They don't come loose against your wages. Once you qualify for real estate professional status (REPS) and materially participate, a rental that used to be passive becomes a "former passive activity." The losses it piled up in earlier years can offset that same rental's net income each year. Whatever is left stays passive.

IRS Publication 925 puts it in two sentences: "You can deduct a prior-year unallowed loss from the activity up to the amount of your current-year net income from the activity. Treat any remaining prior-year unallowed loss like you treat any other passive loss."

So REPS changes how this year's rental results are treated. It doesn't reach back and reclassify the old losses. This page explains the rule, shows the IRS's own example, and covers what the grouping election, a cost segregation year, a sale, and California do to the answer.

For the REPS tests themselves, start with our REPS and passive losses page.

The rule: §469(f)

Section 469(f)(3) defines a former passive activity as one that is not a passive activity for the current year but was passive in a prior year. A rental becomes one the first year you pass both REPS tests and materially participate in it.

Section 469(f)(1) then sets the order:

  • Old losses offset this year's income from the same activity. Any unused deduction allocable to the activity is applied against the activity's income for the year.
  • Old credits work the same way. Unused passive credits from the activity offset the regular tax allocable to that activity's income.
  • The rest stays passive. Anything left over "shall continue to be treated as arising from a passive activity."

Passive means the leftover can still offset passive income from your other passive activities, such as a rental you don't materially participate in or a passive partnership interest. It can't offset wages, business income, or portfolio income. If there's no passive income to absorb it, it carries forward again.

Treas. Reg. §1.469-9(e)(2) confirms this applies to rentals of a qualifying real estate professional. In any year you materially participate in a rental that has prior disallowed losses allocated to it, that rental is treated as a former passive activity.

A simple example

This is a hypothetical, not a client result.

You own one rental. From 2022 through 2025 you weren't a real estate professional, and the rental built up $60,000 of suspended losses on Form 8582. In 2026 you pass both REPS tests and materially participate in the rental.

  • If the rental nets $14,000 of income in 2026: $14,000 of the old losses offsets it. You pay no tax on that rental income. The other $46,000 stays passive. It offsets passive income from other activities if you have any. Otherwise it carries to 2027.
  • If the rental breaks even: none of the old losses get used in 2026. All $60,000 carries forward.
  • If the rental shows a $90,000 loss in 2026 (say, from a cost segregation study): the $90,000 current-year loss is nonpassive and can offset other income, subject to basis, at-risk, and the excess business loss limit. The $60,000 of old losses is still suspended, because the rental had no net income to absorb it.

Watch that last case. The big first-year loss is usable. The old stack isn't touched.

How the grouping election changes it

Without an election, §469(c)(7)(A) and Treas. Reg. §1.469-9(e)(1) treat each rental interest of a real estate professional as its own activity. Each property keeps its own suspended losses. Old losses on Building A can only absorb Building A's income.

If you elect under Treas. Reg. §1.469-9(g) to treat all your rental real estate as one activity, the regulation treats that combined activity as one activity for all purposes of §469, including the former passive activity rule. The old losses from each property are allocated to the combined activity.

The regulation includes an example in §1.469-9(e)(4). An owner has $30,000 of disallowed losses on Building U and $10,000 on Building V. In the year the owner qualifies and makes the election, Building U nets $5,000, Building V loses $5,000, and Building W nets $10,000. The combined activity has $10,000 of net income. All $40,000 of old losses moves to the combined activity, so the owner offsets the full $10,000 with old losses, "regardless of which buildings produced the income or losses." That leaves $30,000 carried forward.

So the election can let a profitable property absorb another property's old losses. It has costs too. It is binding for later years, and it changes what counts as selling your "entire interest" when you sell one property. Weigh both before you file it. See how to make the REPS grouping election.

When the old losses do come out in full

Section 469(g) covers a disposition of your entire interest in a passive activity "or former passive activity." If you sell your whole interest in a fully taxable sale to an unrelated buyer, the remaining suspended losses for that activity are released against any income, including wages.

