What is the definition of "passive activity loss" in tax terms?

The definition of "passive activity loss" in tax terms refers specifically to losses that arise from rental activities or other passive endeavors in which the taxpayer does not materially participate. These losses are important because they generally cannot be used to offset active income, such as wages or business income, unless certain conditions are met.

This classification of activities into passive and non-passive categories is vital to understanding how losses can be applied for tax purposes. For example, rental real estate activities are typically considered passive unless the taxpayer qualifies as a real estate professional, which may allow them to deduct these losses against non-passive income.

The importance of this distinction ultimately guides tax planning strategies for individual taxpayers, especially for those engaged in real estate or investment activities. Understanding that passive activity losses have limited deductibility against active income is crucial for accurate tax reporting and compliance.

In the context of the other options, losses incurred in operating a business would not be classified as passive since they usually arise from active participation. Similarly, cumulative losses claimed against capital gains and losses that can be deducted from ordinary income do not accurately describe passive activity loss, as these concepts blend the classifications of income and loss in different ways.