Passive Loss Limitations in Rental Real Estate
If you think purchasing a rental property will make a great tax shelter, you may need to dig a little deeper into “passive loss limitations” and how they may affect your real estate investment.
First, consider that your rental property (like many other businesses) may not yield positive cash flow at first. Improvements to the property, tenant issues, and other expenses may end up putting you in the negative column. If you do end up with a rental loss, you are subject to complex IRS rules regarding how much of your rental losses you may deduct from other income you earn during the year.
Rental property ventures are treated differently than other business investments by the IRS. In the rental property investment realm, these are “passive loss” limitations.
What is a Passive Activity?
The IRS recognizes two types of passive activities:
- Rentals, including both equipment and rental real estate, regardless of the level of participation.
- Trade or businesses in which the taxpayer does not materially participate.
To that second point, you are considered to materially participate in an activity if you are involved in the operation of the activity on a regular, continuous, and substantial basis. Generally, real estate activities are passive activities even if you do materially participate. (There is an exception for real estate professionals, which I will discuss in a future blog.) Passive activity loss limitations are reported on your tax return using Form 8582. You can learn more here about passive and non-passive activities as defined by the IRS.
What Triggers Passive Loss Limitations?
Income tax losses from rental properties and limited partnership investments in which you do not materially participate are subject to the passive loss limitations. Generally, passive losses are limited to passive activity income. Any passive losses that have been disallowed are carried forward to the next taxable year.
Special Allowance for Rental Activities
There is a special $25,000 rental loss allowance but the real estate investor must meet two conditions to qualify, based on modified adjusted gross income (MAGI) and active participation in the activity:
1 – Taxpayers with MAGI of less than $100,000 may claim up to $25,000 in rental losses. For every dollar over $100,000 the allowance is reduced by 50%, and it is completely phased out/reduced to zero when the MAGI reaches $150,000.
2 – You must also actively participate in the running of your real estate. This is a simple level to attain. You do not have to work any set number of hours to actively participate, you simply have to be the final decision maker about approving tenants, arranging for repairs, setting rents, and other management tasks. If you manage your rentals yourself, you will likely satisfy this requirement.
Disposition of Interest
Time to sell? Generally, you may deduct the entire amount of previously disallowed passive activity losses in the year you dispose of your entire interest in the activity. If you dispose of your interest in a passive activity during a divorce or by gift, the suspended losses are not deductible and adjust the basis in the property.
If you are thinking of investing in rental property as a tax shelter, it is best to discuss this somewhat complex arrangement with a qualified tax or real estate professional, or certified public accountant with expertise in real estate transactions and accounting.