Anyone who runs a business knows that certain expenses can be deducted from income, thereby reducing taxable income. However, things can get a bit murky if the business incurs an overall loss. This is especially true for those managing rentals. Let’s break down what happens when a real estate business has a loss for the year.
How Rental Losses Offset Income
Rental losses are considered passive income. We know what you’re thinking — managing rentals is anything but passive. However, that is how the IRS sees it. But don’t despair. There are a few ways that the IRS categorizes rental income.
- Passive: $0 loss deduction
- Active: $25,000 loss deduction
- Materials: Unlimited loss deduction
Here’s what each of those categories means, starting with passive. A passive activity is defined by Internal Revenue Code (“IRC”) § 469(c) and is one in which the taxpayer does not materially participate.
Passive losses must be matched with other passive income. Other forms of passive income are partnerships and S-corps.
For those taxpayers who have a passive loss that exceeds their passive income, they can carry forward the loss into future years where it can offset other passive income. The loss can be carried until the taxpayer disposes of their interest in the business.
As an example of matching passive losses to passive income is rental losses offsetting partnership income. If no passive loss is incurred in the current year, but one has been carried forward from previous years, it can be applied to current year passive income. Here’s what that might look like:
Rental income: $1000
Partnership income: $1000
= $2000
Carried forward passive loss: $1500
Net income: $500
Losses that are carried forward use form 8582 (Passive Activity Loss Limitations).
The next category we will explore is acting as an active participant. Landlords can deduct up to $25000 in rental losses if they actively participate in the business. Here’s what it means to be an active participant:
- Own 10% of the property
- Make significant decisions about property
- Modified Adjusted Gross Income (MAGI) of $100,000 or less
Taxpayers with a MAGI of over $100,000 can still take advantage of the deduction. However, it phases out between $100,000 – $150,000. More than $150,000 of income, and the deduction is not allowed.
The final category is real estate professionals. From the IRS's point of view, this isn’t someone with a real estate license. Instead, it is a person who materially participates in the activity.
The amount of loss that a real estate professional can use is unlimited.
To be considered a real estate professional, the taxpayer must spend at least 50% of their time in real property businesses, including at least 750 hours per year in the businesses.
Real property businesses include:
- Real property development or redevelopment
- Construction or reconstruction
- Acquisition
- Rental
- Operation or management
- Leasing
- Brokerage
As you can see, going from a passive participant to an active one requires considerably more work. But the rewards in loss deductions can be worth the effort.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
