Passive Activity Loss Rules Explained

IRC Section 469 was enacted as part of the Tax Reform Act of 1986, primarily to curtail the widespread use of tax shelters that generated artificial losses to offset wage and business income. Before 1986, taxpayers could freely invest in passive partnerships and use the resulting losses against earned income, regardless of whether they had any real involvement in the activity.

The passive activity loss rules created a fundamental distinction between income earned through active participation and income from passive investment. Losses from passive activities were restricted to offsetting passive income only, preventing the cross-subsidization of wages or business profits with paper losses from tax shelter investments.

A passive activity is any activity in which the taxpayer does not materially participate, plus all rental activities regardless of participation level. Section 469(c)(2) specifically designates all rental activity as passive per se, making this a bright-line rule that applies even to taxpayers who spend substantial time managing their properties.

The sole exception to the automatic passive classification of rental activities is the real estate professional exception under Section 469(c)(7), which applies when a taxpayer satisfies the 750-hour and more-than-half tests and also materially participates in each rental activity. Short-term rental activities where the average period of customer use is seven days or less may also be treated differently from long-term rentals for classification purposes.

For the vast majority of rental real estate investors, all rental income and losses are passive. This means:

• Rental income is passive income, sheltered by passive losses from the same or other passive activities
• Rental losses, including accelerated depreciation from cost segregation, are passive losses
• Passive rental losses cannot reduce wages, self-employment income, or active business income
• Excess passive losses are suspended and tracked on Form 8582

The automatic passive classification of rental activities is one of the most consequential rules in the tax code for real estate investors because it determines whether the substantial depreciation advantages of real estate investment are immediately usable or merely stored for future use.

Passive losses are absorbed by passive income in the following order. First, current-year passive income from all passive activities is aggregated. Second, current-year passive losses from all passive activities are aggregated. Third, losses are allowed to the extent of income. Any excess is added to the suspended loss carryforward.

Sources of passive income that can absorb passive losses from cost segregation activities include net rental income from other properties, income from passive business investments, income from limited partnerships, and gain from the sale of passive activities. Portfolio income, such as dividends and interest, is not passive income for this purpose and cannot be offset by passive losses.

Form 8582 is the computational form used to calculate the amount of passive activity losses that may be deducted in the current year. It aggregates passive income and losses across all passive activities, applies the limitation, and calculates the suspended loss carryforward for each activity.

Separate worksheets within Form 8582 track activities subject to the $25,000 allowance (Section 469(i) rental activities with active participation), all other rental activities, and other passive activities. The form must be filed whenever a taxpayer has any passive activity loss, even if the entire loss is absorbed by passive income.

Section 469 passive losses that are not absorbed in the current year are suspended and carried forward indefinitely. There is no expiration date on passive loss carryforwards. The carryforward is tracked by activity, meaning that losses from Property A cannot offset income from the sale of Property B (unless the taxpayer has made a grouping election).

Accumulated passive loss carryforwards represent a significant asset on many real estate investors' tax records. These balances grow each year that cost segregation or standard depreciation generates losses in excess of passive income, and they create future tax benefits through one of two mechanisms: absorption by future passive income or release upon disposition.

The PAL rules include several exceptions specific to real estate:

• Section 469(i) allowance: Up to $25,000 of passive rental losses are deductible against non-passive income for active participants with AGI below $150,000
• Real estate professional exception: Qualifying taxpayers under Section 469(c)(7) who materially participate are not subject to the passive classification for their rental activities
• Short-term rental exception: Properties with an average rental period of seven days or less are not automatically classified as rental activities subject to per se passive treatment
• Self-charged interest exception: Interest income from loans to passive activities in which the taxpayer owns an interest may be reclassified as passive under certain circumstances

Upon a fully taxable disposition of a passive activity, all suspended passive losses from that activity are released and become deductible in the year of sale. The released losses are first applied against any gain from the disposition, then against income from other passive activities, then against any income from any source.

This stacking rule means that a large suspended loss from accumulated cost segregation depreciation can, upon disposition, first offset the section 1245 and 1250 recapture, then the remaining capital gain, and any excess may reduce ordinary income from wages or business activities.

The at-risk rules under Section 465 apply before the passive activity loss rules. A taxpayer can only deduct a loss to the extent they are at risk in the activity, meaning the economic amount they stand to lose. Nonrecourse financing that is not qualified nonrecourse financing reduces the at-risk amount.

For most direct real estate investors who personally guarantee mortgages or use qualified nonrecourse financing, the at-risk rules are not an additional constraint. However, investors in limited partnerships or syndications where debt is nonrecourse may have at-risk limitations that prevent them from using some or all of the passive losses generated by the structure.

The passive activity loss rules are the primary legal framework that determines the value of cost segregation depreciation for any given investor. Whether that depreciation produces an immediate tax benefit or a deferred one depends entirely on whether the losses are passive or non-passive.

For investors weighing whether to pursue cost segregation in the context of their passive activity position, the analysis of using cost segregation to offset W-2 income addresses the specific question of how to convert passive losses into active deductions. And for a comparison of how the passive investor experience differs from the REPS-qualifying investor, see the companion guide to passive versus non-passive income classification.