How can you deduct a loss from residential rental property you own and are renting out? Rental activities generally fall into the category of “passive” activities. This means that rental losses you incur can be deducted currently only against passive income and not against nonpassive income, such as your wages or investment income.
However, if you “actively participate” in the residential rental activity, you may be able to deduct a loss of up to $25,000 in a tax year against nonpassive income. You actively participate in the rental activity if you make key management decisions, such as approving new tenants, deciding on rental terms, approving capital expenditures. You also can show active participation by arranging for others to provide services. You need not have regular, continuous, and substantial involvement with the property. To satisfy the active participation test, you (together with your spouse) must own at least 10% of the rental property. Ownership as a limited partner doesn’t count.
If you meet the above tests, you can claim up to $25,000 in losses against nonpassive income ($12,500 if you’re married, file separately, and live apart from your spouse for the entire year). If you’re married, file separately and don’t live apart from your spouse for the entire year, you’re not eligible for this break at all.
If your adjusted gross income (AGI) is above $100,000, the $25,000 allowance amount is reduced by one-half the excess over $100,000. If you’re married, file separately and are eligible for the break, the $12,500 allowance amount is reduced by one-half the excess over $50,000. So, if your AGI is $150,000 or more ($75,000 or more for eligible married taxpayers who file separately), the allowance is reduced to zero. For these purposes, AGI is modified to some extent. For example, you ignore taxable social security income and the individual retirement account (IRA) deduction.
Example. Tina, who’s single, has adjusted gross income of $120,000. One-half of the $20,000 excess ($120,000 − $100,000) equals $10,000. So, Tina’s maximum loss allowance is reduced from $25,000 to $15,000.
Losses that aren’t allowed because of the amount limitations don’t just disappear. They are carried forward and can be deducted against nonpassive income in future years if you continue to actively participate in the rental real estate activity that generated the losses, subject to the $25,000 limit.
If you stop actively participating, the carried-forward losses are treated as passive activity losses that may only be used to offset passive activity income. To the extent your passive losses aren’t used up, you can deduct them in the tax year in which you dispose of your entire interest in the passive activity in a fully taxable transaction.
Written by: Becky Hines