Real Estate Losses – Can You Deduct Them? What This Difference Could Mean to You
8 July 2015
If you own real estate properties for rental to tenants, you should know that the IRS treats passive and nonpassive income – and passive and nonpassive losses – differently, and that this difference can affect your tax liabilities.
Let us take an example: you have one rental property, which has provided you with profits for several years. This year, your tenants did not renew their lease, and several months passed – with no rent coming in – before you found new tenants. During these months, with the house empty, the air-conditioner needed replacing, and you determined that this was a good time to repaint. In addition, utilities, insurance, and other costs associated with your rental property rose.
These factors give you a net loss on your rental property of $20,000 for the year. Whether this $20,000 loss can be deducted on your tax return depends on whether your rental income (and, consequently, your current-year losses) falls under the IRS’ definition of passive or nonpassive activity.
Read on for more details, and please give us a call if you’d like to know more about how the different tax treatments may impact you – we’re always happy to listen, and dedicated to creating tailored solutions that fit your specific situation.
Passive and Nonpassive Income
Income from business and rental activities are classified by the IRS as either passive or nonpassive.
Most income from real estate rentals is passive income. Passive income also includes income from business ventures in which you do not “materially participate.” K-1 income from an LLC may be classified as passive if you do not meet certain participation standards.
Note that certain rental activities of qualified real estate professionals are not considered passive activities and, therefore, are not subject to the passive loss limitations. The requirements for a real estate professional are stringent, and include a minimum of 750 hours of services in real property activities with material participation during the year.
Wages, income from businesses in which you materially participate, and income on investments, such as interest and dividends, are examples of nonpassive income.
Passive income, like nonpassive income, is taxable. But a passive loss may not be deducted against nonpassive income. If your rental income in prior years produced a net passive income, and you have no other passive income to offset the net loss of $20,000 on your rental property, you cannot take the deduction – at least, not this year.
The good news is that the deduction on the passive loss does not vanish – it is only suspended. This year’s passive loss can be used to reduce passive income in a future year when your rental property is again turning a profit. And, if you completely dispose of an asset providing passive income (e.g., sell your rental property), any losses suspended in this fashion can be deducted against nonpassive income in the year of disposition.
Active (Nonpassive) Participation – $25,000 Allowance
Active participation does not require devoting a large amount of time to your real estate rental activities. You actively participate if you make key management decisions – e.g., approving tenants, setting rental terms, or determining and approving appropriate capital expenditures. Note that active participation is different from material participation, mentioned above – material participation requires substantially greater participation than active participation.
If you (or your spouse, if you file jointly) actively participated $25,0001in passive losses relative to real estate rental activity against nonpassive income. However, the allowed deduction for passive losses is subject to phase-out, based upon your modified adjusted gross income (MAGI). Your MAGI is your adjusted gross income (AGI) with certain adjustments and deductions (such as real estate rental losses) added back in. If your MAGI is under $100,000, you can deduct the full allowance of $25,000. If your MAGI is over $100,000, the allowed deduction is reduced by 50% of your MAGI over $100,000 – i.e., if your MAGI is $125,000, your deduction will be reduced by 50% of your income above $100,000 – or $12,500. If your MAGI is $150,000, the deduction is completely phased out – but can be taken in a future year when you have a lower MAGI.
1 If you are married, and you and your spouse file separate tax returns, your allowance will be either $12,500 each (if you were living separately during the year), or $0 (if you were living together).
If you have real estate rentals, please call us to help identify how your individual situation might be impacted, and determine the best way to protect you and your assets against potentially adverse tax consequences, both for the short- and the long-term.
The information presented here is not specific to any individual’s personal circumstances.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.