains, and losses. These forms include Forms 8582, Form 8582-CR, and IRS Form 6198.

Form 8582: Passive Activity Loss Limitations

Form 8582 is used by individual taxpayers, estates, and trusts with passive activity losses to calculate and limit the allowable passive activity loss for the tax year. This form helps to ensure compliance with Section 469 of the Internal Revenue Code. Taxpayers should complete Form 8582 if they:

  • Have a passive activity loss from any rental real estate activity, trade, or business.
  • Have any prior-year unallowed passive activity losses?

Form 8582-CR: Passive Activity Credit Limitations

Form 8582-CR calculates and limits the amount of passive activity credits that can be used in the current tax year. Taxpayers with passive activity credits from rental real estate or business activities where they do not materially participate must complete this form.

IRS Form 6198: At-Risk Limitations

In addition to the passive activity loss rules, taxpayers may need to file IRS Form 6198 for at-risk activity limitations. This form is used when a taxpayer has a loss from an activity they are engaged in as a trade or business or for the production of income and is considered at-risk.

The at-risk rules apply to individuals, estates, trusts, and certain closely held C corporations. If a taxpayer is required to file Form 6198, they must also file Form 8582 to account for passive activity limitations.

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Entities Subject to Passive Activity Loss Rules


Individuals are subject to passive activity loss rules. These rules prohibit using passive losses to offset earned or ordinary income. For individuals, the rules apply to activities such as rental properties and investments in limited partnerships. Taxpayers can only offset passive income with passive losses from the same activity or other passive activities.

Estates and Trusts

Estates and trusts are also subject to the passive activity loss rules. The rules are similar to those applied to individuals, meaning that passive losses generated by estates and trusts can only be used to offset passive income from the same or other passive activities.

Limited Partnerships and Personal Service Corporations

Limited partnerships and personal service corporations (PSCs) fall under the scope of passive activity loss rules. Limited partners generally have their losses and income categorized as passive, irrespective of their involvement in activities. Similarly, personal service corporations, which provide services in fields such as law, engineering, health, and accounting, face passive activity loss restrictions.

Closely Held Corporations

Closely held corporations are subject to passive activity loss rules as well. These corporations have a limited number of shareholders, and their stock is not publicly traded. In such cases, passive losses can only be used to offset passive income. A closely held corporation can only use passive activity losses to offset passive income; it cannot use passive losses to reduce the corporation’s net active income.

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Who do the passive activity loss rules not apply to?

The PAL rules do not apply to those actively involved in a trade or business.

How long can you carry forward passive activity losses?

You can carry passive activity losses (PALs) forward indefinitely until you have enough passive income to deduct them against or until you dispose of the activity that generated the losses.

What is the passive activity and at risk rules?

The passive activity rules and at-risk rules are two sets of tax laws. Passive activity rules say that losses from “passive activities,” such as a rental property you own but don’t personally manage, can only be deducted from passive income. At-risk rules, however, limit the amount you can deduct based on how much you’ve invested or risked in the activity.

Can passive activity losses offset capital gains?

Passive activity losses cannot offset capital gains, only passive income. For example, if you have losses from a rental property, you can’t use them to reduce the taxes on profits from the stock market.

What are the limitations of passive rental losses?

If your adjusted gross income is $100,000 or less, you can deduct up to $25,000 in rental real estate losses as long as you “actively participate”. This amount gradually reduces and phases out entirely once your income exceeds $150,000.

What are considered passive losses?

Passive losses are financial losses associated with investment in passive activities. A typical example is a loss from a rental property you own but don’t actively manage.

What are examples of passive activities?

Common passive activity examples include rental real estate and businesses where you’re not involved in the day-to-day operations.