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How to Use Tax-Loss Carryforward on Your Rental Property

Those real estate tax deductions you're taking this year may even help save you money in future tax years.

[Updated: Feb 04, 2021 ] Mar 29, 2020 by Kevin Vandenboss
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Talking about losses never sounds like a good thing, especially when it comes to investments. In real estate, however, a tax-loss carryforward might be something to get excited about in future tax years.

Not all losses are the same in real estate, and how you plan your activities throughout the year may play a big role in how those losses are handled when it's time to pay the tax bill.

What is a tax loss?

A tax loss occurs when your deductions are more than your rental income for the year. You can experience a tax loss if your expenses were significantly higher than normal or if you had long periods of vacancy.

It's even common for investors to experience a tax loss when they were cash flow positive for the year. This normally happens because of depreciation.

While depreciation isn't an actual expense, it's still a significant tax deduction each year. If the depreciation deduction is higher than your net operating income for the year, you'll show a net operating loss (NOL).

Can you deduct rental property losses?

For most real estate investors, a loss from rental properties is considered a passive loss. The Internal Revenue Service (IRS) says that a passive loss can't be deducted against ordinary income. So if your regular income for the year was $90,000, and you had a passive loss of $2,000 from your real estate investments, your taxable income for the year is still $90,000.

There are some exceptions to this, however, if you fall into one of the following three categories:

  • You're an active participant in the property.
  • You're a material participant in the property.
  • You're a real estate professional.

Active participant

To be considered an active participant, you have to make significant management decisions. Management decisions include approving new tenants, deciding on rental terms, approving expenditures, or other similar decisions.

If you are an active participant, and your adjusted gross income (AGI) is less than $100,000 for the year, you can deduct up to $25,000 of your rental property losses. The allowed deduction begins to phase out after you reach $100,000 AGI, and you can't deduct any amount if your AGI is above $150,000 for the year.

Material participant

Income or losses from a rental property aren't considered passive and are exempt from not being able to deduct the losses if you are a material participant.

The IRS provides a material participant test to determine whether you are considered a material participant for the tax year. The main rules that have to be met for this test are:

  • You participated in the operation of the rental property for at least 500 hours in the tax year.
  • Your participation covered all of the activity for the rental property for the year. This means you didn't hire out any of the work done on the property or had assistance in managing the property.
  • You participated in operation of the property for at least 100 hours in the tax year, and at least as much as any other individual.

It's important to note that activities you would normally participate in as an investor do not count as being an active participant or material participant. These activities include:

  • Studying or reviewing financial statements or reports.
  • Preparing or compiling summaries or analysis of the investment for your own use.
  • Monitoring the finances or operations in a nonmanagerial capacity.

Real estate professional

If you are a real estate professional, and a material participant in all of your rental properties, you are able to deduct all of your rental losses from your income to reduce your tax liability.

Examples of a real estate professional include:

  • Developers.
  • Contractors.
  • Brokers.
  • Leasing agents.
  • Property managers.

To be considered a real estate professional under any of these roles, you have to spend at least half of your working hours in a year on real estate.

Before deciding for yourself what sort of participant you've been, talk to a tax professional experienced with real estate investments.

How tax-loss carryforward works with rental properties

If you're not able to deduct your rental losses, the IRS allows you to carry the losses forward into future tax years to deduct against future rental profits. These losses can be carried forward indefinitely.

For a tax-loss carryforward, you'll have to keep detailed records of how the losses were carried forward, how much of the loss was used in each tax year, and any additional losses.

When the loss is deducted in the following year, the negative amount will be listed as "other income" on your income taxes, and you must attach the statement with a record of your carryforward loss.

If you don't use all of your loss in the next year, you can continue to carry it forward until it's gone.

For example:

This year you have a tax loss of $25,000 that you carry forward to next year.

Next year, you show a net profit of $10,000.

The $25,000 loss wipes out the $10,000 profit, and you still have another $15,000 in loss to carry over to the next year.

Capital losses

A capital loss normally occurs when you sell a property for less than its current tax basis. This doesn't necessarily mean it's sold for less than what you paid for it.

If you paid $1 million for a property and depreciated $100,000 of it over four years, your basis would be $900,000. To have a capital loss, you'll have to sell the property for under $900,000.

Section 1231 loss

Since real estate is a Section 1231 property, any capital losses in excess of capital gains can be deducted from normal income. This is unique compared to assets such as stocks, which only allow you to deduct up to $3,000 toward ordinary income each year.

Writing capital losses off against ordinary income is a huge benefit because it's at a higher tax rate than capital gains tax.

For example, suppose you sell two properties this year, one at a gain of $10,000 and the other at a loss of $30,000. Before that capital loss can be deducted from any ordinary income, it first has to offset the capital gain.

The $30,000 loss wipes out the $10,000 capital gain and leaves you another $20,000 to write off against your ordinary income.

If your ordinary income for the year is $80,000, you can deduct the remaining $20,000 from your ordinary income on your tax returns.

Capital-loss carryover

If your Section 1231 loss was large enough to offset any capital gains and reduce your ordinary income to zero, you can carry forward any remaining loss.

For example, let's say you have a capital loss of $100,000 with no capital gains, and your ordinary income is $80,000. The loss of $100,000 will reduce your income to zero and leave you with another $20,000 to carry forward to the following year.

If you have a capital gain the following year, the loss will first have to be applied to it. If there is still a loss remaining, or you don't have any capital gains that year, the remaining $20,000 capital-loss carryforward can be used to reduce your ordinary taxable income again.

The bottom line

While losses never sound like a good thing, they can come in handy later to lighten your future tax burden. Besides, with real estate, a tax loss doesn't necessarily mean you didn't make money.

Understanding how taxes work in real estate can help you make decisions throughout the year that will be most beneficial when it's time to file your taxes. The IRS offers a lot of tax advantages to real estate investors, and a tax-loss carryforward is one that can be a silver lining on a deal gone bad.

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