If a taxpayer fails to qualify as a real estate professional, losses from rental activities may still be deductible. While real estate professionals are afforded beneficial tax treatment enabling them to deduct losses from their real estate activities, real estate nonprofessionals taxpayers may still benefit.
Exception for rental real estate activities with active participation
If a taxpayer or spouse actively participated in a passive rental real estate activity, they may be able to deduct up to $25,000 of loss from the activity from nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities.
What determines active participation?
A taxpayer actively participated in a rental real estate activity if the taxpayer (and spouse) owned at least 10% of the rental property and made management decisions or arranged for others to provide services. Management decisions that may count as active participation include approving new tenants, deciding on rental terms, and approving expenditures.
Having a property manager will not prevent a taxpayer from meeting the active participation test. A taxpayer’s lack of participation in operations does not preclude qualification as an active participant, as long as the taxpayer is still involved in a significant sense. For example, the service vendors and approving tenants must be approved by the taxpayer before the property manager can commit to a service or lease contract. In other words, the taxpayer is still treated as actively participating if they are involved in meaningful management decisions regarding the rental property.
Maximum special allowance
The maximum special allowance is:
- $25,000 for single taxpayers and married taxpayers filing jointly
- $12,500 for married taxpayers who file separate returns
- $25,000 for a qualifying estate reduced by the special allowance for which the surviving spouse qualified
If the taxpayer’s modified adjusted gross income (MAGI) is $100,000 or less ($50,000 or less if married filing separately), they can deduct losses up to the amount specified above. If MAGI is more than $100,000 (more than $50,000 if married filing separately), the special allowance is limited to 50% of the difference between $150,000 ($75,000 if married filing separately and your MAGI). If MAGI is $150,000 or more ($75,000 if married filing separately), there is no special allowance.
Modified Adjust Gross Income (MAGI)
For purposes of calculating the special allowance for rental real estate activities, modified adjusted gross income is computed by deducting the following items from Adjusted Gross Income (AGI):
- Any passive loss or passive income
- Any rental losses (whether or not allowed by IRC § 469(c)(7))
- IRA, taxable social security
- One-half of self-employment tax
- Exclusion under 137 for adoption expenses
- Student loan interest
- Exclusion for income from US savings bonds (to pay higher education tuition and fees)
- Qualified tuition expenses (tax years 2002 and later)
- Tuition and fees deduction
- Any overall loss from a PTP (publicly traded partnership)
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