Tax Deductions: Deduct up to $25,000 of Rental Real Estate Losses

Suppose you own a house which you rent out to tenants. The last few years you’ve made a profit on the rental. This year, the tenants left, and it took several months to replace them – months with no rents coming in. On top of that, utility costs were up, the furnace broke, and you decided that with no tenants it was a good time to paint the place. The bad news is that you have a net loss of $20,000 on the rental for the year. But, at least you’ll get to write off the loss on your tax return, right? Unfortunately, you may not get the deduction you expected.

Passive and nonpassive income

The IRS categorizes income from business and rental activities as passive and nonpassive.

Passive income includes most real estate rental activities. It also includes income from businesses in which you don’t “materially participate.” For example, income you receive on a K-1 from an LLC is passive if you don’t meet certain participation standards.

Wages and income from businesses in which you materially participate are considerednonpassive income. Portfolio income, such as interest and dividned income, is also nonpassive income.

Passive losses

If you have net passive income for the year, that income is taxable to you. The problem comes in when you have a passive loss. Passive losses can only be deducted against passive income. You cannot deduct passive losses against nonpassive income. In this case, the $20,000 loss on the rental property could not be used to reduce the taxpayer’s nonpassive income, such as salary and interest income. The passive loss doesn’t disappear. It’s suspended until a year in which you have passive income. It can then be used to reduce that passive income. Also, when you completely dispose of a passive activity (e.g. sell the rental property), any losses suspended under the passive activity rules can be utilized in the year of disposition against nonpassive income.

$25,000 exception for active participation

If you (or your spouse if filing a joint return) actively participated in the rental real estate activity, you can deduct up to $25,000 (subject to phaseout – see below) of rental loss from your nonpassive income. You actively participate if you make key management decisions, such as approving tenants, setting rental terms, or approving capital expenditures. You do not need to devote a large number of hours to the activity to meet this standard. Note that active participation is not the same as material participation mentioned above, which requires a substantially higher level of participation.

However, the allowed loss is subject to phaseout based on your adjusted gross income (AGI). There is no phaseout for AGI under $100,000. If your AGI is over $100,000, the allowed deduction is reduced by one-half of the excess over $100,000. So, at AGI of $125,000, the deduction is limited to $12,500, and it’s completely phased out at AGI of $150,000.

Tip: Note that certain rental activities of qualified real estate professionals are not considered passive activites and are not subject to the passive loss limitations. The requirements for a real estate professional are much tougher to meet, and include a minimum of 750 hours of servieces in real property activities with material participation during the year. Click here for more information.

Example

Jack owns a rental property which generates a $22,000 loss. He also has $125,000 of wages and $5,000 of dividend income. His AGI (not considering the loss) is $130,000. 

The phaseout is one-half of the excess of AGI over $100,000: $130,000 – $100,000 = $30,000 x 1/2 = $15,000.

The amount of rental loss allowed for the year after the phaseout is: $22,000 loss – $15,000 phaseout = $7,000 allowed loss.

Jack’s taxable income before deductions is: $125,000 wages + $5,000 dividends – $7,000 allowed rental loss = $123,000.

The disallowed rental loss of $15,000 carries forward to following tax years.