Glossary term
Passive Loss
A passive loss is a tax loss from a passive activity that may be limited under IRS passive activity rules.
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What Is a Passive Loss?
A passive loss is a tax loss from a passive activity, such as many rental activities or businesses in which the taxpayer does not materially participate. Under IRS passive activity rules, passive losses generally can offset passive income, but they may not be fully deductible against wages, portfolio income, or active business income in the current year.
The rules are technical, and exceptions exist. The basic idea is that losses from passive investments cannot always be used immediately to reduce tax on nonpassive income.
Key Takeaways
- A passive loss comes from a passive activity under IRS rules.
- Passive activity losses are generally limited to passive activity income.
- Disallowed passive losses may be carried forward to future years.
- Rental real estate, material participation, active participation, and real estate professional rules can change the outcome.
How Passive Loss Rules Work
The IRS first looks at whether the activity is passive. A trade or business is generally passive if the taxpayer does not materially participate. Rental activities are generally treated as passive even when the taxpayer is involved, unless an exception applies.
If passive deductions exceed passive income, the excess passive loss is generally disallowed for the current year. The taxpayer may carry the suspended loss forward. In many cases, previously disallowed passive losses can become deductible when the taxpayer disposes of the entire interest in the activity in a fully taxable transaction.
Common Passive Loss Situations
Situation | Passive loss issue |
|---|---|
Rental real estate | Losses may be limited unless an exception applies. |
Limited partnership | Investor may not materially participate. |
Side business | Participation level can determine passive or nonpassive treatment. |
Disposition | Suspended losses may be released when the entire interest is sold. |
Tax Planning Context
Passive losses matter because they affect timing. A taxpayer may have an economic loss but not receive an immediate tax deduction against other income. That can surprise rental property investors, limited partners, and high-income taxpayers who expected a loss to reduce wages or investment income.
Taxpayers should also remember that passive activity limits are separate from basis limits, at-risk rules, depreciation rules, and other tax provisions. The order and interaction of those rules can change the amount actually deductible.
The Bottom Line
A passive loss is a tax loss that may be limited because it comes from a passive activity. It can reduce passive income and may carry forward, but it does not automatically offset other income in the year it arises.