Passive Activity Loss Rules and At-Risk Limitations
By SimplyCPA · 11 October 2026
On this page (7)
- Passive activity: A trade or business in which the taxpayer doesn't materially participate, plus most rental activities.
- The rule: Passive losses can offset only passive income; excess losses are suspended and carried forward until there's passive income or the activity is fully disposed of.
- Rental exception: Up to $25,000 of rental losses can offset other income for taxpayers who actively participate, phasing out between $100,000 and $150,000 of modified AGI.
- Real estate professionals: More than 750 hours and more than half of personal services in real property businesses — their rentals can be non-passive if they materially participate.
- Order of limits: Basis first, then at-risk (Section 465), then passive activity (Section 469), then the excess business loss limit (Section 461(l)).
Why the rules exist
Before 1986, high earners bought into loss-generating "tax shelters" to offset salary income. Section 469 stops that by ring-fencing passive losses: they can only offset passive income.
Material participation: the seven tests
An individual materially participates in an activity for the year if any one applies:
- More than 500 hours of participation.
- Participation is substantially all of the participation by all individuals.
- More than 100 hours, and not less than anyone else.
- A significant participation activity (over 100 hours) and total significant participation activities exceed 500 hours.
- Material participation in any five of the preceding ten years.
- A personal service activity with material participation in any three prior years.
- Regular, continuous and substantial participation based on all facts and circumstances (more than 100 hours).
Limited partners generally can't materially participate except under tests 1, 5 or 6.
Rental real estate
- Rental activities are passive by definition — regardless of hours — unless the taxpayer qualifies as a real estate professional: more than 750 hours in real property trades or businesses in which they materially participate, and more than half of all personal services in such businesses.
- $25,000 allowance: an individual who actively participates (a lower standard — such as approving tenants and setting rents) and owns at least 10% can deduct up to $25,000 of rental losses against non-passive income. The allowance is reduced by 50% of modified AGI over $100,000, so it disappears at $150,000.
Example: A salaried taxpayer with modified AGI of $120,000 actively manages a rental that loses $30,000.
Allowance = $25,000 − 50% × ($120,000 − $100,000) = $15,000 deductible against salary. The remaining $15,000 is suspended and carried forward.
Suspended losses
Suspended passive losses carry forward indefinitely. They are released in full when the taxpayer disposes of its entire interest in the activity in a fully taxable transaction to an unrelated party.
The at-risk rules (Section 465)
Losses are limited to the amount the taxpayer is economically at risk: cash and the adjusted basis of property contributed, plus borrowed amounts for which the taxpayer is personally liable. Nonrecourse debt generally isn't at risk — except qualified nonrecourse financing for real estate from a commercial lender.
The ordering of loss limits
- Basis — partnership outside basis or S corporation stock and debt basis.
- At-risk amount.
- Passive activity rules.
- Excess business loss (Section 461(l)) — for non-corporate taxpayers, net business losses above an inflation-adjusted threshold are disallowed and carried forward as an NOL. The OBBBA made this limit permanent.