Many real estate investors also work full-time jobs. Wouldn’t it be great to reduce that wage income (i.e., ordinary income) with rental losses?
It's not uncommon for a rental to produce a loss. This loss is usually a paper loss because of depreciation. In years when a rental produces a loss, can the investor use it to offset their ordinary income?
Some investors will find they can offset ordinary income with rental losses, while some can't. What is the difference between these two types of investors? That's what we're going to explore today.
In many cases, rental income is considered passive income. The loss is also passive if the rental didn't earn any income and took a loss. Passive losses can only offset passive income.
Passive income means that someone else is running the business that produces the income. In this case, the investor is just collecting income and not actively involved in the business. If this investment produces a loss, it cannot offset ordinary income. Ordinary income is considered active and can't be offset by passive losses.
But losses don't automatically qualify as passive if you own a rental property. If you are an active participant in the rental property, losses can fall under a special allowance, which does offset ordinary income.
This special allowance is up to $25,000 in losses. However, the investor must meet certain qualifications.
First, the investor must have active participation in the rental. This means 10% property ownership and having made significant management decisions. Significant means approving new tenants, approving expenditures, making repairs, advertising and showing the property, collecting rent, approving rental terms, and similar activities.
The above tasks don't have to be done by the investor. Someone can be hired to do these tasks. An example might be a property management company. Note that this differs from someone else running the business in which they make significant decisions about the business, not the investor.
The second qualification is meeting certain income restrictions. If the investor’s MAGI (modified adjusted gross income) is under $100,000 (not more than $50,000 if married filing separately), they can claim the full $25,000. The allowance begins to reduce from $100,000 to under $150,000. $150,000 and above do not qualify for the deduction.
As an example, an investor qualifies for the full $25,000 deduction. She makes $90,000 at her full-time job. After the deduction, the investor’s ordinary income is reduced to $65,000.
The loss is claimed on Schedule E. It goes on line 22. The loss originates from form 8582. The loss flows through to line 26 of Schedule E.
What happens if your MAGI is too high, you don’t own 10% of the property, or actively manage it? Does the loss go away?
No. The loss is still declared on Schedule E but doesn't flow down to line 26. It still appears on form 8582. The loss is held there until it can be used at a future date. Perhaps your passive income will be higher at a later date. In that case, the previous rental loss may be able to offset your passive income.
An exception to the rental loss is if you sell the property, you can use the rental loss, including any losses from previous years, assuming they apply to the same property.
Rental losses are different for real estate professionals (REPs). Note that for REPs, rental losses are not considered passive. In this case, all real estate losses can be used to offset other income.
Note that tax reporting for rental losses on form 8582 can get quite complex. It's best to work with a real estate accountant when filing tax returns involving rental properties.