Passive Activity Losses from Rental Property

In these times of high stock prices and low bond yields, investors may be looking to rental real estate as alternative investments.  This asset class can pay off, in the right situation.  Before making a final decision, however, you should be aware of the tax implications, especially within the realm of passive activity loss rules.

Passive Activity Loss Rules – a set of IRS rules that prohibit the use of passive losses to offset earned or ordinary income. They prevent investors from deducting losses incurred from income-producing activities in which they are not materially involved.

Despite the language, these rules don’t apply to familiar investments that might seem passive, such as publicly-traded stocks or corporate/government bonds.  Rental property is deemed to be a passive activity, so the passive activity rules typically apply to individual investors acting as landlords.  Investing in real estate may deliver tax-deferred cash flow, but deducting losses can be challenging (different rules apply to “real estate professionals”, but strict standards and qualifications must be met).

Depreciating while appreciating

Investment property owners can take depreciation deductions, even if the property is increasing in value.  What’s more, this deduction requires no cash outlay.

Example 1:  Brett Parker buys investment property for $400,000 and collects $1,800 in monthly rent.  Thus, his annual income is $21,600.  His out-of-pocket expenses (interest, insurance, maintenance, etc.) total $12,000, so Brett realizes $9,600 in positive cash flow this year.

Suppose that Brett can claim $16,000 of depreciation deductions as well.  Now Brett reports $21,600 of income and $28,000 ($12,000 plus $16,000) of expenses from the property, for a net loss of $6,400.  Brett has reported a loss, so no income tax will be due on his rental income.  As such, this represents $9,600 of tax-free cash flow.  If he also can deduct the $6,400 loss from his other income, the tax treatment would be even better.

Loss lessons

In one scenario, Brett has another rental property that generates $7,500 of net income.  This passive activity income from Property B can be offset by the $6,400 loss from Property A, so Brett reports net taxable income of only $1,100.

However, many people won’t have passive activity income to offset, or their passive activity loss will be greater than that income.  In those cases, deducting the loss from other income is possible, if certain conditions are met.

For one, investors must play an active role in managing the property.  That doesn’t mean you’ll have to screen tenants or fix toilets.  You can hire a property manager but still play an active role, for this purpose, by making decisions involving the property’s operation or management.

Another condition of deducting losses from a rental property relates to your adjusted gross income (AGI).  A deduction as great as $25,000 per year is permitted, but the deduction phases out as your AGI climbs from $100,000 to $150,000.  That phaseout range is the same for taxpayers filing single and married filing jointly.

Example 2:  Joan, Janice, and Jennifer Smith are sisters; they each report a loss, after deducting depreciation, from rental property they own.  Joan’s AGI is $95,000, so she can deduct her rental property loss this year, up to the $25,000 maximum.  Janice’s AGI is $155,000, so she can’t deduct any loss from other income.  (However, because Janice reports a loss, she also won’t owe tax on the cash flow she receives.)

Suppose that Jennifer’s AGI is $130,000.  She is 60% ($30,000/$50,000) through the phaseout range, so she’ll lose 60% of her maximum loss deduction.  Jennifer can deduct rental property losses up to $10,000 (40% of the $25,000 maximum) but won’t be able to deduct larger losses.

Keep in mind that rental property losses you can’t deduct currently are not gone forever.  Unused losses add up, year after year, to offset future passive activity income.  If you have unused losses from prior years, you can use them when your future AGI permits.  Moreover, when you sell the property, you can use all of your banked losses then to reduce the tax you’ll owe on the sale.

Nevertheless, a tax deduction you can take immediately is more valuable than a deduction years in the future.  If your AGI is between $100,000 and $150,000, actions such as taking capital gains or converting a traditional IRA to a Roth IRA can raise your AGI and reduce current deductions for rental property losses.

Additional resources

Rental Real Estate Taxation by Dillon Wright

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