Deducting Rental Losses

Rental losses are a common occurrence in the real estate industry. In fact, more than half of Schedule E forms filed each year report a loss. But despite their ubiquity, many landlords are unsure how to handle rental losses when tax season arrives. This article answers five key questions about commercial or residential rental property losses and their deductibility.

What Are Rental Losses?

A rental loss occurs when a property’s operating expenses exceed the income it generates over a given year. If a landlord owns multiple rental units, the total profit or loss is calculated by combining the income and expenses from all properties.

It is common for rental properties to operate at a loss, especially in their early years. Even experienced property owners with long-term rental units may report a loss due to depreciation deductions. Depreciation is a non-cash expense that allows property owners to account for wear and tear over time, which can lead to a net loss on tax returns even if the rental real estate generates positive cash flow. This scenario can be advantageous, as it reduces taxable income without affecting real cash flow.

Are Rental Losses Deductible?

In some cases, rental real estate losses can be deducted. If a landlord reports a rental loss, it can be carried forward and applied to future years when rental income becomes profitable. This means that losses today can help reduce taxable income in the future.

However, the IRS imposes limitations on rental loss deductions due to how rental income is classified.

What Are Passive Activities?

The IRS generally classifies rental income as passive income, meaning it is earned with minimal active participation or involvement. Examples of passive income include income from rental properties, book royalties, and investments in businesses where the taxpayer does not actively participate.

In contrast, active rental activities income includes wages, salaries, commissions, and other earnings from direct participation in a business. If a taxpayer receives a paycheck from an employee, that income is considered active.

This distinction is important because the IRS only allows passive losses to offset passive activity income. Rental losses cannot be used to offset active income, such as wages or salary, or portfolio income, such as dividends or capital gains.

Rental losses are not lost permanently. Passive activity rules clarify that if they cannot be deducted in the current year, they can be carried forward indefinitely until sufficient passive income is available to offset the losses. Additionally, if the property is sold at a loss, the accumulated losses may be fully deducted at that time.

Does Rental Income Ever Count as Active Income?

In some cases when determining material participation, rental income may be classified as active or nonpassive income. For this to happen, the taxpayer or their spouse must qualify as a real estate professional according to IRS guidelines.

To be classified as a real estate professional, a landlord must meet strict criteria, including spending more than 750 hours per year actively managing rental properties and ensuring that more than 50% of their total working hours are devoted to rental real estate activities. If a landlord holds a full-time job outside the real estate industry, qualifying as a real estate professional may be difficult.

Real estate professionals are exempt from the IRS’s passive loss rules and may deduct rental losses from other sources of active income.

Is There an Exemption from Passive Loss Rules?

The IRS provides an exception known as the real estate loss allowance, which allows some rental property owners to deduct a portion of their losses from active income made from trade or business activity.

To qualify for the real estate loss allowance:

• The landlord’s adjusted gross income (AGI) must be $100,000 or less
• The landlord must actively participate in managing the rental property
• The maximum allowable tax deduction is $25,000 per year

As income increases beyond $100,000, the deduction phases out. By the time a landlord’s AGI reaches $150,000, they no longer qualify for the allowance.

Additionally, rental property owners who structure their rental business as a pass-through entity, such as an LLC or sole proprietorship, may qualify for a 30% deduction under the Tax Cuts and Jobs Act. Consulting a tax advisor can help determine eligibility for this deduction.

Rental Losses and Your Rental Property Business

Rental losses are a reality for many rental property owners, but they are not necessarily a negative outcome at tax time. While the IRS’s passive loss rules limit immediate deductions, losses can be carried forward indefinitely until offset by passive income. In certain cases, rental income may qualify as active income, allowing for greater deductions. Landlords with an AGI below $150,000 may also benefit from the real estate loss allowance.

Ledgre offers tax reporting and expense tracking tools to help landlords maximize their deductions, simplify tax preparation, and understand the intricacies of their financial statements. By effectively managing rental losses and tax benefits, landlords can optimize their rental business and enhance long-term profitability.

Understanding how rental losses affect tax liability can help landlords make informed financial decisions. If you believe you qualify for the real estate professional designation or the real estate loss allowance, consulting a tax professional is advisable as you move forward.

 

Disclaimer: Ledgre does not provide tax or legal advice. All information and materials available on this site are for general informational purposes only. Contact a tax professional for advice with respect to a specific tax matter.