Deductibility of Real Estate Rental Losses

Passive losses from activities in which you did not materially participate usually cannot be deducted from nonpassive income — active (earned from work) or portfolio income. Many taxpayers, who are not real estate professionals or active participants in the real estate business, supplement their income with real estate rentals. As a passive loss, rental losses are not deductible against nonpassive income, but there is an exception for rental income, where up to $25,000 of rental losses can be deducted against active or portfolio income.

Although you need not satisfy the material participation tests that differentiates active from passive activities, you must satisfy active participation tests to qualify for the $25,000 exception, by satisfying at least some of these:

• make management decisions, including:
  • capital or repair decisions;
  • recruiting and selecting new tenants, and
  • specify rental contract terms.
• have at least a 10% interest in the property.

Although the active participation tests do not exclude using a property manager, you must do more than simply accept a manager's decisions to be considered an active participant.

The $25,000 allowance applies only to real estate rentals — not for the rental of personal property. Furthermore, the real estate rentals cannot include the type of rentals that the tax code specifies as active businesses, such as renting out a vacation home. Although trusts do not qualify for the $25,000 allowance, an estate may if the decedent actively participated in the operation, in which case the estate is treated as an active participant for 2 years after the death of the decedent.

Any loss from real estate rental activity must first be subtracted from other passive income. Only then can losses of up to $25,000 be used to offset active or portfolio income. Unused rental losses qualifying for the $25,000 allowance that cannot be offset by income can be carried backward or forward as a business net operating loss if you maintain active participation. The $25,000 allowance is figured on Schedule E, Supplemental Income and Losses.

The $25,000 non-passive deduction allowance is reduced by 50% of modified adjusted gross income (MAGI) over $100,000. Hence, it is phased out completely at $150,000. A married couple filing separately is not eligible for the $25,000 loss allowance unless they lived apart during the entire tax year, in which case, each spouse is entitled to half of the allowance: $12,500, but this amount is phased out by 50% of the MAGI over $50,000. Hence, the allowance phases out completely when the taxpayer's MAGI equals $75,000 or more.

In addition to adjusted gross income, MAGI includes:

• nontaxable interest from United States savings bonds used to pay for qualified educational expenses;
• adoption assistance provided by an employer as a tax-free fringe benefit.

MAGI does not include:

• income or losses from passive activities;
• losses allowed for real estate professionals;
• taxable social security or railroad retirement benefits;
• deductible IRA contributions;
• deductible tuition and educational fees;
• 1/2 of the self-employment tax deduction for self-employed taxpayers;
• deductible student loan interest.
• deduction for domestic production activities.

Losses or gains from a publicly traded partnership (PTP), which is a partnership whose interests are readily marketable, can only be combined with other passive activity losses to the extent of passive income unless the entire interest is disposed of in a fully taxable transaction; any net gains is considered nonpassive income while remaining losses must be carried forward (Inst 8582).

• Example 1: $10,000 Schedule E income + $4000 PTP loss = $6000 nonpassive income.
• Example 2: $10,000 Schedule E loss + $4000 PTP gain = $6000 loss that must be carried forward.

The $25,000 allowance includes not only deductions but also tax credits that are measured in deduction equivalents. The deduction equivalent (DE) of a passive activity credit is the deduction amount equal to the credit in terms of lowering tax liability. For instance, if a taxpayer is in the 35% bracket, a $1000 deduction will reduce tax liability by $350. So a passive activity credit of $350 would be the deduction equivalent of $1,000 since that would save the same amount of money in taxes. The deduction equivalent can be found by dividing the credit amount by the taxpayer's tax bracket, so a $1000 tax credit would be equal to a deduction equivalent of $1000 ÷ .25 for a taxpayer in the 25% bracket, which would mean that the taxpayer must have a deductible amount of $4000 to equal the deduction equivalent of the $1000 tax credit. The deduction equivalent is figured on Form 8582-CR, Passive Activity Credit Limitations.

However, there is no active participation test for low-income housing and rehabilitation credits. There is no MAGI phaseout for the credit for low-income housing property placed in service after 1989. However, the MAGI is reduced by rental real estate losses that can be claimed by real estate professionals, including deductions for contributions to IRAs and pensions, and losses from a publicly traded partnership.

Deductions + deduction equivalents that exceed the $25,000 allowance must be allocated pro rata, first offsetting passive losses, including suspended losses from prior years, then applied to credits in this order:

1. all credits that are not rehabilitation or low-income housing credits,
2. rehabilitation and low-income credits for housing placed in service before 1990,
3. low-income housing credits for housing placed in service after 1989.

If there is a remaining loss that would otherwise be allowed by the $25,000 allowance but that cannot be taken because the taxpayer's income is less than the remaining loss, then the remaining loss can be carried backward or forward as a net operating loss.