# Passive Activity Loss Rules: Definition and When You Can Use Them

![Passive Activity Loss Rules: Regulations that limit a taxpayer's ability to use losses from passive activities to offset earned or ordinary income.](https://www.investopedia.com/thmb/P4saRfRdCvG2T5oRRznZBJsx60c=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/passive-activity-loss-rules.asp-1-FINAL-1-e79b5f394b96412ebd3425b2fc5c9540.png)

*If the taxpayer does not materially participate in the activity producing passive losses, then those losses can be matched only against passive income. — Investopedia*

## What Are Passive Activity Loss Rules?

Passive activity loss rules are tax regulations that limit a taxpayer's ability to use losses from passive activities to offset earned or ordinary income. Being materially involved with earned or ordinary income-producing activities means the income is [active income](https://www.investopedia.com/terms/a/activeincome.asp) and may not be reduced by passive losses. Instead, [passive losses](https://www.investopedia.com/terms/p/passiveloss.asp) can only be used to offset passive income.

### Key Takeaways

*   Passive activity loss rules state that passive losses can be used only to offset passive income.
*   A passive activity is one in which the taxpayer did not materially participate during the year in question.
*   Common passive activity losses may stem from leasing equipment, real estate rentals, or limited partnerships.

## Understanding Passive Activity Loss Rules

The key issue with passive activity loss rules is [material participation](https://www.investopedia.com/terms/m/material-participation-test.asp). According to IRS Topic No. 425, "material participation" is involvement in the operation of a trade or business activity on a "regular, continuous, and substantial basis."

There are seven tests that can define material participation, but the most common one is working at least 500 hours in the business in the course of a year. If the taxpayer does not materially participate in the activity that is producing the passive losses, those losses can be matched only against passive income. If there is no passive income, no loss can be deducted.

Note that rental activities—including real estate rental activities—are considered passive activities even if there is material participation. (Real estate professionals have their own rules for determining material participation.)

> **Important**
>
> Passive income is different from portfolio income. Portfolio income includes capital gains, dividends, and interest.

Passive activity losses are [tax attributes](https://www.investopedia.com/terms/t/tax-attribute.asp) that can only be applied in the current year in most cases. However, if they exceed passive income they can be carried forward without limitation. They cannot be carried back.

Passive activity loss rules are generally applied at the individual level, but they also extend to virtually all businesses and rental activity in various reporting entities, with the exception of C corporations. These are designed to deter the abusive use of tax shelters.

There are detailed rules about how much passive loss is deductible. If you think these rules could apply to your tax situation, consult a tax specialist.

## Passive Losses and Passive Activity

Passive activity is activity that a taxpayer did not materially participate in during the tax year. The [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp) defines two types of passive activity:

1.  Trade or business activities to which the taxpayer did not actively contribute
2.  Rental activities

Unless the taxpayer is a [real estate](https://www.investopedia.com/terms/r/realestate.asp) professional, rental activities usually provide streams of income that are passive. The IRS defines material participation as involvement in the activity of the business on a regular, continuous, and substantial basis.

A passive loss is thus a financial loss within an investment in any trade or business enterprise in which the investor is not a material participant. Passive losses can stem from investments in rental properties, business [partnerships](https://www.investopedia.com/terms/p/partnership.asp), or other activities in which an investor is not materially involved. In order to be considered a non-material participant, the investor cannot be continuously and substantially active or involved in the business activity.

### Common Sources of Passive Losses

Passive losses (and income) can come from the following activities, though there may be some exceptions in each category:

*   Equipment leasing
*   [Rental real estate](https://www.investopedia.com/terms/r/rentalreal-estate-loss-allowance.asp) if you aren't a real estate professional  
    
*   Limited partnerships
*   Partnerships, [S-Corporations](https://www.investopedia.com/articles/investing/091614/understanding-s-corporations.asp), and limited liability companies in which the taxpayer has no material participation
*   Farm in which the taxpayer has no material participation

If you are unsure whether a loss should be classified as passive or not, it is worth consulting with a professional accountant to ensure your taxes are being filed correctly.

