Rental Losses: Can I Deduct them?

Deductions for rental losses can be applied against either passive income (earned with minimal effort) or ordinary income (such as salaries and wages). The way you participate in rental activities significantly impacts how these losses can be deducted.

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February 2, 2023

When Rental losses can only offset passive income

Generally, if you are not a real estate professional, the IRS presumes your rental activity is passive. In this case, passive rental losses are deductible only up to the amount of your passive income. This means that any losses exceeding your passive income cannot offset ordinary income. However, you can carry over the losses to future tax years if you don’t have other passive income.

When rental losses can offset ordinary income

Active participation

The active participation test involves making management decisions, such as approving tenants or setting rental terms, while owning at least 10% of the property. If you meet this requirement, you may deduct up to $25,000 of rental losses against your ordinary income. However, if your MAGI exceeds $100,000, the IRS reduces your allowance by 50%. Your allowance is zero if your MAGI is $150,000 or more.

EXAMPLE:

Consider two married taxpayers who actively participate in managing their 15-unit rental property and incur a $45,000 loss. They also earn $5,000 in passive income from another rental. With a MAGI of $135,000, they can deduct $7,500 (50% of the difference between their MAGI and $150,000) against their ordinary income. The remaining $37,500 is a passive loss. They can offset $5,000 of that loss against other passive income in the current year and carry forward the remaining $32,500 into the following year.

Real estate professionals

You qualify as a real estate professional if you meet the following criteria:

More than 50% of the services you perform in all businesses are in real estate activities
You spend more than 750 hours in real property trades or businesses, and
You materially participate in each rental activity

To determine if you meet one of the seven tests for material participation, you can visit this link: Material Participation Tests.

Short-Term Rental (STR) Tax Loophole

A short-term rental (STR) is generally defined as a rental property with an average stay of seven days or less or 30 days or less and the owner provides similar services as a hotel. The STR loophole is if you materially participate in the STR activity (refer to the material participation test link above), your rental income is ordinary income. As a result, you can deduct your rental losses against ordinary income, such as W-2 income and K-1 income. This loophole is an advantage for STR owners who are not real estate professionals.

Maximizing your rental benefits

In summary, understanding how to navigate rental loss deductions can significantly impact your tax strategy. Whether you’re leveraging active participation or taking advantage of the short-term rental loophole, knowing the rules can lead to substantial savings. For personalized advice and to ensure you’re making the most of your deductions, consult with a tax professional who can guide you through the intricacies of rental property taxation.

References

“Publication 925 (2023), Passive Activity and at-Risk Rules.” Internal Revenue Service, https://www.irs.gov/publications/p925