Passive Activity Loss Rules (PAL Rules) are a set of IRS regulations that determine when taxpayers can deduct passive activity losses (PAL) on their tax returns. The PAL Rules are used to identify when a taxpayer has materially participated in the activity, allowing them to deduct the losses generated from the activity. In general, taxpayers must meet certain criteria to prove they had a material involvement in the activity from which the losses come from in order to be allowed to deduct their PALs.

A passive activity is any venture in which the taxpayer does not materially participate. This means that their involvement in the activity does not extend beyond the usual cash investments or minimal daily decision-making related to the activity. Most common passive activities for which taxpayers attempt to deduct losses include real estate rental activities, holding shares in a limited partnership, or leasing personal property.

Under the PAL Rules, a taxpayer isn’t able to deduct PALs generated from passive activities unless the taxpayer can prove they materially participated in the activity during the tax year that the losses were generated. If such material participation is proven, those PALs can be deducted but only against the income developed from passive activities.

In other words, the PAL Rules generally require that taxpayers offset PALs generated by one passive activity with income earned from another passive activity during the same tax year. The PAL Rules are set up to maintain the integrity of the tax code and keep taxpayers from deducting income they haven’t actually earned.

At-risk rules must also be applied when deducting PALs. At-risk rules limit the amount of losses taxpayers can deduct to the amount of money actually risked in the activity. Losses that exceed the amount of money actually risked may not be deducted until such time as the taxpayer has more at-risk in the activity.

PAL rules provide certain exceptions to the at-risk limits. For example, the rentals of personal property are not limited by the at-risk rules. Another exception is for certain net operating losses which allow individuals, trusts, or estates to deduct losses beyond the amounts they’ve invested (at-risk).

As with all tax matters, it’s important for taxpayers to consult with a qualified tax professional when attempting to take advantage of the PAL Rules. Tax laws, deductions, and credits are complicated and can be difficult to navigate, but with the right professional help, taxpayers may be able to maximize their deductions and minimize their tax liability.