Generally (I stress "GENERALLY") passive losses are only deductible from passive income. Once those losses get the taxable passive income to zero, you're done. Excess loss is just carried forward to the next year.
At tax filing time it is extremely rare for rental property to ever show a taxable profit. Especially if you have a mortgage on the property. When you add up the allowed deductions of Mortgage interest, property taxes, insurance and the depreciation you are required to take by law, that alone is enough to exceed the total rental income received from that property for the entire tax year. Add to that your other deductible rental expenses like repairs, cleaning and maintenance, and you're practically guaranted to never show a taxable profit on rental income.
The losses just carry forward every year and the carry forward amount gets larger and larger with each passing year. You are not allowed to actually realize those losses until the tax year you sell or otherwise dispose of the property. In the tax year you sell here's how your losses are dealt with.
1) First, all prior depreciation taken is recaptured and taxed. The simplest way to see this, is to just subtract the total of all depreciation taken, from your cost basis in the property. So if you purchased the property for $100,000 5 years ago and when you sell it you have $20K in depreciation, subtract that depreciation from your cost basis and your "new" adjusted cost basis on the property is $80,000.
2) If you sell the property for $100,000, you have a $20,000 taxable gain. From that gain you subtract all your carry forward losses and it anything remains, that is what you pay tax on.
3) If after subtracting your losses from your sales gain you have $0 taxable gain, any remaining losses can then be subtracted from "other ordinary income", such as W-2 income. But you will be limited on the amount you can actually deduct from other ordinary income, based on your overall AGI. If the remaining losses exceed that limit, then they are carried over to the next year where you can deduct them from "other oridnary income" again, subject to the same limits.
So depending on the amount of loss you have when you sell the property, it could take you several years before you can actually "realize" and utilize the entire loss.
