Owning commercial or residential rental real estate constitutes a common investment for many Americans. Most rental properties produce net positive cash flow. Even with a net positive cash flow, however, a loss can occur. And in some cases, this loss can’t be deducted in calculating income tax liability.
In general, rental activity falls into the category of a “passive” activity. This means the rental losses you incur in a tax year can only be deducted against passive income and not such nonpassive income as wages or investment income.
In situations in which you “actively participate” in the rental activity and your adjusted gross income (AGI) doesn’t exceed specified levels, you could be able to deduct against nonpassive income a loss of up to $25,000 per tax year.
So what’s active participation? It means you’re involved in managing the rental property and you or your spouse owned at least 10 percent of the rental property at all times during the tax year. Ownership as a limited partner won’t meet the requirement. Active participation can be demonstrated by making such key management decisions as approving a new tenant, determining rental terms or approving a capital expenditure or repair. The good news is you don’t have to complete any repairs yourself to show active participation. You can arrange for others to provide the service and still be an active participant.
The active participation standard is a lower standard of involvement than material participation and is intended to be less stringent. To satisfy the active participation requirement, you don’t have to demonstrate regular, continuous and substantial involvement with the property.
In situations in which the above levels of participation are satisfied, you can claim up to $25,000 in losses against nonpassive income — $12,500 if you’re married, file separately and live apart from your spouse for the entire year. You’re not eligible for this break at all if you are married, file separately and do not live apart from your spouse for the entire year.
The $25,000 allowance is phased out for taxpayers with higher adjusted gross incomes. For taxpayers with an AGI above $100,000, the $25,000 allowance amount is reduced by 50 percent of the excess over $100,000. If you’re married, file separately and are eligible for the break, the $12,500 allowance amount is reduced by half the excess over $50,000. Accordingly, as a taxpayer’s modified AGI increases from $100,000 to $150,000, the $25,000 allowance decreases from $25,000 to zero. Adjusted gross income is modified to some extent for the purposes of calculating the AGI phaseout. For example, you ignore taxable Social Security income, the Individual Retirement Account deduction and deduction for
self-employment (SE) tax. Consult with your tax advisor to learn more on how the modified AGI is calculated.
As an example, a married filing jointly taxpayer with a modified adjusted gross income of $120,000 will have a maximum loss allowance of $15,000 — 50 percent of the $20,000 excess, that is $120,000 minus $100,000, equals $10,000. So, the taxpayer’s maximum loss allowance will be $15,000. The maximum loss allowance of $25,000 is reduced by the $10,000 phaseout.
So what happens to losses that aren’t allowed to be deducted in a tax year because of the phaseout of the allowance? There’s good news: The loss doesn’t just disappear. It’s carried forward and can be deducted against nonpassive income in future years as long as you continue to actively participate in the rental real estate activity that generated the losses, subject to the $25,000 limit.
What happens if you stop participating in management decisions in the rental real estate activity? The carried-forward losses are treated as passive activity losses that only may be used to offset passive activity income. To the extent your passive losses aren’t used up, you can deduct them in the tax year in which you dispose of your entire interest in the passive activity in a fully taxable transaction.
These rules can be complicated and extensive. To learn more about how these rules apply to your specific situation, consult with your tax advisor.