Passive Loss Rules & Real Estate 

Unique tax rules apply to investment real estate. The most troublesome of these are the so-called “passive loss” rules that restrict deductions for losses on rental properties. Investors who are familiar with the passive loss rules are at an advantage. They avoid the pitfalls and find ways to make the rules work for them.

THE RULES

Taxable income from rental real estate is considered “passive income.” Passive losses from rental real estate of other investments can offset this type of income.

Example: Mike Giovanni invested in a real estate limited partnership 20 years ago. The property has been successful, generating $35,000 worth of taxable income for Mike this year. Last year, Mike bought investment property, which he rents to tenants. His loss from this venture (including noncash deductions such as depreciation) is $28,000 this year.

Result: Mike can net his $28,000 passive loss against his $35,000 in passive income and pay tax on only $ 7,000 worth of taxable income from his old limited partnership.

Trap: Without passive income, passive losses are not necessarily deductible.

 Example: Mary Jones also has a $28,000 loss from investment property this year. However, she has no passive income from other ventures. Result: Her use of this loss will depend on her adjusted gross income (AGI).

The $100,000 question: Taxpayers with AGI of no more than $100,000 (without regard to net passive losses, IRA contributions, or taxable Social Security benefits) can deduct up to $25,000 worth of net passive losses per year.

 Required: You must own at least 10% of the property and you must actively participate in its management.

Loophole: You don’t have to do anything as obvious as visiting the property to collect monthly rents to qualify as an active manager. You can hire a management company if you wish, but you must take part in decisions such as tenant selection and setting rent levels to qualify for this passive loss deduction. For married couples, either spouse may play the active role.

Trap: If your AGI is more than $100,000 in a given year, though, the maximum amount of net passive losses you can deduct that year is gradually reduced, phasing out altogether at $150,000 of AGI.

Examples: Mary Jones has a $28,000 passive loss, but her AGI (as defined above) is $125,000. She is halfway through the $100,000 to $150,000 phase-out range, so she can deduct half the $25,000 maximum - $12,500. Next year, Mary’s AGI jumps to $156,000. Now, she’s over the $150,000 ceiling, so she can deduct no losses at all from her rental real estate investment that year.

Carryforwards: What happens to any losses that can’t be deducted immediately because of the passive loss rules? They can be carried forward indefinitely to future years. When you sell the property or otherwise exit from the venture, unused losses can reduce your tax bill that year, regardless of passive income or your AGI.

Tactic: If you can’t use your passive losses from rental real estate, keep track. They’ll prove to be valuable, even many years later.

Real Estate Professionals

As you can see, the passive loss rules make life difficult for high-income individuals and couples. You might have a series of passive losses that you can’t deduct for many years, as long as you hold on to your rental property.

Loophole: If you or your spouse can qualify as a real estate professional, the passive loss rules don’t apply. You’ll be able to deduct any and all losses from your rental property against your other income. To qualify as a real estate professional, two criteria must be met…

The 50% test: At least half of your working hours during the year must be in some real estate-related activity. Examples: Construction, rental, brokerage.

Material participation: Not only do you have to spend at least half of your work hours in real estate to meet the 50% test, you also must “materially participate” in the activities used to get you to the 50% level. To materially participate, you can work at a particular activity more than 500 hours a year. Otherwise, you can work at that activity more that 100 hours a year, while no one else works at them more that you do, or you can do virtually all the work required in that activity.

The 750-hour test: You must work at least 750 hours per year in you r real estate activities. A log you keep can demonstrate your time commitment.

Example: Ted Brown is a retiree who spends 800 hours a year (just over 15 hours a week) on a small apartment building he owns and 700 hours a year as a software consultant. His AGI is $160,000 a year. Ted meets the 50% and 750-hour tests and thus qualifies as a real estate professional, so he can deduct any and all losses from his apartment building against ordinary income. This deduction reduces Ted’s taxable income and his tax bill.

Aggregation Alternative

In the above example, Ted Brown has one rental property, on which he spends 800 hours a year, so he qualifies as a real estate professional. What would happen, though, if Ted divided his 800 hours among two or more rental properties?

Trap: Each property is a separate activity under the Tax Code. If Ted does not meet the 750-hour requirement for each property, he won’t be considered a real estate professional.

Strategy: You can elect to treat all your rental properties as one activity for this purpose. If the total puts you over the 750-hour mark, you can qualify for the tax break.

How to do it: File a statement with your income tax return the first year that you qualify as a real estate professional. The statement should say: “In accordance with Section 1.469-9(g)(3), I state that I am a qualifying real estate professional under IRC Section 469(c)(7), and elect under IRC Section 469(c)(7)(A) to treat all interests in real estate as a single rental real estate activity.”