Many of our clients have rental properties they own on the side in addition to their regular businesses. Come tax time, some of them want to know: “Can I deduct losses from my rental property against my ordinary income?” Unfortunately, this is usually not permitted – but there are some exceptions. Here are how the rules work.
Passive vs. Active Income
For tax purposes, the IRS makes a distinction between passive income and nonpassive (aka active income). Under passive activity loss (PAL) rules, you are not allowed to deduct passive losses against your active income.
So what is passive income and what isn’t? Passive income usually refers to income from activities in which you do not “materially participate.”
Nonpassive income is the opposite and often includes:
- salaries
- professional fees
- income from a business in which you do materially participate
The IRS defines rental real estate activities as passive activities, even if the owner “materially participates” in their management and operations. As a result, if you have tax losses from rental realty, you generally can’t deduct them against your nonpassive income right away.
Exceptions to the Rule
There are a few exceptions to the rule. For example:
- If your modified adjusted gross income is less than $100,000 a year and you “materially participate” in the passive income activity, then you qualify for deductions up to $25,000. This maximum deduction of $25,000 is phased-out as income increases, and is completely eliminated once modified adjusted gross income exceeds $150,000.
- If you qualify as a real estate professional, your rental income is not automatically considered passive income, and in most cases you can deduct losses against your other nonpassive income.
Real Estate Rules are Complex
For tax purposes, there are several litmus tests that determine whether you officially qualify as a real estate professional. The tests are applied on an annual basis and are stringent.
Although your rental losses may not be of any tax benefit to you in the current year, the passive losses are carried forward until they can either be offset by passive income, or when the property is sold.
Want to Know More About Rental Property Deductions?
Particularly if you have multiple rental properties, we highly recommend you speak with a tax professional about how to treat deductions. PDM’s tax experts can help advise you on the best course of action. Contact us; with our years of technical experience, advanced training, and cutting edge technology, we are your financial partner.