Passive Activity Loss Rules, or PAL, are a set of IRS rules stating that passive losses can be used only to offset passive income. These were enacted in 1986 to curb rampant abuses from people using real estate and businesses to generate huge losses to offset income taxes.

Passive income is generated from two kinds of activities: (1) rentals of both real estate and equipment and (2) businesses where a person does not materially participate, such as when a person is a limited partner in a business venture. Passive activity loss rules prevent investors from using losses incurred from income-producing activities in which they are not materially involved.