Understanding Passive Activity Limits and Passive Losses

Losses from rental property are considered passive losses and can generally offset passive income only (that is, income from other rental properties or another small business in which you do not materially participate, not including investments).

If these passive losses exceed your passive income, they are suspended and carried forward indefinitely until future years, when you either have passive income or sell a property at a gain.

Passive Activity Limits

Under the passive activity rules, you can deduct up to $25,000 in passive losses against your ordinary income (W-2 wages) if your modified adjusted gross income (MAGI) is $100,000 or less.
This deduction phases out $1 for every $2 of MAGI above $100,000 until $150,000 when it is completely phased out. These limits apply to both those filing single or married filing joint.

To take losses against your ordinary income, you must demonstrate active participation in the activity. This is less stringent than the material participation requirement for real estate professionals found below, and generally means you play a role in making management decisions of the business.

The Real Estate Professional Status

The real estate professional status historically allowed real estate investors to take unlimited rental losses against their ordinary income. However, there may be some limitations to this under the excess business loss limits found in The Tax Cuts and Jobs Act, but we won’t go into that here.
That said, simply meeting the above requirements will not necessarily allow you to deduct your rental losses against your ordinary income. You must also materially participate in the rental activity using the tests mentioned below.

In any year you elect to be treated as a real estate professional for tax purposes, you’ll need to keep a log of all hours worked within a real estate trade or business. It is also prudent to keep a log of hours spent in non-real estate trades or businesses, if applicable to ensure you’re spending more than half your total working time in a real estate trade or business.

If one spouse qualifies for the 750-hour test, both spouses’ time on the rental properties count toward material participation, and losses can then be taken against either spouse’s income. This is a great strategy for couples where one spouse works in a real estate trade or business, works only part-time, or not at all outside of your investment activities.

  1. You participated in the activity for more than 500 hours.
  2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
  3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
  4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
  5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether consecutive or not) of the 10 immediately preceding tax years.
  6. The activity is a personal service activity in which you materially participated for any 3 (whether consecutive or not) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
  7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

In order to qualify as a real estate professional, you must spend at least 750 hours in a real estate trade or business, and more than half your total working hours must be in a real estate trade or business. Due to these requirements, many investors who work a full-time job or full-time in another business that is not real estate-related will have a hard time qualifying as a real estate professional.

Be sure to consult with your tax professional to analyze your specific tax situation. At Taxperts, we can assess your small business structure and suggest ways to increase your savings. Check out our website, Facebook page, or LinkedIn page to learn more.

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