The Answer … It Depends.
Rental activities generally fall into the category of “passive” activities. This means that the rental losses you currently incur can only be deducted against passive income – not against nonpassive income, which is any type of active income, such as your wages or business income.
However, if you “actively participate” in the residential rental activity, you may be able to deduct a loss of up to $25,000 in a tax year against nonpassive income. Actively participating in the rental activity means that you are making key management decisions, such as approving new tenants, deciding on rental terms or approving capital expenditures. You also can show active participation by arranging for others to provide services. You do not need to have regular, continuous and substantial involvement with the property.
To satisfy the active participation test, you (together with your spouse) must own at least 10 percent of the rental property. Ownership as a limited partner doesn’t count.
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If you meet the above tests, you can claim up to $25,000 in losses against nonpassive income, or $12,500 if you’re married, file separately, and live apart from your spouse for the entire year. If you’re married, file separately and don’t live apart from your spouse for the entire year, you’re not eligible for this break at all.
If your adjusted gross income (AGI) is above $100,000, the $25,000 allowance amount is reduced by one-half the excess over $100,000. If you’re married, file separately and are eligible for the break, the $12,500 allowance amount is reduced by one-half the excess over $50,000. So, if your AGI is $150,000 or more ($75,000 or more for eligible married taxpayers who file separately), the allowance is reduced to zero. For these purposes, AGI is modified to some extent. For example, you ignore taxable Social Security income and the IRA deduction.
Let’s look at an example. Jessica is single and has an AGI of $120,000. One-half of the $20,000 excess ($120,000 minus $100,000) equals $10,000. So, Jessica’s maximum loss allowance is reduced from $25,000 to $15,000.
Losses that aren’t allowed because of the amount limitations don’t just disappear. They are carried forward and can be deducted against nonpassive income in future years if you continue to actively participate in the rental real estate activity that generated the losses, subject to the $25,000 limit.
If you stop actively participating, the carried-forward losses are treated as passive activity losses that may only be used to offset passive activity income. To the extent your passive losses aren’t used up, you can deduct them in the tax year in which you dispose of your entire interest in the passive activity in a fully taxable transaction.
There is a group of taxpayers who are allowed to fully deduct losses from rental real estate. These are the people who are considered real estate professionals. To qualify, you (or your spouse), need to have more than half your personal services, and more than 750 hours, in various real estate activities in which you materially participate.
If you have any questions or would like to discuss this topic further, please call.
By Judy Mondry, CPA, CVA (Cleveland office)