Passive Loss vs. Passive Gain

The fundamental concept is simple: Passive losses can generally only offset passive gains.

What is a Passive Activity?

The IRS defines a passive activity based on the nature of the business and the taxpayer's involvement.

Trade or Business Activity: Any trade or business activity in which the taxpayer does not materially participate during the tax year.

Rental Activities: All rental activities are generally considered passive, regardless of the taxpayer's participation, with specific exceptions for:

Real Estate Professionals (who meet strict criteria).

The Special Allowance for taxpayers who actively participate in rental real estate and meet income limits.

Material Participation: The Key Distinction

Material participation is the most important factor in determining if an income or loss is considered passive or active. If you materially participate, the resulting income/loss is generally classified as active (or non-passive) and is not subject to the PAL limitations.

The IRS provides seven tests to determine if a taxpayer materially participates in a trade or business activity. The most common is the 500-Hour Test.

Example: Participation for more than 500 hours during the tax year is an example of material participation.

Passive Loss vs. Passive Gain

To apply the PAL rules, you must first classify your activity's outcome.

Passive Loss

This occurs when the total expenses from a passive activity exceed the income generated by that activity in a given tax year.

Common Sources: Rental properties that generate a tax loss (due to depreciation, interest, etc.) and limited partnership losses.

Passive Gain (Passive Income)

This is the income generated by a passive activity.

Common Sources: Rental income, a profit share from a limited partnership, or a profit from a business in which you did not materially participate.

Netting Passive Losses Against Passive Gains

The core of the PAL limitations involves a netting process.

The Netting Process

Calculate the Net Income/Loss for Each Passive Activity: Determine the profit or loss from each individual passive activity (e.g., Rental Property A, Limited Partnership B).

Aggregate All Passive Income and Losses: Total all passive gains and all passive losses for the tax year.

Net the Totals: Passive losses are subtracted from passive gains.

Example of Netting:

Suspended Losses (Passive Loss Carryover)

If your total passive losses exceed your total passive gains, the result is a Net Passive Loss. This excess amount is not lost; it becomes a suspended passive loss that is carried forward indefinitely until one of two things happens:

A. Offsetting Future Passive Income

The suspended loss can be carried forward and used to offset any passive income you generate in any future tax year.

B. The Fully Taxable Disposition Exception

This is the most significant way to "free up" and utilize suspended losses.

If you sell your entire interest in the passive activity in a fully taxable transaction to an unrelated party, any current and suspended losses related to that specific activity are "unlocked" and can be deducted in the following order:

First: Deducted against any gain from the sale of the activity.

Second: Deducted against any net income from all other passive activities.

Third: If a net loss remains, it can finally be deducted against non-passive (active) income, such as wages or salary.