By Susan Thomas, Senior Manager
In the first few years of owning a property, it is not uncommon for owners’ operating expenses to exceed annual rental income. Unfortunately, due to the nature of rental activities, the losses from the rental activity may be limited or deferred to future tax years, rather than fully deducted in the year of loss.
Rental real estate activities are defined as income received for the use of real property. In general, rental activities are deemed to be “passive” rather than “active”. “Passive” activities are those activities where an owner is deemed to have more of an investor role due to the owner’s lack of material participation in the activity. Owners that have material participation of “active” activities have generally incurred enough time and effort into the activities (under IRS regulations) to be treated as being actively involved in a trade or business.
Most “passive” losses can only be deducted against other activities that generate “passive” income. Any excess net “passive” losses are suspended and then carried over to future tax years to offset future “passive” net income. If the rental activity is disposed, any unused “passive” losses can be deducted in the year of disposal.
Passive Rental Activity Exceptions
There are certain rental activities that are not considered “passive” activities and any losses generated from these “active” activities can be fully deducted in the year of loss. Such rental activities include:
- Average use of rental property is seven days or less (beach house rental)
- Average use of rental property is thirty days or less and significant personal services are provided (hotel)
- Extraordinary personal services are provided (hospital)
- Rental of property is incidental compared to non-rental activity provided
- Property is available during defined business hours (golf course)
- Property is provided by a related owner to a partnership, S corporation or joint venture
Special Allowance for Rental Real Estate Activities with Active Participation
If an owner actively participates in the management decisions of a rental real estate activity and the owners’ modified adjusted gross income (MAGI) is $100,000 or below, an owner is allowed to deduct up to $25,000 of “passive” rental real estate losses against an owners’ other “active” income for a tax year, including wages. For every two dollars of MAGI in excess of $100,000, one dollar of rental loss is suspended from being deducted against current year “active” income. Owners with MAGI at $150,000 or more will have their entire rental losses suspended from being deducted against current year “active” income.
Real Estate Professional Exception
Owners who qualify as real estate professionals are not subject to the passive loss limitations and can deduct rental losses against other active income regardless of an owners’ MAGI. To qualify as a real estate professional an owner must:
- Have more than 50% of all personal services performed in all trades or businesses in a tax year be in real property trades or businesses which the owner materially participates
- Perform more than 750 hours of service in the tax year in real property trades or businesses which the owner materially participates
It is highly recommended that owners keep contemporaneous records to support their qualification as a real estate professional.
Self-Rented Properties
Property owners also have to be careful in regards to how they title their property in relation to any other owner-related businesses. If an owner rents a property to a business entity that the owner also materially participates, the rental income/loss falls under the self-rented property rules. Income from self-rented property is deemed to be “active” income for the owner and cannot be offset by other “passive” losses. A net loss from self-rented property is deemed to be “passive” losses and cannot be offset against other “active” income (unless an owner qualifies for the special allowance or as a real estate professional as detailed above).
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The information contained in the Knowledge Center is intended solely to provide general guidance on matters of interest for the personal use of the reader, who accepts full responsibility for its use. In no event will CST or its partners, employees or agents, be liable to you or anyone else for any decision made or action taken in reliance on the information in this Knowledge Center or for any consequential, special or similar damages, even if advised of the possibility of such damages.