Depreciation and expenses often make a profitable rental show a tax loss. The passive-activity rules decide what that loss can touch: your W-2 and business income, or nothing this year. Getting this wrong in either direction — claiming losses you can't, or not realizing losses are banked rather than gone — is one of the most common rental-tax mistakes. A CPA should apply these rules to your return; here's the shape of them.
The default: passive stays passive
Rental activity is passive by definition for most owners, regardless of how many hours you spend on it. Passive losses offset passive income (other rentals' profits) but not wages or business income. Unused losses aren't lost: they carry forward as "suspended" losses, usable against future passive income — and fully released when you sell that property in a taxable sale, where they can offset any income.
The $25,000 exception
If you "actively participate" (a low bar: approve tenants, set rents, arrange repairs — most self-managers qualify) you may deduct up to $25,000 of rental losses against ordinary income. The catch is the phase-out: the allowance shrinks once modified adjusted gross income passes $100,000 and disappears at $150,000 — thresholds that have sat unindexed for decades, so many professionals phase out entirely.
Real estate professional status
Owners (or spouses) who spend 750+ hours per year AND more than half their working time in real-property businesses, with material participation in their rentals, can treat rental losses as non-passive — unlimited offset against other income. It's powerful and heavily audited: contemporaneous hour logs are effectively mandatory, and a full-time W-2 job makes qualifying nearly impossible for that spouse.
Worked example
An owner with $120,000 of W-2 income has one rental showing a $9,000 paper loss (mostly depreciation) while producing positive cash flow. Active participation applies, but at $120,000 MAGI the $25,000 allowance phases down to $15,000 — more than enough here, so the full $9,000 deducts, saving roughly $2,200 in a 24% bracket. Her colleague at $160,000 MAGI takes $0 this year; his $9,000 suspends and accumulates until a passive profit, an income dip, or the property's sale unlocks it.
When this rule of thumb breaks
Short-term rentals with average stays of 7 days or less aren't "rental activity" under these rules — with material participation, their losses can be non-passive (the "STR loophole," with its own tests). Self-rentals, grouping elections, and the 3.8% net investment income tax each bend the picture. Suspended losses also make record-keeping mandatory: a loss banked in year 2 pays off in year 9 only if the paper trail survives. This corner of the code moves — verify current thresholds with a CPA rather than memory.