(This post is not meant to be comprehensive tax advice, please consult your tax advisor on matters concerning your situation.) §469 of the Internal Revenue code covers passive activities losses associated with them. It defines a passive activity as any activity which (A) involves the conduct of any trade or business in which the taxpayer does not materially participate or, any rental activity. There are several exceptions to what constitutes a rental activity, but for the purpose of this post I'll discuss a typical long term rental of real estate. Assuming an activity is a rental activity under §469(c)(2), the activity is considered per se passive to the owner unless the owner meets the exception outlined in §469(c)(7)(B). This exception enables a taxpayer in a real property business to avoid the per se passive treatment of rental activities if he meets the following tests. (1) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses (defined in reg. 1.469-9(b)(2)) in which the taxpayer materially participates, and
(2) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. So does this mean a taxpayer meeting the real estate professional status can now treat all real estate activities as non passive? Not quite yet. This is why this rule is often misapplied. If the taxpayer meets the above two tests, their real property rental activities are not per se passive, but still may be passive. So another test must be met. For each rental activity the taxpayer must show material participation in each activity as defined in §469(h) and Reg. §1.469-5T. There are 7 different tests, but any one test can constitute material participation. Typically though, the taxpayer shows material participation from on of the first tow tests: (1) 500 hours in that activity or (2) the individuals participation needs to constitute "substantially all the participation in such activity of all individuals" - that is, more participation/services than anyone else on that particular activity. If the individual is lacking in material participation in some or all of the individual activities, the taxpayer may elect to aggregate all of the activities under §469(c)(7)(A).
If these tests are met, the real estate professional can use losses from these rental activities to offset ordinary income.