In the world of rental real estate, it's quite common for properties to show a loss for tax purposes, even if they generated a net profit. This might sound like an excellent situation -- after all, doesn't a loss help reduce your total taxable income?
However, since rental real estate income is considered to be passive in nature, there are special rules, called the passive activity loss rules, that can limit the amount of rental real estate or other passive business losses you can use on your tax return. Here's a rundown of what all real estate investors should know about these rules and what they mean.
What is a passive activity loss?
As the name implies, a passive activity loss is a financial loss that comes from a business or investment activity in which you do not play an active role. The term was defined in 1986 when the passive activity loss rules went into effect to try to close a tax loophole that allowed high-income individuals with substantial on-paper passive losses to dramatically reduce their taxable income.
There are two main types of passive activity losses:
- Rental real estate.
- Businesses where you don't materially participate.
Because of the large depreciation deductions available to rental property owners, these properties regularly show losses for tax purposes, even if the owners earned a net profit for the year. This is especially common in the first few years of ownership, when repair expenses tend to be the highest. It's also quite common for certain types of businesses to show losses for tax purposes, even when they were profitable by the conventional definition of the word.
Is your loss from rental real estate or a business a passive one?
When it comes to rental real estate, the answer is yes. This is even true if you materially participated in your rental properties. If you materially participated, you may have a slightly more favorable deduction allowance, but it's still considered passive income unless you're a real estate professional. We'll get into the details of how this works later on.
When it comes to income from a business, the general test to use is the so-called "500-hour" test. In a nutshell, you are generally considered to materially participate in a business if you work more than 500 hours during the calendar year at it. (If you're curious, this translates to roughly 10 hours per week.) In short, unless a business takes up a substantial portion of your typical workday, you should probably consider it to be a passive activity.
Why are passive activity losses unique from a tax perspective?
It may seem like a loss is a loss. In other words, it may sound reasonable that if you lost money in the course of running your business, on stock investments, or on rental real estate, then all of those losses should be treated the same in the eyes of the Internal Revenue Service, or IRS.
Unfortunately, that's not the case. Unlike active business losses and (to some extent) capital losses, passive activity losses can typically only be used to offset other passive income.
For example, if you own a portfolio of rental properties and show a $10,000 loss for 2019, and you also have $8,000 in income from a passive business in which you do not materially participate, you can only use the loss to offset the passive business income. You can't use the additional $2,000 to reduce your other taxable income.
Can you deduct passive activity losses on your taxes?
As we already mentioned, a loss that results from a business is generally considered a passive activity loss unless you spend at least 500 hours of your time on it during the calendar year. And a loss that results from rental real estate is always considered to be passive, even if you meet the 500-hour requirement.
Passive activity losses are generally not deductible. They can be used to offset other income that came from passive activities, but they cannot be used to reduce your other taxable income. And contrary to the popular misconception, capital gains and dividend income are not considered to be passive activity income, so you can't use passive activity losses to offset these types of income either.
Having said that, there are two big exceptions for rental real estate losses.
- First, if you actively participate in your rental properties, you may be able to deduct losses up to a certain maximum.
- Second, if you are a real estate professional, the passive activity loss rules don't apply to you at all.
So, let's look at these one at a time.
Are you an active participant in your rental properties?
The first exemption for rental real estate losses is for investors who actively participate in their rental properties. This is generally defined as an investor who also makes management decisions in their rental properties. For example, if you do any or all of these things, you could be considered an active participant:
If you meet the 500-hour rule that we discussed earlier, it certainly helps your case, but it isn't a set-in-stone requirement to be considered an active participant in your rental properties. After all, it's entirely possible to self-manage a rental property or two while spending just a couple of hours each week.
With all of that in mind, if you materially participate in your rental properties, you can deduct your passive rental losses, up to $25,000 if your modified adjusted gross income (MAGI) is $100,000 or less. Above this threshold, the maximum deduction begins to phase out, and it disappears completely with MAGI above $150,000. In other words, even if you actively participate, the passive activity loss rules still apply to rental property investors who have more than $150,000 in annual income.
Are you a real estate professional?
If you are a real estate professional as defined by the IRS, the passive activity loss rules don't apply to your rental real estate income at all. Even if you have a six-figure loss from investment properties, you can deduct every penny of it. The MAGI cap that applies to material participants (as described in the last section) doesn't apply to real estate professionals.
To qualify as a real estate professional in the eyes of the IRS, you'll need to spend at least 751 hours during the year working in real estate businesses, and you must actively participate in each of your rental properties. If this applies to you, and you anticipate having substantial losses from rental properties, it's a good idea to keep a log of your time spent at each rental property.
Two other rules can also limit deductible losses
In addition to the passive activity loss rules we've discussed, there are two other IRS rules that could potentially limit the amount of rental real estate or passive business losses you can deduct: at-risk rules and excess business loss limitation.
The IRS's at-risk rules state that the amount of a claimed loss is limited by the amount of capital that the investor put at risk. For example, if you invest $25,000 in a share of a business and your share of the business' losses in a particularly bad year is $29,000, you can only claim $25,000 of this, even if the other deduction rules (such as material participation) allow you to deduct all of your losses.
Excess business loss limitation
This was implemented as part of the Tax Cuts and Jobs Act and says that under no circumstances can any taxpayer deduct more than $250,000 in net total business losses for a given tax year ($500,000 if married filing jointly). This limit applies regardless of whether you actively participate in a business or qualify as a real estate professional.
What if you can't deduct your passive activity losses?
One important point is that if you end up with a loss from your rental properties or passive business interests and you aren't allowed to deduct them, that doesn't mean the losses are useless. It simply means that you can't use them right now.
Specifically, any unused passive losses can be carried forward to future tax years. For example, if you had an $8,000 nondeductible rental property loss in 2019 and you end up with a $10,000 profit in 2020, you can use the $8,000 loss to reduce your 2020 taxable rental income to $2,000.
In the case of rental real estate, you can also use unclaimed losses to reduce your income when you sell the property. Or, if you're a material participant in your rental properties but exceed the MAGI threshold, you can potentially use it in a future tax year when your MAGI falls below $150,000.
The Millionacres bottom line
The bottom line is that passive activity losses are generally not deductible, but there are a few exceptions. And, there's admittedly quite a bit of gray area in the rules. If you're not sure of whether your rental real estate losses or your passive business losses are tax-deductible, it's a smart idea to seek the advice of a qualified tax professional.