Many people I speak to have questions regarding rental properties. Real estate has always been one of the most popular investment vehicles but with the myriad of rules surrounding rental real estate taxpayers are often confused by what they can and cannot do on their tax returns. This article offers a quick overview of the rules relating to rental real estate.
Background
The government generally only allows losses from “passive activities” to offset income from “passive activities”. Passive activities are any trade or business in which the taxpayer does not materially participate. Real estate rental is generally considered a passive activity and therefore if the general rule was followed, losses would only be allowed against income from passive activities. There are, however, two major exceptions to the general rule.
The two exceptions are for: (1) real estate professionals and (2) up to$25,00 of losses, subject to an Adjusted Gross Income (AGI) phase-out.
Real estate professional
A qualifying real estate professional is allowed to deduct losses from a rental property without limit. The losses while without limit would still have to be legitimate and expenses are subject to the same IRS definition of ordinary and necessary as all other businesses.
A taxpayer qualifies as a real estate professional if:
- More than half of the personal services that he performs during the year are performed in real property trades or businesses in which he/she materially participates; and
- he/she performs more than 750 hours of services during the year in real property trades or businesses in which he/she materially participates.
Real property generally refers to real estate.
$25,000 Allowance
Taxpayers qualifying for this treatment are allowed to deduct up to $25,000 of rental real estate losses against their ordinary income. In order to be eligible for this deduction the taxpayer must:
Actively participate in the rental activity. This means the taxpayer and/or spouse must own at least 10% of the rental property and must have substantial involvement in the management of the property. Active participation includes making management decisions and arranging for others to provide services. Examples of these decisions would include approving new tenants, deciding on rental terms and approving capital improvements or repair expenditures.
Taxpayers meeting the above criteria, as stated earlier, may deduct losses from rental activities up to $25,000 subject to an income phase-out. When a taxpayer’s AGI exceeds $100,000 the $25,000 is reduced by $1 for every $2 that the taxpayer’s income exceeds $100,000 until the entire loss is disallowed at AGI of $150,000. For taxpayers married and filing separately the limits are $12,500 (instead of $25,000) and phase-out begins at $50,000 (instead of $100,000).
Conclusion
This article discusses very general questions relating to rental real estate losses. Many situations are unique and as always if you’re not sure of the rules, then check with a tax professional.
