Passive Activity Loss Rules
The passive activity loss rules, enacted under IRC Section 469, limit the ability of taxpayers to use losses from passive activities — businesses in which they do not materially participate — to offset wages, salaries, or portfolio income.
Congress enacted the passive activity loss (PAL) rules in the Tax Reform Act of 1986 to curtail tax shelter abuse. Prior to 1986, high-income taxpayers routinely invested in limited partnerships designed to generate artificial losses that sheltered ordinary income. The PAL rules essentially quarantine passive losses: they can only offset passive income and cannot reduce non-passive income such as wages, self-employment income, dividends, or interest.
An activity is passive if the taxpayer does not materially participate. The IRS provides seven tests for material participation under Treasury Regulation 1.469-5T, the most commonly used being participation for more than 500 hours during the year, or for more than 100 hours with participation at least as great as any other individual. A limited partnership interest is presumed passive regardless of hours worked.
Real estate is subject to a special exception. A taxpayer who actively participates in rental real estate (a lower standard than material participation) may deduct up to $25,000 of rental losses against non-passive income, but this allowance phases out ratably between AGI of $100,000 and $150,000. Real estate professionals who spend more than 750 hours per year in real property trades or businesses and for whom such activities constitute more than half of their working time are exempt from the passive rules entirely.
Suspended passive losses accumulate year after year and are released in full when the taxpayer disposes of the entire interest in the activity in a fully taxable transaction. This makes tracking basis and suspended losses across multiple passive investments an important record-keeping obligation.