Do passive losses offset capital gains? The allowed-versus-rate split
Form 8582 decides how much loss is allowed. Section 1(h) decides what rate the gain pays. One worked 2026 example shows both.
By Hans Goldstein, Enrolled Agent, admitted to practice before the IRS ·
Two questions, two parts of the code
Most confusion about suspended losses comes from mixing up two questions that sound alike.
- How much of the loss is allowed? This is a section 469 question and Form 8582 answers it. After you sell your entire interest in a fully taxable sale to an unrelated buyer, every dollar of suspended loss is allowed (IRC 469(g)(1)(A)). The gain on the sale is passive income, and the Form 8582 instructions say the gain is entered there "so that the gains might offset other PALs." Think of the gain as the key that opens the lock.
- Which rate does the gain pay? This is a section 1(h) question and Schedule D or Form 4797 answers it. Section 469 and the passive characterization of an item do not affect "the treatment of any item of income or gain under any provision of the Internal Revenue Code other than section 469" (Temp. Reg. 1.469-1T(d)(1)). The key opens the lock. It does not touch the gain.
Once the loss is allowed, Form 8582 is finished with it. The loss moves to Schedule E as an ordinary deduction, and the gain is reported on Form 4797 or Schedule D at its own character. Both then flow to the same tax computation.
The same thing happens whenever passive gain allows passive losses, for example boot gain in a 1031 exchange or an installment payment's gain: the loss is a deduction, the gain keeps its rate.
Why the deduction comes off the ordinary layer
IRC 1(h)(1)(A) taxes "taxable income reduced by the net capital gain" at the regular rates, and the gain on top at 0%, 15% and 20% (25% for unrecaptured section 1250 gain). The ordinary layer is whatever is left after the gain is carved out. A deduction reduces taxable income, so the ordinary layer shrinks first. Only once it reaches zero does the deduction cut into the gain.
Ray's return, line by line
Ray and his spouse file jointly in 2026. Ray earns $300,000 in salary. He sells his only rental, a rental he has held for years, to an unrelated buyer for cash and recognizes a $1,000,000 long-term gain.
He carries $300,000 of suspended passive losses. Left column: no suspended losses are deducted. Right column: the sale allows them.
Ray's gain is passive income and is larger than his losses, so the gain alone absorbs them; the full-disposition rule would add value only if his losses exceeded his gain.
| Without the suspended losses | With the losses allowed | |
|---|---|---|
| Salary | $300,000 | $300,000 |
| Gain on the sale (all long-term, for simplicity) | $1,000,000 | $1,000,000 |
| Passive loss deducted (Schedule E) | $0 | ($300,000) |
| Adjusted gross income | $1,300,000 | $1,000,000 |
| Standard deduction (married, 2026) | ($32,200) | ($32,200) |
| Taxable income | $1,267,800 | $967,800 |
| Part taxed as ordinary income (up to 37%) | $267,800 | $0 |
| Part taxed at the 0% / 15% / 20% gain rates | $1,000,000 | $967,800 |
| Federal income tax | $232,173 | $148,040 |
| Tax saved by the allowed losses | $84,133 |
Look at the two bottom lines of the middle block. In the right column almost all of the $300,000 landed on his paycheck: the ordinary part of taxable income fell from $267,800 to $0. The gain still sits in the gain-rate bands. The saving is $84,133.
The picture most people have, and why it is wrong
Many owners expect the losses to net against the gain first: $1,000,000 minus $300,000 leaves $700,000 of gain, taxed at 20%. That would save only $60,000. It is the wrong picture because the loss is a deduction from taxable income, not a reduction of the gain, and the code takes it from the ordinary layer.
The size of the gain decides only how many losses are allowed, not where they land.
The swap and its limits
| Case | Tax saved | Per dollar of loss |
|---|---|---|
| Ray working: $300,000 salary, $1,000,000 gain, $300,000 of losses, married | $84,133 | 28.0 cents |
| Ray single, same numbers | $92,967 | 31.0 cents |
| Ray retired: $40,000 other income, married | $60,780 | 20.3 cents |
| Ray working with $900,000 of losses (they exceed the paycheck) | $191,838 | 21.3 cents |
| If the losses simply netted against the gain at 20% | $60,000 | 20.0 cents |
- Small paycheck, small swap. A retired owner with $40,000 of other income has little ordinary income to absorb the losses. Most of the deduction then lands on the gain and saves close to the gain rate.
