You might have opted to own rental real estate as an investment for its potential cash flow along with possible deductions and expenses. In most cases, owning real estate for business or investment purposes is considered a passive activity. In other words, you’re not actively involved in the generation of material gain through that ownership.
Because of this, any potential profit you earn is considered passive. By the same token, any losses generated through depreciation or operating expenses are considered passive losses, or in some cases, passive activity losses.
In most cases, passive losses can only be used against passive income. If passive losses exceed passive income, they’re carried forward to other tax years until either you sell the property or that property generates passive income higher than the loss.
But there is a situation in which you could deduct up to $25,000 in passive losses against ordinary income. But this is only allowed in certain situations.
According to the IRS, a passive activity loss for a particular tax year is defined as “the excess of your passive activity deductions over the sum of passive activity gross income and net active income.”
But there are certain situations in which that “passive” ownership could be “active.” Doing so requires you to materially participate in rental activities including the following:
In other words, if you own real estate for trade or investment but are retired or have another job, you’ll have some trouble deducting the above-mentioned $25,000 against ordinary income. Even if you are a hands-on landlord, it doesn’t matter.
The idea here is that you need to participate in that activity on a regular or continual basis.
But let’s say that you do meet the tests above. In this case, there’s more to using that $25,000 passive loss than simply mentioning it on your tax return. You also need to pay attention to your modified adjusted gross income, or MAGI. Specifically, if your MAGI is $100,000 or less, you could deduct up to $25,000 against ordinary income (W-2 salaries or wages).
Getting back to the IRS definition, your MAGI consists of your adjusted gross income – or AGI – before including any student loan interest deductions. Taking this one step further, your AGI is defined as gross income less adjustments to that income. Those adjustments can include educator expenses, student loan interests, contributions to a retirement account, or alimony payments.
So, what happens if your MAGI is above $100,000? For every $2 that your MAGI increases above $100,000, that $25,000 is phased out. So once your MAGI exceeds $150,000 the passive loss allowance will be completely phased out.
Taking that $25,000 passive loss deduction means that 1) you’re actively involved in the acquisition, sale, and management of real estate, and 2) your MAGI doesn’t exceed $100,000. Because this can be a complex topic, it’s always a good idea to check with your tax advisor to determine what can be deducted.