Can Passive Losses Offset Capital Gains?

Passive losses can be used to offset capital gains, but the IRS rules governing this process are detailed and specific. These losses, often generated from activities such as rental real estate or limited partnerships, must first be applied against passive income. If any losses remain, a portion may sometimes be used to offset other types of income, including capital gains. However, the amount you can deduct depends on factors like your adjusted gross income (AGI), the nature of the activity and whether the IRS classifies it as truly passive.

If you need help with your tax strategy, consider working with a financial advisor who specializes in tax planning. Connect with a fiduciary financial advisor today.

What Are Passive Gains and Passive Losses?

The IRS defines passive gains and losses very tightly. Per IRS guidance 425¹:

“Passive activities include trade or business activities in which you don’t materially participate. You materially participate in an activity if you’re involved in the operation of the activity on a regular, continuous, and substantial basis.”

You make passive gains when passive activities generate revenue. Passive losses occur when a passive activity loses money.

Material participation is usually defined as putting less than 500 hours of work into the business over the course of the year, or otherwise being involved with the business on a “regular, continuous and substantial basis.”

Owning rental properties is also considered a passive activity, even if you do materially participate in running and renting the property. The complete rules for material participation and property rental are beyond the scope of this article, but you can find them in IRS guidance 925².

In general, a passive activity needs to be a business, enterprise or trade in which you have invested. For example, vehicle, equipment and real estate rentals are common examples of a passive activity. The same is true for a business in which you’re a financial backer but not an active employee. This means that, from a tax standpoint, “passive income” differs from its common usage. It does not refer to securities-based returns such as dividends or capital gains. Passive income also does not refer to salary, wages, contract payments or other labor-based earnings. It is narrowly defined as business-based revenue in which you did not materially participate.

How Passive Losses Offset Passive Gains

Passive losses can offer valuable tax benefits by reducing the amount of income subject to taxation. As with other forms of investment income, you’re only taxed on your net profits from passive activities. This means you can use passive losses to offset passive gains, paying taxes only on the difference between the two.

The process is similar to calculating capital gains. At the end of the tax year, you total your passive income and subtract your passive losses. You’ll owe taxes only on any remaining net profit.

If your passive losses exceed your passive gains, the excess doesn’t disappear; it can be carried forward into future years as suspended passive losses. These losses remain on your tax record and can be used to offset passive income in later tax years.

For example:

• You earn $5,000 from renting out a beach house.
• You earn $12,000 from an apartment rental.
• You lose $20,000 as a limited partner in a medical practice.

Your total passive income is $17,000, and your $20,000 loss offsets it completely. You’ll have no taxable passive income this year and can carry forward the remaining $3,000 in suspended losses to offset future gains.

Generally, passive losses can only offset passive income, not capital gains, dividends or wages. The key exception occurs through a process known as “releasing passive losses,” which allows certain unused losses to be applied against other types of income under specific circumstances.

What Happens When Passive Losses When Property Is Sold?

As the IRS explains, “generally you may deduct in full any previously disallowed passive activity loss in the year you dispose of your entire interest in the activity.³” 

This means that if you sell your passive activity at a loss – whether it’s a rental property, business interest or other source of passive income – you don’t have to treat it explicitly as a passive loss⁴. This applies to both the year in which you sell the activity and all suspended losses from this activity, as well.

To trigger this exception, you must meet three criteria:

• You must sell your entire interest in the underlying passive activity
• You must trigger a tax event, meaning that you must sell your interest for value in a fully taxable transaction
• And you must sell your interest to an unrelated third party, no family or close affiliates

Once you do that, you can treat all of your losses from this activity as capital losses for the tax year in which you sold the passive activity. You can apply that deduction first to any money you made off the sale of your activity. Then, if you still have losses, you can apply this deduction to your capital gains in general. 

When you dispose of a passive activity, you must abide by the following rules:

Step One

Once the sale is complete, you can apply your current and suspended losses against your gains from this sale. Or, if you took a loss on this sale, you can add this loss to your total current and suspended losses from the activity.

Step Two

If you have remaining gains from selling your passive activity after step one, you can apply any losses from any other passive activities.

Step Three

If you still have losses after step one (your passive losses exceeded the sale value of your passive activity), you can first apply those losses to any other passive gains you had this year.

Step Four

If you still have losses from the disposed activity after Step Three, you can now convert those losses to a general capital gains deduction. At this point you can apply your losses to other capital gains and your general income as appropriate for a capital gains deduction. 

For example, say you have the following passive activities:

• A rental cottage that lost $5,000 this year and has $23,000 in suspended losses from previous years
• A rental condo that lost $1,000 this year
• A rental apartment that made $2,500 this year

You sell the rental cottage for a $15,000 profit. You would apply the disposal rule as follows:

• You sell the cottage realizing a long term capital gain of $15,000.
• You apply this year’s losses, reducing your gains to $10,000.
• You apply the cottage’s suspended losses to its gains, eliminating your gains from the cottage entirely.
• You still have $13,000 in suspended losses from previous years on the cottage.
• You apply the cottage’s suspended losses to your rental apartment’s gains, eliminating those entirely and reducing your suspended losses to $10,500.
• Now that you have eliminated all gains, you can transfer the remaining $10,500 in losses from the cottage to a general capital loss deduction.

Note that we do not apply the losses from your rental condo. This is because it’s considered a separate business activity. As a result, its losses will not convert until you sell the condo.

Alternatively, you could claim the condo and the cottage as a single business activity. If you do that, you would have to sell both properties in order to convert your losses to a capital gains deduction since you can only do this when you dispose of the entire activity.

Bottom Line

Managing passive losses can be complex, as the IRS has strict rules about when and how they can be applied. In general, passive losses can offset passive gains, helping reduce your taxable income from those activities. However, they usually can’t be used to offset other types of income, such as capital gains or wages, unless certain conditions are met. One key exception occurs when you sell your entire interest in a passive activity. In that case, any remaining suspended losses can typically be released and used to offset other income, including capital gains.

Because the rules can be nuanced, it’s a good idea to consult a tax professional or financial advisor who can help you apply passive losses correctly and identify opportunities to lower your overall tax burden.

Tips for Generating Passive Income 

• Although the IRS doesn’t use the term “passive investing” in the common way, it’s still a great way to build value in your portfolio.
• Investing in businesses and rental properties can be a great way to build wealth, but it can also be a confusing process. A financial advisor can potentially offer valuable insight and guidance. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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