With the grouping election in place, the activity is all your rental real estate together. Selling one building usually isn't a disposition of the entire interest, so that building's share of the old losses may not be released. See what happens to suspended passive losses when property is sold for the sale rules, 1031 exchanges, gifts, and death.

Two other things to watch

REPS is tested every year. If you qualify in 2026 and fall short in 2027, the rental is passive again in 2027. Losses from that year join the suspended pile. Keep the time log going every year you plan to claim it.

The forms. The Instructions for Form 8582 spell out the reporting. If the activity's current net income is less than or equal to the prior-year unallowed loss, you enter both on Form 8582. If current net income is larger, you enter the prior-year loss and the income up to that loss. If the activity has a current net loss, you enter the prior-year unallowed loss but not the current loss, which is reported as nonpassive. As a real estate professional, you also complete line 43 of Schedule E.

California is a separate answer

California didn't conform to §469(c)(7). Under the FTB's Form 3801 instructions, all rental activities are passive for California purposes. So on the California return the rental never becomes a former passive activity. Your California suspended losses keep following the normal passive rules on Form FTB 3801, even in a year your federal return treats the rental as nonpassive. Expect two different carryover numbers. See California real estate professional status and FTB 3801.

Planning in your first REPS year

  • Get the old number right. Pull the prior-year unallowed loss for each rental from last year's Form 8582 worksheets. If a property's losses were never tracked, fix that before you file.
  • Decide on the grouping election with the old losses in view. Pooling can help when one property makes money and another carries the old losses. Run it both ways.
  • Model the cost segregation year honestly. A large current-year loss is usable as a real estate professional, but it leaves the old losses waiting. See REPS, cost segregation, and the excess business loss cap.
  • Think about the exit. A fully taxable sale of the whole activity releases what's left. A 1031 exchange generally doesn't.

Frequently asked questions

What happens to suspended passive losses when you become a real estate professional?

They stay suspended, with one change. The rental becomes a former passive activity under IRC §469(f). Each year, the old losses can offset that rental's current net income. Anything left over is still a passive loss. It can offset passive income from other activities or carry forward until you sell your entire interest in a fully taxable sale.

Can prior-year passive losses offset my W-2 income once I qualify for REPS?

Not directly. IRS Publication 925 says you can deduct a prior-year unallowed loss from a former passive activity up to your current-year net income from that activity, and the rest is treated like any other passive loss. Only current-year losses from a rental you materially participate in are nonpassive in a REPS year.

What is a former passive activity?

Under IRC §469(f)(3), it is an activity that isn't passive this year but was passive in a prior year. A rental becomes one in the first year you qualify as a real estate professional and materially participate in it, as long as it has prior disallowed losses.

Does the REPS grouping election help use old suspended losses?

It can. With an election under Treas. Reg. §1.469-9(g), all your rental real estate is one activity, and the old losses from each property are allocated to it. The example in Treas. Reg. §1.469-9(e)(4) shows net income from one building being offset by old losses from other buildings. The tradeoff is that selling one property usually no longer frees its losses.

What if my rental has a loss in my first REPS year?

The current-year loss is nonpassive if you materially participate, subject to basis, at-risk, and the excess business loss limit. The old suspended losses stay suspended, because the activity has no net income for them to offset. The Form 8582 instructions say to enter the prior-year unallowed loss, but not the current-year loss, on Form 8582.

Does California release my suspended losses when I qualify for REPS?

No. California didn't conform to IRC §469(c)(7), and the FTB's Form 3801 instructions treat all rental activities as passive. Your California suspended losses keep running on Form FTB 3801 under the regular passive rules.

Talk it through with us

Bring last year's return with the Form 8582 worksheets, your property list, and a rough hours picture for 2026. We'll tell you how much of the old losses each property carries, whether the grouping election helps or hurts, and what your first REPS year looks like on both the federal and California returns. Book a new client introduction.

LaviCPA is a Los Angeles CPA firm for real estate investors. Shawn Lavi, CPA, is the firm's principal. Elias Lavi, CPA, is its founder and co-owner.