Passive Activity Loss Rules and Limitations

IRS Sec. 469 defines a passive activity as:

  1. Any trade or business of the taxpayer in which the taxpayer does not materially participate, and
  2. Any rental activity of the taxpayer except as provided under Sec. 469(c)(7).

Due to #2, all rental activities are classified as passive activities. Per IRS Regulations, a loss from a passive activity can only offset income from a passive activity. Losses from passive activities cannot offset earned income.

There are two exceptions that allow taxpayers to use passive losses to offset earned income:

  1. The passive loss allowance which allows taxpayers with a Modified Adjusted Gross Income (MAGI) of less than $100,000 to deduct up to $25,000 of passive losses against their other income. This $25,000 deduction is phased out $1 for every $2 that MAGI increases above $100,000. This means that once a taxpayer’s MAGI exceeds $150,000, the passive loss allowance will have been completely phased out.
  2. Qualifying as a Real Estate Professional.

Many of our clients earn above $150,000 and do not qualify as real estate professionals. As a result, if their rentals produce passive losses in excess of passive income, the result is a net passive loss for the rental activities. That loss becomes a suspended passive loss and it is carried forward into the future.