Tax law does not trust your rental property tax deductions.

The law assumes you have the power to make your rental properties throw off paper losses—and that you can do this without suffering any real economic loss.

To stop you from deducting a loss you never truly felt, the government built a “passive loss” test. When you fail this test, your rental property losses get tossed into the suspended-loss tar pit.

Then, in every later year that you again fail the passive-loss test and again have rental losses, the IRS tosses those losses into the tar pit to join the others.

The bad news. You could be sitting on suspended passive losses you have been unable to deduct for years. The good news: The losses are merely suspended, not destroyed. They sit in the pit until you free them.

This article shows you how to unlock suspended losses so you can use them to offset ordinary income, reduce your tax bill, and put money back in your pocket. It also explains a new 2026 tax trap you’ll need to avoid when exiting your investment.

Do What the Woolly Mammoth Could Not

There is one move that pulls your passive losses out of the suspended-loss tar pit all at once. It is drastic, but it works:

sell your rental properties.

Lawmakers reason that when you sell your investment, you finally prove the economic reality of your earlier losses. So the sale of your rental property (or properties, if you grouped them) frees your suspended losses and lets you deduct them.

First, the freed losses soak up any other passive income you have.                                                                                                                   Whatever is left over becomes a non-passive—“active”—loss that can offset your wages, your portfolio income,and your other ordinary income. (But watch out for the new speed bump on that last step, as we explain in“Beware the Second Tar Pit” below.)

Tactic 1: Every Property for Itself

You free your suspended losses only when you sell your entire interest in the activity.

The “entire interest” rule turns on how you group your properties for passive-loss purposes. You treat your rentals in one of two ways. You can either

• treat each rental property as its own separate activity, or

• group all your rental properties together as a single activity.

Under the default rule, your individual rental properties are separate activities. So if you never made an election telling the IRS that you grouped your properties, you have not grouped them.

• Bottom line for separate properties. If you treat your properties separately, you sell your entire interest in an activity every time you sell one property.

• Bottom line for grouped properties. If you grouped your properties together, you do not sell your entire interest until you sell the last property in the group.

So if you treat each rental as its own activity, freeing the suspended losses is easy: Sell the property, and presto! The losses are free to offset your other income. 

 Tactic 2: Avoid Your Family

Tax law will not let your family help you escape the suspended-loss tar pit. Sell your rental property (or rental group) to a related person, and your suspended losses stay suspended. 

The good news is that the losses do not disappear. The moment your relative sells the property to someone unrelated to you, your suspended losses break free and you deduct them against your other income.

To be clear: the losses stay with you even though the property goes to your relative. When your relative eventually sells, the suspended losses release to you—not to your relative.                                                                                                                                                        Know your relatives. Related persons include your spouse, your siblings, your parents, and your children.7 Your in-laws do not count as relatives for this purpose.

Family includes your corporations. Beware: selling to a corporation in which you own more than 50 percent triggers the same trap as selling to your brother. And if you and your brother together own more than 50 percent of a corporation, that corporation counts as a relative, so selling a property to it does not release your suspended losses either.

Key point. Know exactly who your relatives are, and do not sell suspended-loss property to any of them.

Tactic 3: Don’t Be Kind

Give away your property, and you give away your suspended losses.9 They are no longer yours. You can never use them. 

The person who receives your gift gets the losses but only in “fossilized” form.

Here is what happens: when you give the property away, the law adds your suspended losses to the property’s basis in the hands of the recipient.

Example. You gift your daughter a rental property in which you have a $100,000 basis and $25,000 of suspended losses. Your daughter’s basis becomes $125,000. If she later sells for $200,000, she has a $75,000 gain. 

Here is the “ouch” in this kindness: You converted tax-favored ordinary deductions—worth as much as 37 percent in your top bracket—into mere capital-gain basis for your daughter, where the benefit may be only 15 or 20 percent (and only if and when she sells). You handed away a richer deduction and got back a thinner one.

Key point. Do not gift suspended-loss property.

Tactic 4: Don’t Die

When you die, the IRS releases your suspended passive losses—but not all of them. At death, the law frees only the suspended losses that exceed the step-up in basis on your property.

The basis step-up. When your heirs inherit from you, they take a new basis equal to the property’s fair market value at your death.12 That is great for your heirs—they permanently avoid tax on the appreciation that built up during your lifetime.                                            Example. You buy a rental property for $200,000, and it is worth $1 million when you die. Over the years, you racked up $10,000 of suspended losses. Your heir inherits the property with a $1 million basis—an $800,000 stepup.

Because your suspended losses ($10,000) do not exceed the step-up ($800,000), neither you (on your final return) nor your heirs get to use them. The losses die with you.

Key point. If you are holding meaningful suspended losses, freeing them while you are alive usually beats letting them vanish upon your death.

Beware the Second Tar Pit: The Excess Business Loss Limit

Even after you do everything right and free your suspended losses by selling, a second gate can still cap how much you deduct this year.

It is the excess business loss limitation under tax code Section 461(l). Once your freed-up rental losses turn non-passive, they become “business” losses—and this rule limits how much net business loss you can use against your wages, interest, dividends, and other non-business income in a single year. 

OBBBA made this limit permanent and reset its thresholds. For 2026, you can use net business losses against non-business income only up to $256,000 if you are single, or $512,000 if you are married, filing jointly. Anything above that is your “excess business loss” for the year.

The excess does not disappear, but it is delayed. It carries forward as a net operating loss, and in future years a net operating loss can offset up to 80 percent of your taxable income—so the deduction can stretch out over more than one return.

Example. You are single. You sell your rentals and free $450,000 of suspended losses, which are now non-passive. You also have $500,000 of wage and investment income and no other business income or loss. Your 2026 single excess business loss threshold is $256,000, so you deduct $256,000 of the freed losses against your other income this year. The remaining $194,000 is an excess business loss—carried forward as a net operating loss to 2027 and beyond.

The full Section 461(l) calculation aggregates all your business income and losses for the year (including any gain on the sale itself), and capital gains get special treatment in the math. The point is simple: with large suspended losses, “free the losses” no longer always means “deduct them all this year.” Model the timing before you sell—and consider spreading sales across more than one tax year so more of your freed losses land under the annual threshold.

 Takeaways

Your suspended passive losses are real money waiting to be claimed. To get that money, keep the following in mind:

• Sell your rental properties to free the losses. Make sure to sell your entire interest.

• Do not sell to family members or to corporations you (or your family) control.

• Do not gift suspended-loss property, or you forfeit the deduction.

• Do not let the losses ride until death, where the basis step-up can swallow them.

And in 2026, plan the timing of your sale around the excess business loss limit, so the deduction is not bottled up in a carryforward.

Know where the traps are, and watch your suspended losses come out of the pit and onto your return—where they belong.