EA Part 1 Passive Activity Rules: When Rental Losses Are Deductible

The passive activity loss (PAL) rules under IRC §469 exist to prevent taxpayers from using losses from investments they don't actively manage to shelter wages and other ordinary income. EA Part 1 tests these rules because rental real estate is common, the exceptions are specific, and the interactions with at-risk rules add another layer of complexity.

What Is a Passive Activity?

A passive activity is any trade or business in which the taxpayer does not materially participate, plus all rental activities (with exceptions).

Material participation is defined by meeting any one of seven tests, the most important of which are:

• The taxpayer participates more than 500 hours during the year
• The taxpayer's participation is substantially all the participation by anyone
• The taxpayer participates more than 100 hours and no one else participates more than the taxpayer

If a taxpayer fails all seven tests, the activity is passive.

Portfolio income — interest, dividends, royalties, and capital gains from investments — is not passive income. It cannot be offset by passive losses. This is a critical distinction on the exam.

The Passive Activity Loss Rule

Losses from passive activities can only offset passive activity income. If passive losses exceed passive income in a given year, the excess loss is suspended — it carries forward to future years. It is not lost; it is simply deferred.

Suspended passive losses become deductible in full when the taxpayer disposes of the entire interest in the passive activity in a fully taxable transaction.

Rental Real Estate: The General Rule

All rental activities are treated as passive, even if the taxpayer participates significantly. However, there are two major exceptions.

Exception 1: The $25,000 Rental Real Estate Allowance

If a taxpayer actively participates in a rental real estate activity, they may deduct up to $25,000 of rental losses against non-passive income each year.

Active participation is a lower standard than material participation — the taxpayer must make management decisions (approve tenants, set rental terms, authorize repairs) but does not need to meet the 500-hour test.

AGI phase-out: The $25,000 allowance phases out at a rate of 50 cents per dollar of MAGI above $100,000. It is completely eliminated when MAGI reaches $150,000.

• At $100,000 MAGI: full $25,000 allowance
• At $125,000 MAGI: $12,500 allowance ($25,000 − 50% × $25,000)
• At $150,000 or above: $0 allowance

Important: MAGI for this purpose is calculated before this rental loss deduction and before IRA deductions.

Losses disallowed under the phase-out are suspended and treated the same as other suspended passive losses.

Exception 2: Real Estate Professional

A taxpayer qualifies as a real estate professional if:

1. More than 50% of personal services performed during the year are in real property trades or businesses in which the taxpayer materially participates, AND
2. The taxpayer performs more than 750 hours of service during the year in real property trades or businesses in which they materially participate

For married taxpayers, each spouse must separately meet the real estate professional test — hours cannot be combined.

If a taxpayer qualifies as a real estate professional, their rental activities are no longer automatically treated as passive. However, they must still materially participate in each individual rental activity (or elect to group all rental activities as a single activity) to treat the income or loss as non-passive.

This exception is significant because it can allow an unlimited rental loss deduction — but the requirements are strict, and the IRS scrutinizes these claims.

At-Risk Rules: A Prerequisite

The at-risk rules under IRC §465 must be satisfied before the passive activity rules even apply. A taxpayer can only deduct losses to the extent they are personally "at risk" — meaning they have invested cash, property, or borrowed amounts for which they are personally liable.

At-risk amounts include:

• Cash contributed to the activity
• Adjusted basis of property contributed
• Amounts borrowed for which the taxpayer is personally liable or has pledged property not used in the activity as security

Not at-risk: Nonrecourse financing (where the lender's only remedy is the collateral) is generally not at-risk, except for qualified nonrecourse real estate financing from commercial lenders or government agencies.

Losses disallowed by the at-risk rules carry forward. They are not permanently lost.

The ordering is: at-risk rules apply first → passive activity rules apply second → whatever survives both restrictions is deductible.

Suspended Losses and Dispositions

When a taxpayer disposes of their entire interest in a passive activity in a fully taxable sale, the suspended passive losses from that activity are released and become deductible in the year of sale. They are treated as ordinary losses, offsetting any income in the following order:

1. Net income or gain from the same activity
2. Net income or gain from other passive activities
3. Any remaining amount against non-passive income (wages, portfolio income, etc.)

A gift, transfer at death, or installment sale does not trigger the release of all suspended losses in the year of transfer. With installment sales, suspended losses are released proportionally as gain is recognized.

Common Exam Traps

Trap 1: The $25,000 rental real estate allowance phases out based on MAGI, not taxable income. The distinction matters when large deductions reduce taxable income significantly below MAGI.

Trap 2: A limited partner in a limited partnership is generally passive regardless of hours worked. The passive activity rules treat limited partners as per se passive unless they meet specific participation tests as a general partner would.

Trap 3: Portfolio income (dividends, interest) cannot be offset by passive losses — even if all the taxpayer's income is from passive activities. The rules create three separate baskets: active income, passive income, and portfolio income.

Trap 4: The real estate professional rules do not automatically make all rental income active. The taxpayer must still materially participate in each rental activity.

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