Reducing Tax on Rental Income: The Role of Passive Losses

As a periodontist, I was never taught anything about money, much less real estate or taxes, in school.

The fault is mine for not seeking this information earlier in my career.

It’s amazing that once you learn how to use the tax code correctly, it can change your financial outlook.

Speaking of taxes, one of the more confusing topics that my Passive Investor Circle members have involves the role of passive losses in real estate.

Let me explain.

The IRS usually classifies income from rental properties as passive. As a landlord, there are certain limits on how much you can deduct in losses from these properties. If you’re actively involved and recognized as a real estate professional, you might be able to deduct your real estate expenses from your regular income. In my case, dental income.

Sounds pretty good, right?

Want to learn more about qualifying as a real estate professional? Check out this video:

This means you can offset it against money you make from other sources. But, if your income is only from passive sources like rentals, you can only deduct losses from these same sources. Also, there’s a cap on how much you can deduct.

You might think you wouldn’t fall under these passive loss rules because you actively manage your properties. You might feel managing your rentals is hardly a passive task, so you should qualify as actively involved.

However, our friends over at the IRS often view rental income as passive regardless of your involvement, meaning these limits would still apply to you.

In this article, we’ll explain how you can determine your status in real estate activities, understand the rules around passive income, and learn about the limitations of deducting passive losses.

Key Takeaways

• Passive losses from real estate investments are tied to IRS regulations and can impact your tax deductions.
• You may use such losses to offset passive income, with potential limitations based on income and real estate professional status.
• Navigating these rules requires staying informed on IRS guidelines, participation tests, and proper reporting methods for deductions.

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What Is Passive Income?

Before we get into passive losses, let’s define passive income.

Passive income includes income from trade or business activities in which the taxpayer does not materially participate and income from rental activities, regardless of participation level.

Examples include:

• Real estate rental income
• Business income from a limited partnership
• Dividends, interest, and royalties from investments

What Are Passive Losses in Real Estate?

Passive losses in real estate are when your total expenses from a passive activity exceed the income you generate from it. According to the Internal Revenue Service (IRS), these activities often include rental properties where you do not actively participate in the daily management or operations.

Most of the time, busy W2 earners hire property managers to handle the day-to-day operations of their real estate.

Passive Activity Loss Rules

Passive Activity Loss Rules set by the IRS stipulate that you can usually offset passive losses only with passive income. This means that losses from rental properties can neutralize earnings from other rental activities or businesses where you have a non-material participation.

One of the issues that confuses people investing in real estate syndications is that they can use passive losses to offset their active income. This is why many doctors initially want to invest in syndications, as they think it can offset their W2 income.

Unfortunately, it doesn’t work like this.

As noted above, passive losses can only offset passive income. 

Keep in mind that:

• Rental Real Estate Professionals may have different stipulations. If you qualify as a professional, losses may be treated as non-passive and could offset other types of income.

Remember:

• Tax Consequences: If passive losses exceed passive income, the excess loss carries forward to subsequent years, potentially offsetting future passive income.

Determining Real Estate Professional Status (REPS)

In navigating the tax implications of real estate activities, it’s important to understand whether you qualify as a real estate professional.

If you do, this can be a game changer to your financial future.

Why? This designation impacts your ability to deduct losses without being restricted by passive activity limitations.

Qualification Criteria

To attain real estate professional status, you must meet two key criteria:

• Engage in real property trade or business activities regularly, continuously, and substantially.
• Not be engaged in these activities as an investor who does not materially participate.

Real property trade or business activities include development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.

The 750 Hour Requirement

One of the main requirements for qualifying for REPS status is meeting the 750-hour threshold. Annually, you must devote more than 750 hours of services (~15 hours/week) during the tax year to the real property trade or business activities in which you materially participate.

Also, the hours you spend on real property trades or businesses must be more than the hours spent on personal services in other trades or businesses.

Material Participation Tests

Material participation means being involved in the operation of the activity on a regular, continuous, and substantial basis. The IRS has defined seven tests for material participation:

Criteria for Material Participation	Description
500 Hours	Participation in the activity for more than 500 hours during the tax year.
Substantial Participation	Your participation is substantially all the participation in the activity of all individuals for the tax year.
100 Hours and as Much as Any Other Individual	Participation of at least 100 hours during the tax year, and no one else participates more than you.
Significant Participation Activity	Participation in several activities for more than 100 hours each, with total participation exceeding 500 hours during the tax year.
Material Participation in Five of the Past Ten Tax Years	For personal service activities, material participation in the activity for any five tax years during the preceding ten tax years.
Material Participation in Any Three Prior Tax Years	For nonpersonal service activities, material participation for any three previous years.
Based on Facts and Circumstances	Participation based on all facts and circumstances, on a regular, continuous, and substantial basis.

Successfully proving REPS status exempts you from passive loss rules that typically limit deductions of rental losses.

As a qualifying real estate professional, your losses from rental real estate activities may not be passive. They could be fully deductible against nonpassive income if you materially participate in the activity.

$25,000 Rental Real Estate Exception

If you can demonstrate active participation in your rental activity, you may qualify for the $25,000 rental real estate exception. This special allowance lets you deduct up to $25,000 in passive rental real estate losses yearly against non-passive income.

But the bad news for the doctor, dentist or other high-income professional: This exception phases out at a rate of $0.50 on the dollar for adjusted gross incomes between $100,000 and $150,000, eliminating the allowance for incomes above $150,000.

