Rental Real Estate Losses

Rental real estate has significant tax advantages. One of them is the ability to claim losses against other income in limited circumstances.

As a default, many taxpayers cannot claim tax losses generated by rental real estate because of the passive activity loss rules. This post describes the situations where the owner of rental real estate are able to claim real estate tax losses against other income.

The Passive Activity Loss Rules

The passive activity loss rules can be greatly oversimplified by saying “you can only deduct passive losses against passive income.” So what do we mean by “passive income”?

For this purpose, “passive income” is not necessarily what you may colloquially refer to as passive income. Portfolio income such as interest, dividends, and capital gains does not count as passive income. Wage income is also not passive income. Income from trade or business activities that the taxpayer does not materially participate in is generally passive income.

What is “material participation”? That could be its own blog post, but for our purposes, it is sufficient to know that, by itself, the activity of renting real estate is not “material participation” in a trade or business. Thus, in most instances, renting real estate will be considered a passive activity that generates passive income and passive losses.

Situations Where Real Estate Losses Can Offset Other Income

Other Rental Income

Passive income, including rental real estate income, can be offset by passive losses. Thus, if a taxpayer rents Condo A and Condo B, and Condo A has $5,000 of net taxable income during the year and Condo B has $4,000 of a net taxable loss during the year, the taxpayer will be able to offset $4,000 of Condo A’s income with Condo B’s loss on his tax return.

Real Estate Professionals

First, the wet blanket. Most taxpayers will not qualify as real estate professionals. If you have a full time job outside of real estate, you can forget about qualifying as a real estate professional.

Why would one want to be a so-called “real estate professional”? Real estate professionals are allowed to deduct losses generated by rental real estate unencumbered by the passive activity loss rules.

How does one qualify as a real estate professional? To qualify, generally one must work primarily in real estate trades or businesses they materially participate in (i.e., you must work more in real estate than in any other jobs or business activities) and must work at least 750 hours during the year in real estate activities.

Qualification could be its own blog post, but for purposes of this particular post it suffices to say that (a) “real estate professional” is a high threshold, and (b) it is great to qualify, because you are able to deduct rental real estate losses against other income unencumbered by the passive activity loss rules.

Active Participation

Taxpayers who are not real estate professionals, but actively participate in their rental real estate can deduct up to $25,000 in rental real estate losses if their modified adjusted gross income (“MAGI”) is below certain limits. The threshold for “active participation” is much lower than that for “material participation.” Generally speaking, the two main requirements are that the taxpayer makes decisions with respect to the activity (or hires someone to do so) and owns at least ten percent of the activity.

Thus, you can actively participate in renting out a house you own in your own name. You cannot actively participate in the renting of real estate by a partnership if you own less than 10 percent of that partnership.

If your MAGI is $100,000 or less, you can deduct up to $25,000 of active participation rental real estate losses. If your MAGI Is $150,000 or more, you cannot deduct any active participation rental real estate losses. In between those two amounts, the $25,000 potential maximum loss is reduced by fifty cents for every dollar above $100,000.

Here’s an example:

Shirley owns House A which she rents out. After taking into account depreciation and other tax deductions, in 2019 House A generates a $15,000 taxable loss reported on Schedule E of Shirley’s tax return. Shirley reports a MAGI of $125,000 on her 2019 tax return. Thus, she is able to claim $12,500 of the House A loss against her other income on her 2019 tax return. The remaining $2,500 of the House A loss will be a suspended passive loss that will carry forward to her 2020 tax return.

Future Passive Income

Previously suspended passive losses can offset future passive income.

Continuing with Shirley from above, in 2020 Shirley has a MAGI of $200,000 and House A reports a rental profit of $1,000 on Shirley’s Schedule E. Shirley can use $1,000 of her previously suspended $2,500 passive loss to offset the $1,000 in income generated by House A on her 2020 tax return. The remaining $1,500 of the House A loss will be a suspended passive loss that will carry forward to her 2021 tax return.

Dispositions

Dispositions of property used in a passive activity creates passive income or passive loss. A disposition of substantially all of a passive activity can trigger the use of all of that activity’s previously suspended passive losses.

One important point here: to trigger the use of all the previously suspended passive loss upon a disposition, the disposition must be of substantially all of the activity. Disposing of only part of the activity, even a significant part, is not enough to trigger the use of all of the previously suspended passive loss.

For example, imagine you and a partner are 50/50 partners in a partnership that invests in four rental properties. Unless you are trying to qualify as a real estate professional, it is usually advantageous to list each of the four rental properties from that partnership as its own separate activity on Schedule E, Part 2. That way, the future sale of one of the four properties will be sufficient to be the disposition of “substantially all” of that property and trigger any previously suspended passive losses related to that particular property.

If the partnership is instead listed as a single activity, the future disposition of any one (or two or three) property owned by the partnership will not be enough to constitute “substantially all” of the activity. While any gain from the disposition creates passive income which can be offset with previously suspended and/or current passive losses, the entire previously suspended loss with respect to that particular property is not necessarily usable because the one property is only a component part of a single activity.

Conclusion

The ability to use rental real estate losses against other income, in the limited circumstances described above, is a significant tax advantage of rental real estate. While tax losses should never be the driving factor in the decision to invest in rental real estate, potential real estate investors should go into the investment understanding the impact it will have on their taxes. Investors in rental real estate often benefit from consultations with tax professionals in order to maximize the potential tax benefits of the investment.

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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, investment, financial, legal, and tax matters.