Why Are Rental Losses Disallowed?

Real estate investors know that income-generating investment properties aren’t always in the black. Losses can be common on rental properties, especially in years where you have to fund capital expenditures for major repairs or upgrades to the property, or if you have extended periods where your property sits vacant. 

The IRS allows property owners to claim a deduction for losses incurred by their rental properties, but there are some caveats. Let’s take a closer look.  

Tax Deductions For Passive Losses on Rental Properties 

Rental property owners are allowed to claim a $25,000 deduction for losses on their income tax returns, provided their modified adjusted gross income falls at or below $100,000. Losses are claimed on IRS Form 8582, Passive Activity Loss Limitations. 

For taxpayers reporting between $100,000 and $150,000 in gross adjusted income, the $25,000 deduction is phased out on a $1 basis for $2 you are above the $100,000 income threshold. Taxpayers reporting more than $150,000 in modified adjusted gross income are not allowed to claim the rental loss deduction. 

3 Important Considerations For Claiming the Rental Property Loss Deduction  

In addition to income limitations, you must meet the following conditions in order to claim the rental property loss deduction: 

1. Be a non-real estate professional 
2. Own at least 10 percent of the asset 
3. Demonstrate active management of the property 

The IRS views real estate professionals as taxpayers who spend more than 50 percent of their time engaged in business activities that involve real estate. “Activity” includes property management, acquisitions, construction and development, approving tenants and drawing up lease agreements, and real estate brokerage. Additionally, you must devote at least 750 working hours to these tasks to qualify for the real estate professional designation.1 If you do meet the criteria for the real estate professional designation, you can claim losses on investment properties without limits. 

No. 2 is self-explanatory – you have to hold at least a 10 percent stake in the asset in which you intend to claim the rental loss deduction. If you make decisions regarding the operation and management of the rental property, you qualify for No. 3; however, you can still meet this requirement if you have a third-party company managing your rental asset. 

If you don’t meet these criteria – or you simply make too much money in a given tax year – your rental losses may be disallowed. 

Rental income also is considered passive income as opposed to ordinary income you earn by working at a regular job. Passive losses typically can only offset passive income. For example, if you earned $20,000 on your stock market investments, but lost $20,000 on your rental property, you are at net zero for loss/gain for tax reporting purposes. The rental property loss deduction is an exception – the $25,000 can be used to offset ordinary income. However, you must ensure you can clearly demonstrate you meet the rules stipulated above.  

On a final note, if you incur more than $25,000 in rental property losses, you are allowed to carry those losses over into future tax years until the amount of loss is exhausted or you divest the asset. 

Closing Thoughts 

Investors who don’t qualify for the real estate professional designation can claim losses of up to $25,000 on their rental properties. Losses are income-dependent and are disallowed if you report more than $150,000 in modified gross adjusted income. 

Rental property loss deductions can be complicated. A prudent course of action would be to discuss your situation with a tax professional who has extensive experience with real property tax law.