Passive Activity Loss (PAL) Rules

The passive activity loss rules of Section 469 are the third and usually toughest gate for deducting business and rental losses. Activities in which the taxpayer does not materially participate, plus all rental activities by default, are "passive," and passive losses can only offset passive income, not wages or portfolio income. Disallowed losses are suspended and carry forward indefinitely, becoming fully deductible in the year the taxpayer disposes of the entire activity in a taxable sale. Two major escape hatches exist for real estate: an active-participation allowance that lets moderate-income landlords deduct up to $25,000 of rental losses (phasing out between $100,000 and $150,000 of AGI), and real estate professional status, which removes the automatic passive label from rentals entirely. The rules apply after basis and at-risk limits, in that order.