Passive activity rules (IRC Section 469) limit the ability of taxpayers to use losses from passive activities to offset active income (wages, salaries, business income) or portfolio income (dividends, interest).
Definition of passive activity: - Any trade or business in which the taxpayer does NOT materially participate. - All rental activities (by default, regardless of participation). - Limited partnership interests (typically passive).
Material participation tests (7 tests — must meet at least one): - Work in activity >500 hours/year. - Work in activity more than anyone else (all individuals combined >100 hours and taxpayer's hours are highest). - Work >100 hours and no one works more. - Several other tests...
The rule: - Passive losses can only offset passive income. - Excess passive losses are suspended (carried forward to future years). - Suspended losses are released when the passive activity is sold (or fully disposed of in a taxable transaction).
Real estate exception ("active participation"): - Taxpayers who actively participate in rental activities (make management decisions) AND have MAGI ≤ $100,000 can deduct up to $25,000 of rental losses against non-passive income. - Phase out: $25,000 allowance phases out $1 for every $2 of MAGI above $100,000 ($0 at $150,000 MAGI).
Real estate professional exception: If >50% of personal services AND >750 hours are in real estate activities, rental income is NOT automatically passive → can offset other income.
> Exam tip: Passive losses can only offset passive income (not wages). The $25,000 rental loss allowance phases out from $100K–$150K MAGI. Real estate professional status removes the passive limitation. Key for CFP® and EA Part 2.