Understanding Passive Activity Loss Rules: How Depreciation and Cost Recovery Impact Your Taxes

Anthony Brister
7 days ago
5 min read

Introduction: The Rules That Quietly Control Your Deductions

Depreciation is often celebrated as one of the greatest tax benefits in real estate and business ownership. It's a non-cash expense that reduces your taxable income, improves your bottom line, and creates the illusion of losses—even when your business is profitable.

But there’s a catch.

For many investors and business owners, those losses don’t reduce taxes right away. Instead, they get caught in a web of IRS restrictions known as Passive Activity Loss Rules (PAL rules)—rules that quietly delay your ability to use some of your most powerful deductions.

This blog unpacks the relationship between depreciation, cost recovery, and passive activity loss limitations, giving you the knowledge to avoid surprises—and the strategy to use these rules to your advantage.

Not sure how this fits with bonus depreciation and Real Estate Professional Status? Read our blog on Real Estate Professional Status and Bonus Depreciation next.

A stack of US twenty-dollar bills on a white background, neatly arranged, with visible serial numbers and historical figure portraits.

What Are Passive Activity Loss Rules?

The IRS created Passive Activity Loss Rules (IRC §469) to limit deductions from business or investment activities in which the taxpayer does not materially participate.

Income and losses are categorized as:

Active: You materially participate (e.g., your main business or W-2 job)
Passive: You don’t materially participate (e.g., rental properties, silent partnerships)

Passive losses can only offset passive income. They can’t reduce your salary, business profits, or other forms of active income unless you qualify for certain exceptions.

If you don’t qualify, those deductions get suspended and carried forward until you either:

Earn passive income in future years, or
Dispose of the activity in a fully taxable sale to an unrelated party

Note: Investment income like interest or capital gains is considered portfolio income—not passive income—and cannot be offset by passive losses.

Depreciation and Cost Recovery: Core Concepts

Depreciation is the process of recovering the cost of tangible property over time. Under the IRS’s MACRS system:

Residential real estate: 27.5-year straight-line recovery
Commercial property: 39-year straight-line recovery
Personal property (e.g., appliances, furniture): 5–15 years

Depreciation generates “paper losses”—reductions in taxable income without impacting your actual cash flow. While powerful, depreciation from passive activities often becomes a suspended loss under PAL rules if you don’t qualify to use it.

So, while depreciation technically reduces income, it may not reduce your tax bill until you can unlock those losses.

The $25,000 Special Allowance (and Who Loses It)

There is a key exception for rental property owners: the $25,000 special allowance under IRC §469(i).

If you:

Own at least 10% of a rental property, and
Actively participate (not the same as materially participate),

you may deduct up to $25,000 in passive losses against non-passive income.

But this allowance is subject to income limits:

It begins to phase out at $100,000 of modified adjusted gross income (MAGI)
It fully phases out at $150,000 MAGI

For every $1 over $100,000 MAGI, the allowance is reduced by $0.50. For example, if your MAGI is $120,000, your allowance would be reduced by $10,000, leaving only $15,000 of deductible losses.

Married filing separately? Your phase-out range is $50,000 to $75,000, and if you lived with your spouse at any time during the year, you generally can’t take the allowance at all.

High earners often lose access to this benefit, and their passive losses get suspended until used against future passive income or upon property disposition.

Suspended Losses: They’re Not Gone—Just Deferred

Suspended passive losses carry forward indefinitely. You can’t deduct them until:

You generate enough passive income to absorb them, or
You sell the entire interest in the passive activity in a fully taxable transaction

Caution: A 1031 exchange or installment sale does not release suspended losses—they carry over with the replacement property.

Example:You accumulate $100,000 in depreciation-related losses on a rental property. If you sell the property outright (no 1031) and report a gain, the $100,000 in losses is now released and can offset that gain or other income in that year.

Tax documents labeled "Tax Statement for Year 2019" are scattered with a pen and mileage log on a white paper background.

How to Avoid the Trap: Planning Strategies That Work

If you’re generating passive losses you can’t currently use, you’re not alone. Here are several strategies to unlock those deductions:

1. Qualify as a Real Estate Professional (REP)

If you meet these tests:

Spend 750+ hours/year in real property trades
More than 50% of all working hours are in real estate
Materially participate in each rental activity

You can reclassify your rental losses as non-passive, making them deductible against active income.

Pro tip: Make a grouping election to treat all rentals as one activity for material participation. Without grouping, you must materially participate in each rental individually.

We break down REP in full detail in our related blog.

2. Make a Grouping Election

If you own multiple rental properties, you can elect to treat them as one activity to help meet the material participation test. This simplifies meeting REP status or avoiding suspended losses.

Note: Grouping is a formal election that must be filed with your tax return. It is generally irrevocable.

3. Acquire Passive Income Streams

If you can’t unlock the losses through REP or grouping, look for other passive income sources to apply your losses:

Other profitable rental properties
Silent partnerships or limited investments
Royalties or private lending income

This helps soak up your suspended losses while maintaining passive classification.

Cost Segregation and Bonus Depreciation: Great Tools—When Used Strategically

A cost segregation study breaks down a property into components with shorter recovery lives—allowing more of the cost to be depreciated upfront.

Bonus depreciation, under current 2025 tax law, allows 40% of qualifying asset costs to be deducted in the year placed in service.

Previously 100% (2017–2022), bonus depreciation is now phased down annually: 2023 (80%), 2024 (60%), 2025 (40%), 2026 (20%), and 2027 (0%).

This sounds like a slam dunk—but here’s the catch:

In a passive activity, all those deductions are passive losses.If you can’t use them (no REP status or other passive income), the deductions are suspended.

That’s why timing matters:

Use cost seg after you’ve qualified for REP
Use it when you expect passive income
Consider cost seg before a taxable disposition to release losses

Planning tip: Accelerated depreciation creates recapture risk when you sell. Depreciation recapture is taxed at up to 25% for real estate, so weigh the benefit of upfront deductions against potential taxes later.

Common Mistakes to Avoid

Assuming depreciation always reduces taxes – Not if the losses are suspended.
Failing to track carryforward losses – Make sure your tax pro is keeping records year to year.
Doing a cost seg study without REP or passive income – It might not help you now.
Skipping grouping elections – If you have multiple rentals, this is often essential to meet participation tests.

Empty toilet paper roll labeled "Inflation" in red marker on a silver holder, set against a gray wall, creating a humorous metaphor.

Conclusion: Use the Rules—Don’t Let Them Use You

Depreciation, cost segregation, and bonus depreciation are incredible tax planning tools—but only when used intentionally. The Passive Activity Loss Rules aren’t there to punish you; they’re meant to prevent abuse. But that doesn’t mean you can’t work with them.