Your most recent return might contain a stash of tax deductions you can’t use (yet). They’re in a tax-code junk drawer called “Suspended Passive Losses.” Every year that your rental property or side investment loses money on paper, those losses pile up on Form 8582 until you free them.

Here’s how to do just that.

How losses get stuck in passive activity loss rules

The IRS treats rental real estate and any businesses you don’t materially participate in as passive. In general, passive losses can only offset passive income. So if your rental losses are $12,000 and you have no other passive income, you may not be able to deduct that loss. It carries forward to next year. Passive loss carryforwards don’t expire; they hang out on your tax return until you can use them on future passive income.

Fortunately, you have options for putting them to work.

How to turn passive losses into tax deductions

Here are four ways to put those losses to work. Pick the one that fits your situation and let’s get them out of the junk drawer.

1. Offset passive gains

This is the easiest way to use passive losses. If you have another passive activity that makes money, you can use passive losses to offset that income.

Passive activity income includes profit from another rental, income from a business where you invest but don’t work, and the gain when you sell a passive activity.

For example, say you have $20,000 of suspended losses from Rental A. Rental B generates a $15,000 profit this year. The loss from Rental A cancels the profit from Rental B, so you don’t owe any taxes on it.

You can also group activities, meaning you combine activities that form one “appropriate economic unit,” such as two rentals in the same town, so they count as one activity. A combined profit can absorb a combined loss. Grouping choices generally lock in after you make them, so be sure to discuss the grouping election with your tax advisor first.

2. Use the active participation allowance

This may be an option even if you don’t have other passive income. If you actively participate in a rental, you can deduct up to $25,000 of rental losses against your other income, such as wages.

To qualify, you need to meet two tests:

1. You own at least 10% of the property
2. You make real management decisions, like approving tenants, setting rent, or signing off on repairs. Hiring a property manager won’t disqualify you as long as you still make the big calls.

Income limits apply to this option. The allowance phases out by $0.50 for every dollar your modified adjusted gross income (MAGI) exceeds $100,000. It disappears completely at $150,000. The maximum deduction is $12,500 for married couples filing separately, and the phase-out starts at $50,000.

The allowance can absorb old suspended losses as well as losses from the current year. If your income falls below the limits in a given year, you can release stuck losses created in earlier high-income years. A job loss, career break, slow business year, or the first years of retirement can be the perfect opportunity to use these losses, so plan for them deliberately.

3. Sell the activity

Selling your entire interest in a passive activity to an unrelated buyer in a fully taxable transaction frees up suspended losses from that activity. You can deduct them against any income, including wages and investment income.

Gifting property doesn’t count, and selling to a family member doesn’t either. In those cases, suspended losses stay suspended until you have another opportunity to use them.

Of course, in the tax world, we like to say “don’t let the tax tail wag the investment dog.” Meaning don’t let tax avoidance become the main driver of your investment or life decisions. Run the numbers on the full tax bill before you put the property up for sale, and base your decision on the core financial and economic value.

4. Start materially participating in the business

If you stop being a passive investor, your losses are no longer passive.

IRS Publication 925 provides seven material participation tests. You materially participated in the activity if you satisfy any one of these:

1. You worked in the activity more than 500 hours during the year
2. You do substantially all the work
3. You work more than 100 hours in the activity, and no one else works more than you
4. The activity is a significant participation activity (SPA), and your total participation across all your SPAs exceeds 500 hours
5. You materially participated in the activity for any 5 of the immediately preceding tax years
6. The activity is a personal service activity, such as law, healthcare, or engineering, and you materially participated in it for any three prior tax years
7. You participate in the activity on a regular, continuous, and substantial basis, given all the facts and circumstances

This option works for operating businesses, but not for rentals. A rental stays passive no matter how many hours you put in unless you qualify as a real estate professional. That means you spend more than half your working time in real estate trades or businesses and log more than 750 hours a year in them.

Most people with full-time jobs can’t meet that test, although a spouse sometimes can. Once an activity becomes nonpassive, your old suspended losses can offset income from that activity.

If you want to use this option, keep a contemporaneous log of your hours with dates and tasks. The IRS frequently challenges material participation. It’s much harder to recreate a record of the time you spent working in the business years later, under pressure from an IRS audit.

Tax planning for this year

Look at last year’s tax return for Form 8582. It shows your suspended loss balance for each activity. If you see a number there, it’s worth discussing how to free up that deduction.

Suspended losses don’t release themselves, and the right strategy depends on your taxable income, your properties, and how much time you want to spend on them.

Reach out to NewWay Accounting. We can review your stuck passive losses and map out which of the options above could lower your tax bill now or in future tax years.