Passive Activity Loss

Passive activity loss (PAL) rules under IRC Section 469 limit the deductibility of losses from business or rental activities in which the taxpayer does not materially participate. A passive activity is generally any trade or business where the taxpayer does not participate in operations on a regular, continuous, and substantial basis — typically defined as more than 500 hours per year.

Passive losses can only be used to offset passive income from other passive activities. They cannot be deducted against wages, salaries, or portfolio income (interest and dividends). Disallowed passive losses are suspended and carried forward to future years, where they can be applied against future passive income or released entirely when the activity is sold in a fully taxable transaction.

Rental activities are automatically classified as passive regardless of the owner's participation, with two important exceptions. Real estate professionals who spend more than 750 hours per year in real property trades and more than half their working time in real estate can treat rental activities as non-passive. Additionally, active participants in rental real estate with modified AGI under $100,000 can deduct up to $25,000 in rental losses annually against non-passive income, with the allowance phasing out between $100,000 and $150,000 of modified AGI.