The tax rules for rental property losses are tricky. Here’s what you need to know. If you own rental real estate, you may have annual tax losses, because allowable deductions exceed rental income. This can occur even with a property that throws off positive cash flow, because you are allowed to deduct the non-cash expense of depreciation. However, your ability to actually deduct the full amount of your rental losses in the current year might be at risk. Or not. Here’s what you need to know. The dreaded passive activity loss rules As a general rule, tax losses from owning rental real estate are treated as passive activity losses, or PALs. That’s not a good thing because the general rule is that you can only deduct PALs to the extent you have passive income from other sources (such as positive operating income from other rental properties or gains from selling rental properties). Unfortunately, many owners have little or no passive income. In that case, most or all of their PALs are suspended and carried over to future tax years. You can then deduct suspended PALs when you have passive income or when you sell the properties that generated the PALs. But those things might not happen for years. Rats! Thankfully, there are two favorable exceptions to the general rule that PALs can only be deducted to the extent you have passive income. So don’t give up hope, and please keep reading. Exception 1: For “active” real estate investors The most widely-available exception says you can deduct up to $25,000 of rental real estate PALs if: (1) your modified adjusted gross income (MAGI) is no more than $100,000 and (2) you actively participate in the property or properties. Active participation means owning at least a 10% stake and at least making management-type decisions like approving tenants, signing leases, authorizing repairs, and so forth. So you don’t have to mow lawns or snake out drains to pass the active participation test. But if you use a management company to handle all the details of running your rental property, you will fail the test, and Exception 1 will be off limits for that property. If your MAGI falls between $100,000 and $150,000, Exception 1 is phased out pro-rata. For example, if your MAGI is $125,000, you can deduct up to $12,500 of PALs from rental properties in which you actively participate (half the $25,000 maximum). Once your MAGI hits $150,000, Exception 1 is completely disallowed, and you fall back under the anti-taxpayer general PAL rule explained earlier (deductible PALs limited to passive income). Exception 2: For real estate pros The second exception is only available to folks who I call real estate professionals. To be eligible, you must spend over 750 hours during the year on real estate activities in which you materially participate (not counting your spouse’s time if you’re married). And those 750 hours must be over half the time you spend working. If you clear both hurdles, losses from rental properties in which you materially participate are not PALs, and you can generally deduct them in the tax year in which they are incurred. Meeting the material participation standard is harder than passing the Exception 1 active participation test. The three most-likely ways to meet the material participation standard are by: 1. Making sure the time you spend on your rental property during the year constitutes substantially all the time spent by all individuals. 2. Spending more than 100 hours on your property and making sure no other individual spends more time than you. 3. Spending over than 500 hours on the property. You only have to pass one of these three tests to meet the material standard. If you are married, you can combine your hours with your spouse’s. If you own multiple rental properties, you can choose to treat them all as one activity, and then count the combined hours spent on them all to pass any of the three tests. (That said, check with your tax advisor before combining properties, because doing so can have a negative side effect if you later sell properties with suspended PALs.) Special rule for properties in resort areas If your rental property is in a resort area, the average rental period may be seven days or less. In this seven-day-rental scenario, the IRS says you’re running a hotel-like business as opposed to just renting out your property to make ends meet. That makes you ineligible for both Exception 1 and Exception 2. However, if you materially participate in the property, your tax losses are not PALs, and you can generally deduct them in the year in which they are incurred. Once again, the three most-likely ways to meet the material standard are by: 1. Making sure the time you spend on your property during the year constitutes substantially all the time spent by all individuals. 2. Spending more than 100 hours on your property and making sure no other individual spends more time than you. 3. Spending over than 500 hours on the property. If you are married, you can combine your hours with your spouse’s to pass one of these tests. However, if you fail all the tests, your losses will be PALs, and they will fall under the anti-taxpayer general rule. Once again, that rule says your rental losses (PALs) will be suspended unless you have passive income from other sources. Suspended PALs can be deducted in the future when you have passive income or when you sell the loss-producing property. For more information The tax rules for rental property losses are tricky, and I’ve left out some details to keep this from turning into a book. For more information, check out IRS Publication 527 (Residential Rental Property) at the IRS website.
