# Passive Activity Rules: What Business Owners and Real Estate Investors Need to Know

Source: https://advisor.one/passive-activity-rules

Category: Real Estate Investors · Published: June 12, 2025

*Passive income might sound like the dream — but when it comes to the IRS, the passive activity loss (PAL) rules can quickly turn that dream into a ...*

Passive income might sound like the dream — but when it comes to the IRS, the **passive activity loss (PAL) rules** can quickly turn that dream into a tax trap.

Whether you’re investing in real estate or holding a silent ownership stake in a business, understanding how **passive activity rules work** is key to unlocking deductions, reducing tax liability, and maximizing your returns.

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#### **What Is a Passive Activity?**

According to the IRS, a **passive activity** is:

1. **Any rental activity**, _regardless of your involvement_ (with a few exceptions), or 2. **Any trade or business** in which you **don’t materially participate**

If an activity is passive, you can **only deduct losses** from it **against other passive income** — not your W-2 income, active business profits, or investment gains.

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#### **Why This Matters**

Let’s say your rental property shows a $25,000 paper loss (thanks to depreciation). Great! But if it’s considered a passive activity and you have **no passive income to offset it**, the loss is suspended.

**Suspended losses** can only be used in future years — or when you sell the property.

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#### **How to Determine If You Materially Participate**

Material participation means you’re **actively involved** in the operations. The IRS has **7 tests** — meet any one and the activity is considered non-passive.

Common tests include:

- Working **500+ hours** during the year in the activity
- Being the **only person who materially participates**
- Working **100+ hours** and more than anyone else

For real estate professionals, there are special rules (see below).

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#### **The $25,000 Exception (for Real Estate)**

If you:

- Actively participate in a rental real estate activity (e.g., manage tenants, approve expenses), and
- Your **adjusted gross income (AGI)** is **under $100,000**,

You may deduct up to **$25,000** in passive losses against non-passive income. This phases out completely at **$150,000 AGI**.

**AdvisorOne Tip**: Many real estate investors lose this benefit simply by not documenting their participation. Keep logs.

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#### **Special Rule: Real Estate Professional Status (REPS)**

If you qualify as a **real estate professional**, your rental losses are **not passive** and can offset ordinary income. Requirements:

- **750+ hours** per year in real estate trades or businesses
- **More than 50%** of your total working time is in real estate
- You materially participate in each rental activity (or group them)

This is a powerful strategy to unlock big paper losses from depreciation.

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#### **Passive vs. Portfolio Income**

It’s important to understand what passive income **isn’t**:

- **Interest, dividends, and capital gains** are **portfolio income** — not passive
- **W-2 wages or self-employment income** are **active**

Passive losses can’t offset portfolio income. But smart tax planning can help you structure activities to **generate usable passive income** (e.g., preferred equity, syndications).

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#### **Unlocking Suspended Losses**

If you have accumulated suspended passive losses, you can:

- **Sell the passive activity** in a **taxable transaction**
- The full amount of suspended losses becomes deductible against **any income**

That’s why exit planning is a tax strategy — not just a business decision.

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### Final Takeaway

Passive activity rules are often misunderstood, but they drive major tax outcomes — especially for high-income earners and real estate investors.

At AdvisorOne, we help clients structure ownership, track participation, and strategically unlock passive losses to reduce their effective tax rate and grow smarter.