As an owner of, or investor in rental property, you could be in a position to take advantage of many deductions in addition to potentially receiving cash flow. Prospective tax benefits are one reason why many investors turn to rental real estate ownership.
But what happens if you own a rental property – or properties – in which losses were incurred during a specific year? Can those losses on rental property carry forward?
The answer to the above depends on whether you’re an “active” participant (as in a full-time, employed real estate professional) or a “passive” one (a real estate investor). For purposes of this article, let’s assume that you are not a real estate professional who buys, sells or rents properties for a living. Rather, you’re an investor who likes the potential benefits that come from real estate ownership.
Before continuing, the main rule of thumb is that gains and losses associated with rental real estate are considered passive, with few exceptions. According to the IRS, “passive activities include trade or business activities in which you don’t materially participate.” The IRS includes real estate investment/ownership as a passive activity.
Because of this designation, any income generated from your rental real estate investments is considered passive income. Meanwhile, passive income refers to regular earnings received from a source other than an employer or contractor. Passive loss (or passive activity loss) occurs when a property’s operating expenses exceed the rental income.
Something else that’s important to know: Passive losses can only be used to offset passive income. As such, you may have a passive loss in a given year, but you might have to wait to carry that loss forward to the next year. In fact, the IRS points out that in most cases, passive losses exceeding passive income in a particular year are generally disallowed for that year.
Now let’s get back to the question of this article – whether losses on rental property can be carried forward. The answer is yes. You can carry forward those losses until the entire amount is used up.
But again, passive losses can only be used to offset against passive income. If, for example, you invest in rental real estate that generated $50,000 in losses in Year 1, but then created a profit of $100,000 the following year, you can use that $50,000 to reduce that income to $50,000. But that $50,000 can only be used to offset that passive income. You couldn’t use that $50,000 as a deduction against your entire income.
Understanding investment real estate income and expenses can be tricky. As such, when considering losses on your rental property, be sure to work with a professional tax advisor, who can help you through the process and answer any questions you might have.