It is not uncommon for real estate investors to have rental property losses. The goal for many investors is not cash flow, but rather to hold on to the property for future appreciation.
The deductibility of net rental losses on your personal tax return depends on many factors.
General Rule: Rentals are Passive Activities
Under IRC § 469(c)(2), rental income and losses are considered to be passive income/loss, and are therefore subject to passive activity rules. Passive losses can only be deducted against passive income. For example, if your rental home produces a $15,000 loss on Schedule E, you are generally not able to offset your other (non-passive) income against this loss. The loss is carried forward to the next year.
Exception 1: The taxpayer actively participates in a rental real estate activity and qualifies for the $25,000 special allowance.
Exception 2: There is a qualifying disposition under IRC § 469(g). A qualifying disposition would be a sale of the property.
Exception 3: The taxpayer meets the requirements of IRC § 469(c)(7) for real estate professionals.
$25,000 Special Allowance Loss
A taxpayer may deduct up to $25,000 in rental real estate losses as long as the taxpayer actively participates and his modified adjusted gross income is less than $100,000.
Active participation test: As long as a taxpayer participates in management decisions in a bona fide sense, he actively participates in the real estate rental activity. There is no specific hour requirement. However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager. Most taxpayers are able to meet this test if they can show they made important management decisions in regards to their rental property. You can have a management company if you are making the key decisions, such as accepting tenants, signing the contract, making the final determination on the rental price, etc.
Modified adjusted gross income (MAGI) is calculated by taking your Adjusted Gross Income and subtracting:
- Any passive loss or passive income, or
- Any rental losses (whether or not allowed by IRC § 469(c)(7)), or
- IRA, taxable social security or
- One-half of self-employment tax (IRC § 469(i)(3)(E)) or
- Exclusion under 137 for adoption expenses or
- Student loan interest.
- Exclusion for income from US savings bonds (to pay higher education tuition and fees)
- Qualified tuition expenses (tax years 2002 and later)
- Tuition and fees deduction
- Any overall loss from a PTP (publicly traded partnership)
The full $25,000 allowance is available for taxpayers whose MAGI is less than $100,000. For every $2 a taxpayer’s MAGI exceeds $100,000, the allowance is reduced by $1.
In the year that you sell your rental property, you can deduct all of the carryover passive losses that you accumulated during the rental period. For example, Bob has $100,000 of W-2 wages in year 10. From years 1-9 he had $30,000 of passive loss carryovers from his rental property because they were not deductible on his tax returns. In year 10 he sells the rental property for a gain of $10,000. He therefore has total income of $110,000 (the W-2 wages and gain from the sale). However, his net income (before deductions) will be $80,000 since the $30,000 passive loss carryover will be applied.
Real Estate Professional
If you are considered a real estate professional, then your rental income/losses are not subject to passive activity loss limitations and all losses can be fully deducted on your tax return. In order to be considered a real estate professional, you must meet the material participation test, which involves meeting at least one of the following:
- The taxpayer works 500 hours or more during the year in the activity.
- The taxpayer does substantially all the work in the activity.
- The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
- The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
- The taxpayer materially participated in the activity in any 5 of the prior 10 years.
- The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
- Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.
If you are a W-2 wage employee or have another significant source of income, and you do not spend significant time managing the rental property, you most likely will not meet the test. Real estate agents or those with real estate businesses are generally able meet at least one of the requirements.
Whether you are able to deduct your rental loss in the current year or not, the losses are not “lost.” You can carry them forward to future years and deduct them fully when you sell the property. It is important to keep track of your loss carryovers and to log the time you spend participating in rental activity if you are a real estate professional.
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