Passive Activity Loss Rules — § 469 and the At-Risk Limits

If you own a rental property or invest in a business you don't actively run, the passive activity loss rules determine whether — and when — you can deduct losses from that activity against your other income. Under 26 U.S.C. § 469, losses from "passive" activities (those in which you don't materially participate) are generally suspended rather than deducted immediately. They carry forward indefinitely and become fully deductible only when you sell or otherwise dispose of the activity. A companion rule, the at-risk limitation under § 465, caps deductible losses at the amount of cash and recourse debt you've personally committed to an activity — so you can never deduct more than you could truly lose.

Current Law (2026)

Parameter	Value
Passive loss general rule	Passive losses deductible only against passive income; excess suspended and carried forward
Rental real estate allowance	Up to $25,000 of rental losses deductible against ordinary income if you "actively participate"
Allowance phase-out	$25,000 allowance reduced $1 for every $2 of AGI above $100,000; eliminated at $150,000 AGI
Real estate professional exception	If >750 hours/year AND more than half your work time is in real property trades or businesses, rental is NOT passive
Material participation tests	7 IRS tests; most common: 500+ hours/year in activity
At-risk rule (§ 465)	Losses deductible only up to amounts "at risk" — cash contributed plus recourse debt
Passive income offset	Passive losses can offset passive income from any source (rental, limited partnership, S-corp you don't manage)
Disposition rule	On complete taxable disposition, all suspended losses freed — deductible against any income
Applies to	Individuals, estates, trusts, closely held C-corps, personal service corporations

Legal Authority

26 U.S.C. § 469 — Passive activity losses and credits limited: defines passive activity, material participation, rental activity rules, exceptions, carryforward and disposition rules
26 U.S.C. § 465 — At-risk limitations: caps deductible losses to amounts contributed and recourse borrowing; applies before § 469 analysis
26 U.S.C. § 1245 — Depreciation recapture on personal property: interacts with passive rules on disposition
26 U.S.C. § 1250 — Depreciation recapture on real property: Section 1250 "unrecaptured" gain taxed at 25% applies when passive rental property is sold

The Two-Step Loss Test

Before you can deduct a loss from a business or investment, it must survive two sequential hurdles. Both must be passed before the loss reduces your tax bill:

Step 1 — At-Risk Test (§ 465): Your deductible loss cannot exceed the amount you're "at risk" in the activity. You're at risk for cash you contributed, property you put in, and amounts you personally borrowed for the activity (where you're personally liable, or pledged non-activity property as security). You are generally not at risk for nonrecourse debt — debt secured only by the activity's assets — unless it's qualified nonrecourse real estate financing from a commercial lender. Losses that fail this test are suspended and can be used when your at-risk amount increases.

Step 2 — Passive Activity Test (§ 469): If a loss survives the at-risk test, it must then pass the passive activity filter. The activity must be one in which you materially participate; if you don't, losses are passive and can only offset passive income.

What Counts as a Passive Activity

Under § 469, an activity is passive if it is (a) a trade or business in which the taxpayer does not materially participate, or (b) any rental activity — regardless of participation — unless one of the special exceptions applies.

Exceptions that can make rental non-passive:

Real estate professional status (§ 469(c)(7)) — See below
Short-term rentals — Average rental period of 7 days or fewer are treated as a service business, not a rental; you must still materially participate to avoid passive treatment
$25,000 rental allowance — Not an exception to passive rules, but a special allowance that lets active participants deduct up to $25,000 of rental losses against ordinary income even though they don't fully escape the passive framework

What's not passive:

Working interests in oil and gas (direct unlimited liability)
Self-charged interest in some passthrough arrangements
Former passive activities that generated income in prior years

Material Participation — The 7 Tests

You materially participate in an activity if you meet any one of seven IRS tests for the year. The most commonly used are:

500-hour test — You participated more than 500 hours during the year
Substantially all test — Your participation was substantially all of the total participation by all individuals (including non-owners)
100-hour parity test — You participated more than 100 hours AND no one else participated more than you
Significant participation aggregate — You participated 100–500 hours in each of several "significant participation activities," and the total across all of them exceeds 500 hours
Five-of-ten-year history — You materially participated in the activity in any 5 of the prior 10 years
Personal service history — The activity is a personal service business and you materially participated in any 3 prior years
Facts and circumstances — You participated more than 100 hours and based on all facts and circumstances, you participated on a regular, continuous, and substantial basis

For rental activities, you never satisfy these tests to escape passive treatment — unless you qualify as a real estate professional.

