Deductibility of Real Estate Rental Losses

Passive losses from activities in which the taxpayer did not materially participate usually cannot be deducted from nonpassive income — active or portfolio income. Many taxpayers, who are not real estate professionals or active participants in the real estate business, supplement their income with real estate rentals. As a passive loss, rental losses would not be deductible against nonpassive income, but there is an exception for rental income, where up to $25,000 of rental losses can be deducted against active or portfolio income.

Although the taxpayer does not have to satisfy the material participation tests that differentiates active from passive activities, they do have to satisfy active participation tests to qualify for the $25,000 exception. The taxpayer must satisfy at least some of the following:

• The taxpayer should make management decisions, including:
  • capital or repair decisions;
  • recruit and select new tenants, and
  • specify rental contract terms.
• the taxpayer must have at least 10% interest in the property.

Although the active participation tests do not exclude using a property manager, the taxpayer does have to do more than simply accept a manager's decisions to be considered an active participant.

The $25,000 allowance applies only to real estate rentals — not for the rental of personal property. Furthermore, the real estate rentals cannot include the type of rentals that the tax code specifies as active businesses, such as renting out a vacation home. Although trusts do not qualify for the $25,000 allowance, an estate may if the decedent actively participated in the operation, in which case the estate is treated as an active participant for 2 years after the death of the decedent.

Any loss from real estate rental activity must first be subtracted from other passive income. Only then can losses of up to $25,000 be used to offset active or portfolio income. Any unused rental losses that qualify for the $25,000 allowance that cannot be offset by any income can be carried backward or forward as abusiness net operating loss as long as the taxpayer maintains active participation. The $25,000 allowance is figured on Schedule E, Supplemental Income and Losses.

The $25,000 non-passive deduction allowance is reduced by 50% of the taxpayer's modified adjusted gross income (MAGI) that exceeds $100,000. Hence, it is phased out completely at $150,000. A married couple filing separately is not eligible for the $25,000 loss allowance unless they lived apart during the entire tax year, in which case, each spouse is entitled to half of the allowance: $12,500, but this amount is phased out by 50% of the MAGI over $50,000. Hence, the allowance phases out completely when the taxpayer's MAGI equals $75,000 or more.