Here are the essential elements regarding passive activity loss rules:

The tax law separates your income (or loss) into three categories. First, your income from the trade or business in which you “materially participate” isn’t passive income. Material participation means involvement in the operations of the activity on a regular, continuous, and substantial basis. For the vast majority of taxpayers, this is essentially how they earn a living, e.g., for a doctor, it’s his or her medical practice. The regulations on material participation are lengthy and complex, but one guideline they contain says that if you participate in the activity for more than 500 hours during the year, it’s not passive.

The second income or loss category is “portfolio.” This covers your investments that don’t fall into the “passive” category, discussed below. These are primarily your savings and investments in stocks, bonds, and the like.

Finally, “passive” activities are your dealings with regard to trades or businesses in which you don’t “materially participate.” Typical examples include investments in tax-shelter limited partnerships constructing and operating shopping centers, apartment complexes, etc. And, of course, your income or loss from these activities is your passive income or loss.

The passive loss rules. Except as explained below, under the passive loss rules, passive losses are only deductible against passive income and not against income from the other categories. Thus, if a doctor has $250,000 of income from his medical practice, $20,000 of portfolio income (from stocks, bonds, and savings), and a $10,000 loss from an investment in a shopping mall, the loss cannot be deducted.

This loss is “suspended” and carried forward into future years until passive income is earned against which suspended losses can be deducted. The loss can also be deducted (against non-passive income) in the year in which the investment which generated the loss is disposed of in a fully taxable transaction, or in the year the taxpayer dies.

Special rules for rental activities. Unless you meet specified tests that place you in the real estate business (e.g., more than 750 hours spent in the business during the year), your real estate rental activities fall into the passive category. However, special rules may allow you to deduct up to $25,000 in losses against non-passive income.

The deduction may be allowed if you “actively participate” in the real estate rental activity. This test is easier to meet than the material participation test noted above. All you have to do is participate in a significant way, e.g., by making management decisions or arranging for others to provide service. For example, if you are renting out an apartment and you negotiate the rent and select the tenant, you meet this test. You also have to be (counting what your spouse may own) at least a 10% owner. Ownership as a limited partner doesn’t qualify.

The $25,000 loss allowance is reduced for high adjusted gross income (AGI) taxpayers. If AGI is above $100,000, the $25,000 amount is reduced by 50% of the excess over $100,000. For example, if AGI is $120,000, the loss allowance is $15,000 ($25,000 minus 50% of ($120,000 – $100,000)). (For these purposes, several modifications are made to AGI, for example, exclude taxable Social Security benefits and ignore the IRA deduction).)