The $25,000 Rental Allowance

Congress created a special middle ground for small landlords. If you:

Actively participate (make management decisions, even by approving tenants through a property manager), AND
Your modified AGI is below $100,000

You can deduct up to $25,000 of rental losses against wages, salaries, and other ordinary income. This allowance phases out at a rate of $1 for every $2 of AGI between $100,000 and $150,000 — so someone with $130,000 AGI loses $15,000 of the allowance and can only use $10,000.

Active participation is a much lower standard than material participation. You can qualify even if you use a property management company, as long as you participate in decisions like setting rental terms, approving repairs over a threshold, and choosing tenants.

Real Estate Professional Exception

This is the major exception that turns rental losses fully deductible for serious real estate investors. To qualify under § 469(c)(7), you must:

Spend more than 750 hours during the year in real property trades or businesses in which you materially participate, AND
More than half your total working time across all work activities is spent in those real property businesses

If both conditions are met, your rental activities are treated as nonpassive — losses are deductible without limit against ordinary income (subject only to the at-risk test). However, each rental property is treated as a separate activity unless you make a grouping election to combine them into one activity.

Qualifying real property trades or businesses include: real estate development, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage. Rental losses freed by this exception also avoid depreciation recapture reclassification issues and can offset Section 1231 gains in the disposition year. A full-time employee in one of these businesses can count those hours.

Passive Credits

The § 469 rules apply to credits as well as losses. Credits from passive activities (like the low-income housing tax credit or rehabilitation credit) can only offset the tax attributable to passive income. Suspended passive credits are harder to unlock than losses — they become deductible on disposition, but only to the extent there's a tax liability.

Suspended Losses and Disposition

When you sell or otherwise fully dispose of a passive activity in a taxable transaction, all previously suspended losses from that activity are released. They:

First offset any passive income from other activities
Then offset any net income or gain from the disposed activity
Finally, any remaining amount is deductible against ordinary income — no limits

This makes the year of sale for a chronically loss-generating rental property particularly significant. A landlord who accumulated $80,000 in suspended losses over many years can deduct all $80,000 against wages or other income in the disposition year.

Partial dispositions (selling a portion of an activity) only release a proportionate share of suspended losses. Gifting a passive activity does not release suspended losses — the donee inherits them. Death releases losses only to the extent they exceed the step-up in basis.

How It Affects You

If you own one or two rental properties and have W-2 income: Your ability to deduct rental losses right now depends almost entirely on your AGI. The $25,000 rental allowance works like this: if you "actively participate" (make management decisions — approving tenants, setting rents, authorizing repairs) and your AGI is $100,000 or below, you can deduct up to $25,000 of rental losses against your W-2 and other ordinary income each year. If your AGI is between $100,000 and $150,000, the allowance phases out — you lose $1 of the $25,000 for every $2 of AGI above $100,000. At $125,000 AGI, only $12,500 is available. At $150,000 AGI or above, the allowance disappears entirely — all rental losses are suspended. The losses don't disappear; they accumulate year by year and release in full when you sell the property. A rental property with $10,000/year in suspended losses held for 8 years gives you $80,000+ of deductions (plus any current-year loss) in the year of sale — often meaningfully reducing the tax on the capital gain.

If you're considering qualifying as a real estate professional: This is the most powerful way to unlock unlimited rental loss deductions. Requirements: (1) more than 750 hours of personal services in real property trades or businesses during the year, AND (2) more than half of your total working hours are in real estate activities. A spouse who meets this test can make all the couple's rental activities non-passive — even if the other spouse works full-time elsewhere — but both conditions must be met by the same individual. To materially participate in each rental separately, you must either group all rentals under a single grouping election (done on your return once, largely irrevocable) or individually meet a material participation test for each property. The IRS audits real estate professional claims aggressively: keep a contemporaneous time log (calendar, journal, or GPS data) throughout the year. "I estimate I spent 800 hours" written after an audit notice is not convincing.

If you have passive losses from limited partnerships, syndications, or businesses you don't manage: These losses are locked inside the passive category. You can use them against other passive income (a profitable rental or LP interest), but not against W-2, business, or investment income. The unlock happens at disposition — when you sell or otherwise fully dispose of your interest in a taxable transaction, all suspended losses from that activity are freed and deductible against any income. This is why investors in real estate syndications often see a large paper loss in years 1–7 (depreciation heavy) and a taxable gain at sale — the suspended losses offset the gain. If you're buying into a real estate fund or LP, ask the sponsor what their expected disposition timeline is, as it determines when you can use your accumulated passive losses.

