United States
Hong KongPassive activity losses, and why they get suspended
Income falls into active, portfolio and passive categories. Passive losses generally offset only passive income, with the excess suspended and carried forward until the activity is disposed of in a fully taxable transaction.
Three buckets, and losses generally cannot cross between them. That is the rule and most of the questions follow from it.
The three categories
| Category | Includes |
|---|---|
| Active | Wages, salary, self-employment income from a business you materially participate in |
| Portfolio | Interest, dividends, capital gains, royalties |
| Passive | Rental activities, and businesses in which you do not materially participate |
Passive losses offset passive income. They do not offset wages, and they do not offset portfolio income. That is the point of the rules, which were enacted to stop tax shelters generating paper losses against salary.
Material participation
Whether an activity is passive turns on whether you materially participate, tested by a set of alternatives - most commonly more than 500 hours during the year, or substantially all the participation in the activity.
A limited partner is generally treated as not materially participating, which is why limited partnership losses are passive by default.
The rental real estate exception
Rental activity is passive by definition. There is an exception: a taxpayer who actively participates may deduct up to USD 25,000 of rental losses against non-passive income.
It phases out as adjusted gross income rises above USD 100,000 and disappears entirely at 150,000. Active participation is a lower bar than material participation - approving tenants, setting terms, approving expenditure.
There is also a real estate professional exception with much stricter hour requirements, which removes the passive characterization entirely.
Losses disallowed under these rules carry forward indefinitely. On a fully taxable disposition of the entire interest, all suspended losses for that activity are released and become deductible without limitation. That release is a favorite exam point.
The at-risk rules
A separate and earlier limitation. You may only deduct losses to the extent you are at risk - cash contributed, the adjusted basis of property contributed, and amounts borrowed for which you are personally liable.
Non-recourse debt generally does not count, with an exception for qualified non-recourse financing in real estate.
The order is: at-risk first, then passive activity, then the basis limitation. Questions occasionally require all three to be applied in sequence.
Why this appears in planning
Any client with rental property, a limited partnership, or a business they do not run day to day is inside these rules.
The planning consequence is that generating passive income can be valuable purely because it unlocks suspended losses, which is a genuinely useful thing to be able to say to a client with a stack of them.
Dollar limits and rate thresholds here are indexed annually and several were changed by the 2025 reconciliation act. Confirm the current figure against the IRS before relying on it, and expect the exam to test the rule rather than the number.
Common questions
What are the three income categories?
Active - wages and businesses you materially participate in. Portfolio - interest, dividends, capital gains and royalties. Passive - rental activities and businesses you do not materially participate in.
Can passive losses offset salary?
No. They generally offset only passive income, with the excess suspended and carried forward. The rules exist to stop shelters generating paper losses against wages.
What is the rental real estate exception?
A taxpayer who actively participates may deduct up to USD 25,000 of rental losses against non-passive income, phasing out from USD 100,000 of AGI and disappearing at 150,000.
What happens to suspended losses?
They carry forward indefinitely and are released in full on a fully taxable disposition of the entire interest, becoming deductible without limitation.
What are the at-risk rules?
A separate earlier limit allowing deductions only to the extent you are at risk - cash and property contributed and debt you are personally liable for. At-risk applies before the passive rules.