As you do your taxes, it's not uncommon for your rental properties to show a loss for tax purposes on your Schedule E, even if they actually earned a substantial profit. If this happens, you might be wondering if you can use your rental property losses to reduce your taxable income for the year.
The short answer is "maybe." The Internal Revenue Service (IRS) generally doesn't allow passive losses from real estate investments to be deducted from any type of income other than rental profits. However, there are a few big exceptions. Here's what all real estate investors need to know about the passive loss rules.
What is a passive business activity?
According to the IRS, a passive activity is one in which the taxpayer doesn't materially participate. For example, if you own an interest in a business but don't have any role in its day-to-day operations or major management decisions, you are considered a passive investor. Other forms of passive activities include equipment leasing and limited partnerships.
This is in contrast to nonpassive activities, such as a job, freelance work (1099 income), running a small business, or (surprisingly to many) most forms of investment income like stocks and bonds.
Rental real estate is considered to be a passive activity by the IRS regardless of how much the taxpayer participates.
Why do so many rental properties lose money?
The short answer is that rental properties are entitled to some pretty big tax deductions -- particularly depreciation.
For starters, when your property generates rental income, you can use the property's expenses to reduce their taxable rental income. This includes expenses like property taxes, insurance, mortgage interest, and more.
Furthermore, rental property owners can deduct a certain percentage of their cost basis in each property every year, a concept known as depreciation. For residential rental properties, you can find your annual depreciation deduction by dividing the property's cost basis by 27.5.
Here's the key point: Depreciation isn't actually an expense. You aren't actually paying anything. This is what makes depreciation one of the most unique tax benefits of real estate. Depreciation is intended to allow businesses to recoup the cost of capital assets over the course of their usable lifespan. However, unlike most capital assets (say, a piece of machinery), real estate is never "used up."
Consider this simplified example. You buy a rental property for $100,000 that generates $12,000 in gross rental income annually. Your total expenses for the property are $9,000, which leaves you with $3,000 in taxable rental income. However, you're also entitled to a $3,636 annual depreciation deduction. So, even though your rental property provided you with $3,000 in actual profit, it will show a $636 loss for tax purposes.
You can use IRS Schedule E to figure out your taxable rental income (or loss) from each of your investment properties.
Can I deduct passive losses from my real estate investments?
As mentioned in the introduction, the answer here is "maybe." If your rental properties or other passive business activities show a tax loss for the year, there are four factors that determine how much (if any) you can use as a deduction on your taxes:
- At-risk rules
- Passive activity loss rules
- Whether you are an active participant in your investments
- Whether you are a real estate professional
Let's look at these one at a time:
The simple explanation of the at-risk rules is that your tax losses on a particular investment cannot exceed the amount of money you put at risk on the investment. For example, if you only invest $10,000 to acquire rental real estate, you can't claim any losses on the property in excess of that amount, regardless of how much money the property actually lost or what the other passive loss rules say.
In practice, the at-risk rules generally only apply when you sell a property. It's not uncommon in bad markets for investors to lose more than their initial out-of-pocket expense when selling a property, but it's very uncommon for a property to produce a single-year rental loss that exceeds your initial capital investment. Even so, this should be the first component in your passive loss checklist.
Passive activity loss rules
There are three "levels" of investor activity when it comes to owning and managing rental properties:
- Passive investors
- Active participants
- Real estate professionals
So, let's look at the first group first. Passive investors are defined as those who own rental properties but don't play an active role in their day-to-day operations. This group is the most restricted when it comes to deducting rental income losses.
The passive activity loss rules are perhaps the largest limiting factor when it comes to deducting rental income losses, and they apply to non-active rental property investors. If you aren't a real estate professional or an active investor (more on those in the next two sections), rental property investing is classified as a passive business activity.
This means that any losses on your rental properties are only deductible to the extent of your rental income and cannot be used to offset other forms of taxable income. For example, if your portfolio of rental properties generated a $5,000 loss during 2019 and you earned $80,000 from your job, you can't use the loss to reduce the tax you'll pay on your employment income.
Are you an active participant in your rental property investing?
If you are an active participant in your rental properties, you may have the ability to deduct more rental losses on your taxes than a passive investor.
What is an "active participant?" Basically, the IRS defines an active participant as someone who makes management decisions regarding their rental properties. Just to name a few examples, this could mean that you:
- Found and approved tenants yourself.
- Obtained estimates for repairs.
- Approved repairs or capital expenditures yourself.
If you are an active participant in your rental properties and you have modified adjusted gross income (MAGI) of $100,000 or less, you can deduct as much as $25,000 in rental real estate losses from your taxable income in a given tax year. If you exceed this MAGI limit but are under $150,000, you are entitled to deduct some of your rental losses. Taxpayers with MAGI above $150,000 cannot deduct rental losses, even as an active participant, unless they are real estate professionals.
Are you a real estate professional?
If you are a real estate professional, rental real estate is not considered a passive activity for you. Therefore, the passive income deduction rules don't apply to you at all: You can deduct any amount of rental income losses from your taxable income regardless of how much it is or how much your MAGI is.
The IRS defines a real estate professional as someone who spends more than half of their total working hours for the year in real estate businesses. This typically means a total of at least 751 hours throughout the year spent on real estate, and you must be a material participant in all of your rental properties.
Being a material participant is different than being an active participant as discussed in the last section. The IRS has a list of official material participation tests in IRS Publication 925, and just to name some of the most commonly applicable (only one of them needs to apply):
- You participated in the activity for more than 500 hours in a year.
- Your participation was substantially all of the participation in the activity of all individuals during the year.
- You participated in the activity on a "regular, continuous, and substantial basis" throughout the tax year.
When in doubt, seek help from the pros
To be fair, there's quite a bit of gray area in the U.S. tax code, and the rental income loss rules are certainly no exception. For example, are you really an active participant in your rental properties? Do you meet the definition of a real estate professional?
If you run into anything you can't answer in a straightforward "yes" or "no," it's a smart idea to seek the advice of an experienced tax professional. Rental income deductions (especially large losses) often get extra scrutiny from the IRS, so it's important to be sure you're doing it right.
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