DEFINITION of 'Passive Activity Loss Rules'

A set of rules that prohibits using passive losses to offset earned or ordinary income. Passive activity loss rules prevent investors from using losses incurred from income-producing activities in which they are not materially involved.

Being materially involved with earned or ordinary income-producing activities means the income is active income and may not be reduced by passive losses. Passive losses can be used only to offset passive income.

BREAKING DOWN 'Passive Activity Loss Rules'

The key issue with passive activity loss rules is material participation. If the taxpayer does not materially participate in the activity that is producing the passive losses, then those losses can only be declared against passive income. If there is no passive income, then no loss can be deducted.

Passive activity losses can only be carried forward; they cannot be carried back.

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