The passive activity loss rules under §469 limit the deductibility of losses from passive activities - generally, trade or business activities in which the taxpayer does not materially participate, and all rental activities regardless of participation. Passive losses can only offset passive income. They cannot offset wages, interest, dividends, capital gains, or other non-passive income. Unused passive losses are "suspended" and carry forward until the taxpayer generates passive income to absorb them or disposes of the entire activity in a fully taxable transaction. For real estate investors in particular, §469 determines whether rental losses are currently deductible or indefinitely deferred.
Passive activities: Any trade or business in which the taxpayer does not materially participate, and all rental activities (with limited exceptions). Losses are passive and can only offset passive income.
Non-passive (active) activities: Trades or businesses in which the taxpayer materially participates. Losses are deductible against any type of income (subject to other limitations such as at-risk rules and basis limitations).
Portfolio income: Dividends, interest, capital gains, and royalties are neither passive nor active - they are "portfolio income" that passive losses cannot offset. This is a separate category that prevents investors from using rental losses against their investment portfolio.
A taxpayer materially participates in an activity if they satisfy any one of the following seven tests for the tax year:
Test 1: Participates more than 500 hours in the activity.
Test 2: Participation constitutes substantially all the participation of all individuals in the activity for the year.
Test 3: Participates more than 100 hours, and no other individual participates more hours than the taxpayer.
Test 4: Activity is a significant participation activity (SPA) and total SPA hours for all SPAs exceed 500 hours.
Test 5: Materially participated in the activity for any 5 years (not necessarily consecutive) of the 10 preceding tax years.
Test 6: Activity is a personal service activity and taxpayer materially participated for any 3 prior years.
Test 7: Based on all facts and circumstances, participates on a regular, continuous, and substantial basis (and more than 100 hours).
An exception to the passive loss rules allows taxpayers who actively participate in rental real estate to deduct up to $25,000 of rental losses against non-passive income per year. "Active participation" is a lower standard than material participation - it requires only that the taxpayer make management decisions in a bona fide sense (approving tenants, setting rental terms, approving repairs). The $25,000 allowance phases out at $100 for every $200 of AGI above $100,000, and is completely eliminated at $150,000 AGI. Married filing separately taxpayers have a reduced $12,500 limit that phases out beginning at $50,000.
Passive losses that cannot be deducted in the current year are suspended and carried forward. They are released and become fully deductible when the taxpayer disposes of their entire interest in the passive activity in a fully taxable transaction. A taxpayer who has accumulated $200,000 of suspended rental losses over years can recognize and deduct all $200,000 in the year the property is sold. This makes the tax economics of rental properties a long game: losses accumulate tax-deferred until the eventual sale, when they offset the gain.