Normally, it’s not good news when you hear the word “losses” in connection with your business. Rental losses, however, can be a good thing.
Keep in mind – we’re talking about rental tax losses, not rental cash flow losses. It is possible to generate positive cash flow from your rentals but still have a net tax loss (deductions > rental income)… But are those rental losses deductible?
In a surprising turn of events, the answer is not a simple “yes” or “no”.
Rental Activities Are Passive
Rental activities are passive in nature. Although there are certain exceptions to this rule, let’s proceed with the general understanding that rental income and losses are passive (not active).
Passive losses can only be used to offset passive income. Passive losses cannot offset earned, active, or portfolio income (for example, W-2 and 1099 income, dividends, interest, capital gains, etc.). If you have passive losses in excess of passive income, the losses are limited and carried forward to future years. This is known as passive activity loss (PAL) limitation.
To illustrate further, let’s assume you own two rental properties in each of the following two scenarios:
Scenario 1
- Property A generates net taxable income of $3,000 after depreciation
- Property B generates a tax loss of $2,500 after depreciation
The loss from Property B would be used in full to offset $2,500 of income from Property A. This leaves $500 of taxable income in the current year.
Scenario 2
- Property A generates net taxable income of $3,000 after depreciation
- Property B generates a tax loss of $3,500 after depreciation
The loss from Property B would be used up to the amount of income from Property A ($3,000). This results in no taxable income or loss in the current year and a $500 suspended loss carryover to the following year.
As with almost anything else in the Tax Code, however – where there’s a rule, there’s an exception (or multiple).
When Can Passive Rental Losses Be Deducted Against Nonpassive Income?
The IRS allows taxpayers below a certain income threshold to deduct up to $25,000 of net passive losses against nonpassive income if they actively participated in a passive rental real estate activity.
Active participation is not as intense as material participation. Basically, to be considered actively participating in a rental real estate activity, you have to be involved in and make management decisions in a bona fide sense. This requirement can be met even if you have a property manager. You also must have a 10% or greater interest in the activity; limited partners cannot actively participate.
If you actively participate, your modified adjusted gross income (MAGI)—see Publication 925 for how to compute MAGI—must be below $100,000 in order for you to be eligible for the maximum $25,000 special allowance. If your MAGI is above $100,000, the special allowance begins to phase out; it’s reduced by 50% of the amount of your MAGI that exceeds $100,000. Therefore, you are no longer eligible for the special allowance once your MAGI hits $150,000.
Stick with me here, we’ll go through some examples with numbers in a minute.
The MAGI threshold is the same for single and married filing joint taxpayers; those who are married filing separately must halve each dollar amount above.
Example #1
John is a single taxpayer who owns five rental properties all in his name, which he manages himself. His MAGI is $75,000 and net rental losses total $18,000.
Because his MAGI is below the $100,000 threshold, John can deduct the $18,000 of losses in full in the current year against nonpassive income.
Assume the same scenario above for Year 2, except John’s net rental loss is now $27,000 due to extra depreciation on improvements made throughout the year. John’s MAGI still falls below the phase-out threshold, but the loss that he is allowed to deduct against nonpassive income is limited to the special allowance of $25,000.
What happens to the additional $2,000 in losses?
You guessed it – they will be suspended and carried forward to the following year.
Example #2
Anne owns eight rental properties with her husband, Mike. They manage all the properties themselves and file a joint tax return. Their joint MAGI is $120,000 and their portfolio produces a net rental loss of $19,000.
Because their MAGI exceeds the $100,000 threshold, the special allowance will phase out. Remember, the special allowance of $25,000 is reduced by 50% of the amount of your MAGI in excess of $100,000. Let’s calculate the phaseout step by step:
- Subtract the threshold from MAGI → $120,000 – $100,000 = $20,000
- Multiply the difference from Step 1 by 50% → $20,000 x 50% = $10,000
- Reduce the maximum special allowance by the product from Step 2 → $25,000 – $10,000 = $15,000
Easy peasy, right?!
The maximum allowable deductible loss for Anne and Mike is $15,000. Anne and Mike are, therefore, able to deduct $15,000 of their rental losses against nonpassive income; the remaining $4,000 of losses will be suspended and carried over to the following year.
Other Exceptions to the PAL Limitation Rules
There are only two other scenarios in which rental real estate losses can be deducted against nonpassive income:
- You have short-term rentals that are considered active – these losses can be deducted in full. Whether or not your short-term rental activity is considered active depends on a few different criteria.
- You qualify as a real estate professional – this converts passive real estate activities to active, allowing the losses to be deducted in full.
Each of these topics requires special attention and will be covered in more depth in future articles.
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