The rental of real estate is, by definition, considered a passive activity. Passive income is taxed like other income, and no special reporting is required. Passive losses, however, are typically limited and allowed only to the extent of passive income. That means if you have passive losses, but no passive income, the loss is not allowed.
Because of these passive loss rules, multiple years of rental losses may catch the attention of the IRS. That doesn’t mean the losses aren’t allowed, but if you are reporting losses, make sure you are claiming them appropriately. There are exceptions to the limitations, and rental real estate losses can be allowed.
A special allowance for up to $25,000 in passive losses from rental real estate is permitted to be deducted against nonpassive income. To qualify you must be actively involved in your rental real estate. Aside from the requirement to own at least 10% of the property, being actively involved means you must have substantial involvement in managing the rental, such as approving new tenants, determining rental terms, approving expenses, etc.
The special allowance for active participation is, unfortunately, limited. If your Adjusted Gross Income (AGI) exceeds $100,000, the allowance is phased out at a 50% rate, up to $150,000. In other words, the excess over $100,000 is multiplied by 50% and subtracted from $25,000 to determine the allowance. If your AGI is $110,000, the $10,000 in excess of the limit means the $25,000 is reduced by $5,000, so only $20,000 is permitted as a deduction. At $150,000 the entire $25,000 has been phased out. Any losses disallowed are carried forward to future years.
Another exception to the passive loss rules for rental real estate applies to real estate professionals. To be a real estate professional means more than having a real estate license. There are strict rules to qualify as a real estate professional, the explanation of which are beyond the scope of this brief article.
The IRS knows people don’t keep renting a house to lose money. Renting a property at discounted rates to family members is also cause for suspicion when losses are reported. Make sure rents are at fair market value, and keep records to document rent income and various expenses. Simple steps will help make sure any investigations will be resolved in your favor.
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