Many real estate agents and brokers own rental properties or think about acquiring them. Sometimes, it works out amazingly, but other times, it leads to losses. These losses can lead to a rental property tax deduction on IRS Schedule E form. But, you need to understand the IRS restrictions on rental losses.
What is the rental property tax deduction?
Investing in real estate can lead to great returns but it doesn’t always lead to a profit. When that happens, you can take a rental property tax deduction. Like many investments, real estate may not always pay off during the first few years. The government wants to encourage investment, so it allows for write-offs with some strict limitations.
If you have rental property losses, you have plenty of company. IRS stats show that more than half of the 8.7 million taxpayers with rental income showed a loss. Some of this is due to the depreciation deduction allowed on the cost of the property.
What is a rental loss limitation?
You have a rental loss limitation if all the deductions from a rental property you own exceed the annual rent and other money you receive from the property. If you own multiple properties, combine the netted annual income or losses from each property to determine if you have profit or loss from all your rental activities for the year.
What tax form to use for rental property
You report your rental income and deductible expenses on IRS Schedule E. You can find a sample of this form on the IRS website.
Passive loss rules for rental loss limitation
Under the tax rules that apply to everybody except real estate professionals, rental losses are subject to the passive activity loss (the “PAL”) rules. Under PAL rules, all of your income and losses during the year fall into three separate categories:
- Active income or loss: Salary or wages you earn from a job. This could be income and deductions from a business you actively manage, self-employment income for personal services, Social Security benefits and more.
- Passive income or loss. Income and deductions from rental properties. Income and deductions from businesses in which you don’t materially participate (actively manage). Casualty losses from rental property are not passive losses.
- Portfolio income or loss. Income from investments, such as interest earned on savings, or dividends earned on stocks. Gains or losses from selling investments. Expenses paid for investments.
Passive loss limits
You cannot use passive losses to offset active or portfolio income. Nor can you use active or portfolio losses to offset passive income.
Passive income or loss includes profit or loss from real estate rentals. It also includes income from any business in which the taxpayer does not “materially participate.” The PAL rules apply to any ordinary rental of a house, duplex, condominium or apartment building.
This is true whether you rent the property month-to-month or have a lease. Although the rules don’t apply to short-term rentals, including most time-shares and many vacation homes, such losses get deducted from any income you earn during the year, provided that you actively manage the rental activity.
Because of the PAL rules, landlords ordinarily cannot deduct their rental losses from their active or portfolio income.
Example: John owns several rental properties. He lost $50,000 from his rentals and had $250,000 in active income from his business. He cannot deduct the $50,000 loss from his $250,000 income. This is because rental losses are passive losses.
Passive losses a landlord can’t deduct during the current year don’t disappear. You can use these suspended losses in any future year when you have enough passive income for them to offset.
When you sell a rental property, you may deduct your suspended losses from your profits to determine your taxable gain. You can apply this to any other income you earn during that year. You must keep track of suspended losses from each of your passive activities from year to year.
Yet, there is a limited exception to these rules: the $25,000 offset. If you qualify as real estate pro for tax purposes, you can avoid the restrictions of the PAL rules. Many real estate agents and brokers (but not all), can qualify as real estate professionals and avoid the PAL rules. This is one of the main tax advantages of being a real estate agent.
The $25,000 offset for rental property
Congress felt it was unfair to prevent landlords with moderate incomes from deducting their rental losses from their non-rental income. The government created a $25,000 offset to address this issue.
The $25,000 offset allows landlords to deduct up to $25,000 in rental losses from any non-passive income they earn during the year. The offset applies to all rental properties you may own. You don’t get a separate $25,000 for each property you own.
To qualify for the offset, two things must be true. You must actively participate in your rental activity income within the income limits. You must also be at least a 10 percent owner of the rental activity. Any individual who meets these requirements may use the $25,000 offset.
This is so whether he or she owns rental property alone or with one or more co-owners. General partners in partnerships that own rental property may use the exemption, but not limited partners. Corporations and trusts cannot use this offset.
Rental property tax deduction: What does actively participate mean?
You must actively participate in the running of your real estate to qualify for the $25,000 offset. This is very easy to do. It only requires you to be the person who makes the final decisions about rental property activity.
You don’t have to work any set number of hours to actively participate. If you manage the rentals yourself, this requirement shouldn’t be a problem. If your spouse performs these duties, you can still qualify for the offset.
Rental property tax deduction income limits: MAGI IRS
The $25,000 offset is intended for landlords who earn moderate incomes. If your modified adjusted gross income (MAGI) is less than $100,000, you’re entitled to the full $25,000 offset. It goes down as your MAGI increases and is eliminated completely once your modified adjusted gross income exceeds $150,000.
The offset amount is $25,000 for both single and married taxpayers filing joint returns. Married people who file separate tax returns and live separately for the entire year are each entitled to a $12,500 offset. Married people who file separate returns and live together anytime during the year get no offset at all.
The phaseout of the $25,000 offset works as follows. For every dollar your MAGI exceeds $100,000, you reduce your $25,000 offset by 50 cents.
For example, if your MAGI is $110,000, you reduce your offset by $5,000 (50 cents × $10,000 = $5,000). In that case, you could deduct only $20,000 in passive losses for the year ($25,000 – $5,000 = $20,000). Once your MAGI is $150,000 or more, your offset disappears entirely (50 cents × $50,000 = $25,000).
There are a few ways you might be able to reduce your MAGI if it exceeds $150,000. One way is to defer some of the compensation you’re owed to the following year. Another way is to make contributions to a Keogh plan, which you can deduct from your MAGI.
What isn’t included in your MAGI IRS?
Your MAGI consists of all your taxable income for the year, it doesn’t include taxable Social Security benefits, passive activity income or loss, minus the following expenses:
- Self-employed health insurance premiums paid during the year
- Contributions to SIMPLE retirement plans and Keogh retirement plans
- Alimony paid during the year
- Deductible tuition, fees, and student loan interest, and
- Penalties for early withdrawal of savings
- Ownership requirement
To qualify for the offset, you must own at least 10 percent of all interests in your real estate activity for the entire year. If you’re married, your spouse’s ownership interests are counted, too. You can determine the ownership percentage by the value of the property.
For example, if the rental property is worth $100,000, you must own at least $10,000. If you own more than one rental building, you must own 10 percent or more of each building.
This rule should not pose a problem for most small landlords. Yet, it eliminates most owners of vacation timeshares. A person who buys a timeshare usually obtains less than a 10 percent stake in the property. If you own a condominium, you need own only 10 percent of the value of your particular condominium unit, not of the entire building.