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 would not be 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 do not have to satisfy the material participation tests that differentiates active from passive activities, you do have to satisfy active participation tests to qualify for the $25,000 exception, by satisfying at least some of the following:
- 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 do have to 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. Any unused rental losses that qualify for the $25,000 allowance that cannot be offset by any income can be carried backward or forward as a business net operating loss as long as 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 your modified adjusted gross income (MAGI) that exceeds $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;
- ½ 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 amount of the deduction that would be required to equal the credit in terms of lowering tax liability. For instance, if a taxpayer is in the 28% bracket, a $1000 deduction will reduce his tax liability by $280. So if he has a passive activity credit of $280, then that would be the deduction equivalent of $1,000, since that would save the same amount of money in taxes. Generally, the deduction equivalent can be found by dividing the amount of the credit by the taxpayers 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 plus deduction equivalents that exceed the $25,000 allowance must be allocated pro rata, first offsetting passive losses, including suspended losses from prior years, and then applied to credits in the following order:
- all credits that are not rehabilitation or low-income housing credits,
- rehabilitation and low-income credits for housing placed in service before 1990,
- 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.
Example: Apportioning Losses and Deductible Equivalents of Tax Credits Among Multiple Rental Activities
Suppose you, in the 28% tax bracket, have the following real estate rental activities with the following losses or credits (calculations are rounded to the nearest dollar):
- Activity A: $5,000 of credits
- Activity B: $15,000 of losses
- Activity C: $20,000 of losses.
- Total Losses = $35,000
- Deductible Equivalent of Credits = $5,000 / .28 = $17,857
Since total losses + DE > $25,000, $25,000 of the loss can be subtracted from active or portfolio income, but the remaining losses must first be allocated to the 2 losing activities to determine the suspended losses that can be carried forward for each activity:
- Allocated Losses for Activity B = $25,000 × $15,000 / $35,000 = $10,714
- Allocated Losses for Activity C = $25,000 × $20,000 / $35,000 = $14,286
Therefore, the following losses and deductible equivalents are carried forward:
- Suspended Losses for Activity B = $15,000 – $10,714 = $4,286
- Suspended Losses for Activity C = $20,000 – $14,286 = $5,714
- Deductible Equivalent for Activity A: $17,857.
So if each activity earned $10,000 in the next tax year, then the profits for each activity for that year is as follows:
- Activity A Loss = $10,000 – $17,857 = -$7,857
- Activity B Profit = $10,000 – $4,286 = $5,714
- Activity C Profit = $10,000 – $5,714 = $4,286
Because this is a new tax year and $7,857 < $25,000 , the $7,857 loss from Activity A can be used to offset active or portfolio income.