Related article: Material Participation: A Game Changer for Your Business

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IRS Guidelines and Reporting

The IRS has specific guidelines for reporting income and losses from passive activities, including real estate. Understanding and following these rules will ensure you correctly handle your tax obligations.

Form 8582: Passive Activity Loss Limitations

You will use Form 8582 to report passive losses and determine the allowable amount that can be deducted. Taxpayers are subject to passive activity loss limitations, meaning that losses from passive activities can generally only be offset against income from passive activities.

Here’s a condensed view of how to approach Form 8582:

• Step 1: Identify Activities – List out all your passive activities.
• Step 2: Calculate Income/Losses – Figure the income or loss for each one.
• Step 3: Apply Limitations – Use Form 8582 to apply the at-risk and passive activity loss rules.

Proper Documentation Methods

As you can imagine, maintaining accurate records is essential for supporting the income, deductions, credits, and losses from passive activities. It’s your responsibility to keep detailed accounting logs that include:

• Dates and details of all transactions
• Proof of participation in the activity for material participation standards
• Service and expense invoices, receipts, and bank statements

Sufficient documentation is critical should your return be selected for an audit by the IRS.

Tax Reporting for Real Estate Activities

Real estate professionals need to pay special attention to how they report activities to the IRS. If you meet the criteria of a real estate professional, here’s what you should do:

1. Report Nonpassive Income/Losses: For income or losses from material participation in real estate, report these as nonpassive on Schedule E (Form 1040).

2. Understand Special Rules: Be aware of special rules for passive activity held through Publicly Traded Partnerships (PTP).

By accurately following these reporting practices, you’ll help ensure that you comply with IRS regulations.

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How To Calculate and Apply Deductions

Your ability to maximize tax savings hinges on understanding how to calculate and apply deductible expenses, accurately compute depreciation, and manage carry forwards of any unused losses.

Let’s break down each of these sections…

#1. What Are Deductible Rental Real Estate Expenses?

You can deduct all ordinary and necessary expenses related to managing, conserving, and maintaining your rental property. These expenses may include:

• Mortgage interest
• Property tax
• Operating expenses
• Repairs and maintenance
• Utilities
• Insurance

Make sure to keep meticulous records of these expenditures, as they directly impact the total deduction you can claim against your rental income.

#2. Depreciation Calculation

Depreciation allows you to distribute the cost of your property over its useful life as outlined by the IRS. To calculate depreciation on residential rental property:

1. Determine your property’s basis, which is generally its cost plus any improvements.
2. Subtract the value of the land from the total cost since land is not depreciable.
3. Divide the adjusted basis of the property by the recovery period of 27.5 years for residential real estate to find the annual depreciation expense.

This annual expense is a non-cash deduction that you claim each year on your tax return.

Related video: 

#3. Carry Forward of Unused Losses

If you have passive losses that exceed your rental income, you can’t use the excess losses to offset other non-passive income in the current year. However, you can carry forward these suspended losses to future tax years. These carried forward losses can be used:

• To offset future passive income from the same property or other passive activities
• Fully when you dispose of the property in a taxable transaction to an unrelated party

Frequently Asked Questions

How do passive activity loss rules affect real estate investors for tax purposes?

The passive activity loss rules are particularly relevant for real estate investors when it comes to tax purposes. Generally, these rules limit the ability to deduct losses from passive activities, which include most rental real estate activities. For real estate investors, losses that are not allowed in the current year under these rules can be carried forward to future years. This means that if you incur a net loss in your real estate business activity, you may not be able to use that loss to offset other types of income, such as ordinary income or portfolio income, in the current tax year. However, unused losses can be carried forward and applied against passive income in future years. Additionally, real estate professionals who meet certain criteria for active participation and involvement in management decisions might be exempt from some of these restrictions.

How do passive activity loss limitations affect the deductibility of real estate losses?

Your ability to deduct losses from passive real estate activities is subject to specific IRS rules. For example, if your modified adjusted gross income (MAGI) is $100,000 or less, you may deduct up to $25,000 in passive losses. This deduction starts to phase out if your MAGI exceeds $100,000 and is completely phased out at $150,000.

In what circumstances can a real estate professional deduct passive losses?

Real estate professionals who actively participate in their real estate business can potentially treat losses from rental real estate as non-passive. This classification allows them to deduct ordinary losses against other types of income such as wages, dividends, and non-passive income, subject to certain conditions.

What are the rules for carrying over passive losses from rental properties?

If you cannot deduct your passive activity losses in the current year because they exceed your passive income, you are allowed to carry forward disallowed passive losses to the next taxable year. These losses will remain as passive and can only offset future passive income.

Can passive losses be used to offset capital gains?

Generally, passive losses from real estate are not allowed to be used to offset capital gains. They can only offset passive income. However, there may be exceptions if you dispose of your entire interest in a passive activity in a fully taxable transaction to an unrelated party.

What amount of loss is deductible from rental property on a tax return?

Up to $25,000 in losses may be deductible if you actively participate in rental property and your MAGI is below $100,000. This deduction is limited beyond this income threshold and not allowed once MAGI reaches $150,000. The full amount of losses can be deducted if you are a real estate professional who materially participates in the activity.

What are some examples of passive activities in real estate?

Passive activities in real estate typically include rental properties where you do not materially participate in the management or operation on a regular, continuous, and substantial basis. Examples are owning a property that is managed by a separate property management company or limited partnership interests in real estate investments.