## What Is a Passive Activity?

Under U.S. tax law, a passive activity is one that produced income or losses that did not involve any material participation by the taxpayer. For example, if you own farmland but rent it out to a farmer who does all the work, you're making passive income.

Passive losses cannot be used to offset earned income. They can only be used to offset other passive income.

## Is Passive Income Taxable?

Yes, passive income is taxable, usually at the same rate as the taxpayer would pay on earned income. If you have passive income, you may be able to offset the taxes due on it with [some deductions](https://www.investopedia.com/terms/p/passiveincome.asp).

## What Is Active Income vs. Passive Income?

Active income is earned through producing or helping to produce a product or service. Passive income is received without any substantial effort. Active income and passive income are both taxable, usually at the same rate. However, the difference is important when a taxpayer has losses in passive income. In such cases, the passive activity loss rules forbid [taxpayers](https://www.investopedia.com/terms/t/taxpayer.asp) from using passive losses to reduce active or earned income.

## The Bottom Line

Passive income, while taxable, operates under different rules than active income when it comes to deductions. Although passive income is taxed the same way as active income, the critical difference lies in the treatment of passive losses. If you incur losses from passive income, you cannot use those losses to offset gains from active income sources, as passive losses can only offset passive income.  

> **Article Sources**
>
> 1.  Internal Revenue Service. "[Instructions for Form 8582, Passive Activity Loss Limitations](https://www.irs.gov/pub/irs-pdf/i8582.pdf)." Page 1.
>     
> 2.  Internal Revenue Service. "[Topic No. 425, Passive Activities -- Losses and Credits](https://www.irs.gov/taxtopics/tc425)."
>     
> 3.  Internal Revenue Service. "[Publication 925, Passive Activity and At-Risk Rules](https://www.irs.gov/pub/irs-pdf/p925.pdf)." Page 5.
>     
> 4.  Internal Revenue Service. "[Publication 925, Passive Activity and At-Risk Rules](https://www.irs.gov/pub/irs-pdf/p925.pdf)." Pages 5-6.
>     
> 5.  Internal Revenue Service. "[Publication 925, Passive Activity and At-Risk Rules](https://www.irs.gov/pub/irs-pdf/p925.pdf)." Page 7.
>     
> 6.  Internal Revenue Service. "[Publication 925, Passive Activity and At-Risk Rules](https://www.irs.gov/pub/irs-pdf/p925.pdf)." Page 2.
>     
> 7.  Internal Revenue Service. "[Publication 925, Passive Activity and At-Risk Rules](https://www.irs.gov/pub/irs-pdf/p925.pdf)." Pages 6-8.
>     
> 8.  Internal Revenue Service. "[Publication 925, Passive Activity and At-Risk Rules](https://www.irs.gov/pub/irs-pdf/p925.pdf)." Page 3.
>     
> 9.  Internal Revenue Service. "[Publication 925, Passive Activity and At-Risk Rules](https://www.irs.gov/pub/irs-pdf/p925.pdf)." Pages 3, 5-6.
>     
> 10.  Internal Revenue Service. "[Publication 925, Passive Activity and At-Risk Rules](https://www.irs.gov/pub/irs-pdf/p925.pdf)." Pages 3-4.
>      
> 11.  Internal Revenue Service. "[Publication 925, Passive Activity and At-Risk Rules](https://www.irs.gov/pub/irs-pdf/p925.pdf)." Pages 2-4, 6, 12.
>      
> 12.  Internal Revenue Service. "[Instructions for Schedule F Profit and Loss From Farming](https://www.irs.gov/pub/irs-prior/i1040sf--2022.pdf)." Page 2.
>      
> 13.  Internal Revenue Service. "[Form 4835, Farm Rental Income and Expenses](https://www.irs.gov/pub/irs-pdf/f4835.pdf)." Page 2.
>      
> 14.  CMP. "[Passive Income Tax: Guide to Taxation for Your Passive Income Streams](https://blog.cmp.cpa/passive-income-tax)."