No one goes into owning real estate with the idea that they might take a loss on it. But it can happen—issues like depreciation, unexpected repairs, or a sudden bump in interest rates that might impact your mortgage.
If there is any upside to these losses, they can be used as tax deductions. You can also carry over, or carry forward, those losses indefinitely until the entire amount is used up.
But you can’t deduct those losses against just anything. Losses generated from rental properties are considered passive losses. As such, they can be deducted only against passive income.
Let’s explain passive income. This represents earnings you might receive that don’t come from a salary or wages. For example, the paycheck you receive for doing your job falls under the active income or earnings category. The rental income you receive from real estate ownership is considered passive income.
Taking this further, a passive loss is like it sounds – you have no material involvement in its occurrence. From an accounting point of view, passive losses on rental property occur when operating expenses on that property exceed rental income. The rule of thumb is that losses are suspended once they exceed passive income. They can be carried forward indefinitely into future years until they’ve been used up against future passive income.
There can be exceptions regarding the use of those passive losses against earnings. One is if you’re a qualified real estate professional and materially participate in rental operations. Under that scenario, it is possible to use passive losses against non-passive gains as long as:
The takeaway from the above is that once offset against passive income, the remaining passive loss amount can be carried forward to future years until used up. But to ensure that you’re following the process correctly (and you don’t end up with a note from the IRS claiming that you owe more taxes), be sure to follow the advice of a tax professional.