If you have a short-term rental (Airbnb/VRBO with average stay under 7 days): Short-term rentals are not classified as rental activities under § 469 — they're treated as a service business. This means you CAN deduct losses against ordinary income if you materially participate (generally 500+ hours of personal participation in the STR activity). Many taxpayers with STRs they actively manage qualify for material participation under the 500-hour or substantially-all test. However, the IRS is increasing scrutiny of high-loss STR deductions — document your hours meticulously (guest communications, cleaning coordination, maintenance, marketing) and keep records of all actual rental days. The grouping election also applies to STRs: if you have multiple STR properties, you can group them to combine hours toward material participation thresholds.

State Variations

Most states follow the federal passive activity rules with conformity to the IRC. However:

California conforms to federal passive rules but has its own AGI-based phase-out calculations using California AGI
New York generally conforms but some state-specific modifications to income calculations affect the phase-out computations
States without income taxes (Florida, Texas, Nevada) have no analog to passive activity rules
Some states have more favorable treatment for real estate professionals or different participation hour requirements

Interaction with the Net Investment Income Tax

Net investment income (NII) tax of 3.8% (under § 1411) applies to passive income — including rental income from passive activities. A real estate professional who has converted their rental income to nonpassive income escapes the NII tax on that rental income. This interaction between § 469 and § 1411 is one of the main reasons high-income investors pursue real estate professional status.

Pending Legislation

The Tax Cuts and Jobs Act of 2017 made no changes to the passive activity rules themselves, which have been largely stable since 1986 (Tax Reform Act). Proposals to modify the real estate professional exception (raising the hour threshold or imposing income caps) appear occasionally in budget discussions but have not advanced significantly. The AGI phase-out thresholds for the $25,000 rental allowance are not indexed for inflation and have remained at $100,000–$150,000 since 1986, which means inflation has substantially eroded the benefit for middle-income landlords over time.

Recent Developments

The IRS has continued active audit examination of real estate professional claims, particularly targeting taxpayers who claim the status while appearing to hold W-2 employment. Tax Court decisions in 2023–2025 reinforced that time logs must be contemporaneous and specific — broad estimates made at tax time have repeatedly been rejected. The IRS also continues to scrutinize grouping elections, which can be used to consolidate participation hours across multiple rental properties to more easily meet the 500-hour material participation test.

OBBBA passive loss and real estate provisions (2025): The One Big Beautiful Bill Act modified the passive activity loss framework for real estate. The OBBBA increased the $25,000 rental real estate allowance phase-out threshold from $100,000/$150,000 AGI to $150,000/$200,000 — allowing more middle-income landlords with limited active participation to deduct rental losses against ordinary income. The bill also modified the real estate professional exception's 750-hour requirement for married couples filing jointly, allowing the couple's combined hours to count toward the test in limited circumstances.
Short-term rental PAL audit focus: IRS has specifically flagged short-term rentals (Airbnb, VRBO) as a compliance concern. Short-term rentals (average rental period of 7 days or less) are treated differently from long-term rentals — they are subject to the passive activity rules but may qualify for different material participation tests. The IRS's concern is that taxpayers misclassify short-term rental income as active business income (subject to self-employment tax but allowing loss deductions) rather than passive rental income (no SE tax but losses are passive). The proliferation of professional Airbnb operators with multiple properties has created complex PAL questions that IRS guidance has not fully resolved.
Qualified opportunity zone funds and PAL interaction: Qualified Opportunity Zone (QOZ) fund investments — introduced in the TCJA and extended by the OBBBA through 2028 — interact with the passive activity rules in complex ways. QOZ fund investments are typically passive, and QOZ fund losses are subject to PAL rules like other passive investments. However, when investors sell or exit QOZ fund investments and recognize the excluded gain, the exclusion is not affected by suspended passive losses from the fund. The interaction between QOZ gain exclusions and PAL suspended losses at fund exit is an emerging Tax Court issue as the first 10-year QOZ fund exits occur in 2028-2030.
Rental real estate and high-income surtax planning: The net investment income tax (NIIT, 3.8%) applies to passive rental income for taxpayers with income above $200,000 (single)/$250,000 (joint). Achieving real estate professional status eliminates the NIIT on rental income by reclassifying it as non-passive — a significant tax benefit at high income levels. For a physician or attorney earning $500,000 in wages and $100,000 in rental income, achieving real estate professional status saves $3,800 in NIIT annually. The OBBBA did not change the NIIT; the Biden-era proposal to extend NIIT to S corporation and partnership active income was not enacted.