- Losses bigger than the paycheck. The swap applies up to the size of the ordinary layer. The rest saves the gain rate.
- Depreciation recapture. The part of a real estate gain that comes from depreciation is taxed at up to 25% (unrecaptured section 1250 gain, IRC 1(h)(1)(E)), or as ordinary income if it is section 1245 recapture. Those slices narrow the gap between the two layers. See the recapture calculator. The table above treats the whole gain as 0% to 20% gain.
- Loss character. Some K-1 losses are themselves capital or section 1231 losses and keep that character. They net against the gain instead, which shrinks the swap (the Form 8582 instructions handle 28% rate losses in Part IX).
- Other limits. The excess business loss limit ($256,000 single, $512,000 joint for 2026) can cap a released loss from a trade or business. The 3.8% tax and state tax follow their own rules.
- California. No swap on the state return, because California does not give gain a lower rate.
Play with it
Drag the sliders and watch where the released loss lands. The first lesson is the rate swap on this page. The other three cover an installment sale, the pile-up that follows a one-year sale, and a 1031 exchange with boot.
Open the Playground full screen. Rough 2026 estimate for education.
What to do with this
Ask your preparer for two numbers before you sign a contract: the total suspended loss by activity, and a tax run of the sale year with the losses released and with them still stuck. The difference is the value of the release. If you want to see it for your own sale, the capital gains calculator shows the gain side, and the full guide is here.
Sources and dates
- 26 USC 1(h)(1)(A) and (E); 26 USC 469(g)(1)(A).
- Temp. Reg. 1.469-1T(d)(1).
- 2025 Instructions for Form 8582, "Disposition of an Entire Interest" and "Entire disposition with an overall gain"; IRS Publication 925 (2025), Passive Activity and At-Risk Rules, "Passive Activity Income."
- Rev. Proc. 2025-32, 2026 tax rate tables and section .31. Ray's figures are computed with the 2026 tables, married filing jointly, standard deduction $32,200, gain taxed as long-term gain, federal income tax only.
Checked against the sources above on October 30, 2026. Dollar figures are 2026 federal (Rev. Proc. 2025-32) unless the page says otherwise. Education only, not tax or legal advice for your situation.
Questions
Do passive losses offset capital gains?
Passive losses offset passive income, and gain from selling a passive activity is passive income (Pub. 925), so they can absorb that gain. But absorbing is not the same as changing its rate. The allowed loss is an ordinary deduction, the gain keeps its capital gain character, and the deduction comes off ordinary income first (Temp. Reg. 1.469-1T(d)(1); IRC 1(h)(1)(A)).
Can passive losses offset capital gains from stocks?
Generally not, except in the year you sell your entire interest in a passive activity in a fully taxable sale. Gain from stocks is portfolio income, not passive income (IRC 469(e)(1)), so ordinary passive losses cannot offset it until a qualifying sale makes them non-passive.
Does the gain escape tax when losses are released?
No. The gain is taxed at its own rate. The losses reduce other income, which is why the tax falls. Ray's gain pays its full long-term rate in both columns of the table.
Why is the saving more than 20 cents per dollar?
Because the deduction first removes income that was taxed at 24%, 32%, 35% or 37%, not income taxed at 20%. Ray saves about 28 cents per dollar of loss because his salary sits in those higher brackets.
What if my losses are bigger than my salary?
Once the ordinary layer is used up, the rest of the deduction cuts into the gain and saves only the gain rate. In the $900,000 case above, the first part saves about 28 cents per dollar and the remainder about 20 cents, so the total is $191,838, not three times $84,133.
Does this work in California?
Not the swap. California taxes capital gain at the same rates as ordinary income, so a deduction saves the same state rate whichever layer it comes off. The release itself still happens on the California return (Form FTB 3801 tracks California's carryover).
Is the 3.8% tax affected?
Yes, it can be. Losses allowed under IRC 469(g)(1) are taken into account in computing net investment income in the same way they are taken into account in computing taxable income (Reg. 1.1411-4(g)(9)). The table on this page is federal income tax only. Ask your preparer to run the 3.8% tax both ways.
Related
- Suspended passive losses: the complete guide
- Form 8582 explained
- Suspended losses and an installment sale
- Passive vs nonpassive income
- All passive loss guides
Run my numbers with Hans: book a scope call
Hans Goldstein is an Enrolled Agent, admitted to practice before the Internal Revenue Service. Not affiliated with or endorsed by the IRS. He is not a CPA or attorney. Education only, not tax or legal advice for your situation.