What happens to passive activity losses in relation to passive activity gains for tax purposes?

Passive activity losses are subject to specific tax regulations that distinguish them from other types of income and losses. When a taxpayer has passive activity losses, these losses can only offset passive activity gains, not active income.

If a taxpayer has passive losses that exceed any passive gains in a given tax year, the excess losses cannot be utilized to reduce their active income. Instead, these unused passive activity losses can be carried forward to future years. This allows the taxpayer to offset future passive gains with these losses, which is beneficial for managing tax liabilities over time. As passive gains are realized in future years, the carried-forward losses can be applied, thus potentially reducing taxable income in those future years.

This mechanism ensures that taxpayers are not losing the benefits of their passive losses; they are simply deferred until they can be used alongside passive income. The option indicating that passive activity losses can be carried forward to future years aligns with these tax rules, making it the correct reason for how passive activity losses interact with passive activity gains for tax purposes.