Passive Activity Loss (PAL) Rules: IRS Limits on Deducting Passive Losses

The Passive Activity Loss (PAL) rules were created to curb tax shelter abuses that once allowed investors to deduct real estate losses from other income. These rules limit how landlords and business owners can offset their rental and business losses. Understanding how PAL rules work (and when exceptions apply) is important for anyone earning income from rental properties or business investments.

What Are the PAL Rules For?

Forty years ago, landlords could freely deduct their rental losses from all of the other income they or their spouses earned during the year (assuming they filed a joint return). However, the unfettered deductibility of real estate losses led to enormous abuses. In the 1980s, wealthy individuals invested in real estate limited partnerships and other tax shelters created solely to generate large losses through depreciation, interest, and other deductions. The investors in these tax shelters would use the losses to offset their other income. The tax benefits obtained could far exceed the amount of money invested in the tax shelter.

All this came to an abrupt end in 1986, when Congress enacted the PAL rules. (I.R.C. § 469.) These rules were designed to limit a taxpayer's ability to use rental or business losses to offset other income. The PAL rules apply to all business activities, but are particularly strict for rental real estate because real estate was the primary tax shelter.

How the PAL Rules Work

Most landlords earn income and incur expenses from more than one source in addition to income and expenses from their rental property, they might earn a salary from a job, or make money from a business they own. They might also have investments other than rental property, such as stocks and bonds.

For purposes of the PAL rules, all the income you earn and losses you incur are divided into three separate categories:

• Active income or loss. Income or loss from any business activity, other than real estate rentals, in which you materially participate (actively manage). This includes salary and other income from a job or a business you run, or the money you earn from selling your personal services. Social Security benefits are included as well.
• Passive income or loss. Income or loss from (1) businesses in which you don't materially participate, and (2) all rental properties you own. Under the rules, income and loss from rental activities are automatically passive, whether or not the landlord materially participates in the rental activity. (Casualty losses from rental property aren't passive losses.)
• Portfolio income or loss. Income or loss from investments, such as interest earned on savings, or dividends earned on stocks; gains or losses when investments are sold; expenses paid for investments.

Imagine three buckets, one for each of the three kinds of income or loss. Every penny you earn during the year must go into one of these three buckets. In addition, all the money you spend on investments or business activities, such as a rental real estate business, any business you actively manage, or any self-employment activity, goes into one of the buckets. Money you spend for personal purposes, such as food and clothing, isn't counted.

• Active income or loss. Income or loss from your job or business activities (other than real estate rentals) in which you materially participate.
• Passive income or loss. Income or loss from rental properties or businesses in which you don't materially participate.
• Portfolio income or loss. Income or loss from any investments.

Here's the key to the PAL rules: The contents of the passive bucket must always stay in that bucket. You can't use passive losses to offset income in the other two buckets. Nor can you use passive income to offset losses from the other buckets.

This is what the PAL rules are intended to do: Prevent you from deducting your passive losses (such as from rental activities) from your active or portfolio income. So, there is no point in investing in real estate rentals just to incur tax losses because you won't be able to use these losses to offset your other non–real estate income.

$25,000 Offset and the Real Estate Professional Exemption

The PAL rules have accomplished their purpose of preventing wealthy people from investing in rental real estate solely to create tax losses. But the rules apply to all owners of rental property, even landlords who are in the business of renting properties to earn a living and have no interest in obtaining tax losses. To prevent undue economic hardship to these people, special rules were created that wholly or partly exempt many small landlords and people active in the real estate industry from the PAL rules. These are:

• the $25,000 offset, and
• the real estate professional exemption.

Congress felt it was unfair to prevent landlords with moderate incomes from deducting their rental losses from their nonrental income. So, a special exception—the $25,000 offset—was fashioned for them. It permits landlords to deduct up to $25,000 in rental losses from any other nonpassive income they earn during the year.

Also, because the PAL rules were intended to curtail passive investors' use of real estate tax shelters, those actively engaged in the real estate business felt it was unfair to have the rules apply to them. Congress agreed and created a special exemption from the passive loss rules for real estate professionals. This rule provides substantially more relief than the $25,000 offset because there is no maximum offset amount or income limit requirements.

To learn more about the $25,000 offset and the real estate professional exemption, get Every Landlord's Tax Deduction Guide by Stephen Fishman, J.D. (Nolo).

Talk to an Expert

The passive activity loss rules are some of the most complicated, confusing, and difficult in the area of tax law. Because these rules can make you or break you come tax time, it's also a good idea to talk with a tax lawyer or another tax professional about them.