Having a rental property loss is not uncommon. In fact, most rental property owners report losses, especially within the first few years. However, if you are thinking of renting out a property because you want to offset your income with a rental property loss, there are a few things you should know.
Typically, when a taxpayer has a loss from a business they are able to offset their income from an employer or investments. Because of certain IRS rules, your rental property loss may only be able to be partially taken or in some cases not at all.
What’s Considered A Rental Property Loss?
Just like in any business, a rental property loss is when the expenses you incurred for renting the property exceed the amount of income you received for renting the property. This information is reported on Sch. E of your tax return. If you have multiple rental properties, your loss is calculated based on the total income and expenses for all rental properties.
Typical expenses for a rental property include:
- Cleaning and Maintenance
- Mortgage Interest
Rental property depreciation is often over looked as an expense and can cause the rental expenses to exceed the rental income, creating a loss.
Rental Property Loss = Passive Loss
According to Internal Revenue Code (“IRC”) § 469(c) a passive activity involves the conduct of any trade or business in which the taxpayer does not materially participate. Passive activities create passive income or losses. More importantly, passive losses can only offset passive income. Passive income generally only comes from two places, rental income or a business where the taxpayer doesn’t materially participate (work 750 hrs. or less each year). Rental losses will not offset income from your job, business you manage, or from stock investments.
So, do you just lose the loss? No. The loss is carried forward and applied to passive income in future years. For instance, in years 1-3 of renting out your property you accumulate $15,000 worth of losses. In year 4 you calculate your rental income and expenses, which show you actually made $5,000. You can actually use $5,000 of your previous years losses to offset the $5,000 you made in year 4.
A rental loss is carried forward indefinitely. The only way to get rid of your rental losses is by offsetting other passive income or by disposing your entire interest in the property from which the loss was generated.
Two Exceptions To The Passive Loss Rule
You may be asking yourself, “why rent a property if I’m not able to use the loss?” Well, there are two exceptions to the passive loss rule that may allow you to use the rental loss.
Modified Adjusted Gross Income
The first exception relates to your Modified Adjusted Gross Income (MAGI). If a taxpayer’s MAGI is $100,000 or less for the tax year, the taxpayer can deduct up to $25,000 of rental loss. This means you can apply your rental loss, up to $25,000, against any income, whether it is passive or not. However, you must have actively participated in the rental activity and have more than a 10% ownership interest in the property.
Taxpayers may also be able to take a reduced amount of the rental loss if their MAGI is more than $100,000. The $25,000 deduction allowance is phased out from $100,000 – $150,000. This means that the full $25,000 deduction allowance can be taken until your MAGI exceeds $100,000. As your MAGI nears $150,000, the $25,000 deduction allowance will be reduced. Once your MAGI reaches $150,000, the deduction allowance is no longer able to be taken.
Real Estate Professionals
The second exception is for those that qualify as a real estate professional. If the taxpayer or their spouse can be considered a real estate professional, there is no limit to the rental loss that can be taken and it can be applied to income other than passive income.
To be considered a real estate professional a taxpayer must spend a majority of their time (at least 50%) in real property business:
- Development or redevelopment
- Construction or reconstruction
- Acquisition or conversion
- Management or operation
They must also complete more than 750 hours of service per year in the real property business. If the taxpayer is an employee of a business that deals in real property business, that taxpayer must be at least a 5% owner in that business to be considered a real estate professional.
It is important to note that just because a taxpayer has their real estate license, it does not mean they are a real estate professional by IRS standards.
Finally, the real estate professional must materially participate in the rental property. If the taxpayer owns multiple properties, the taxpayer can elect to lump the properties together as one for the material participation requirements. The most common way to meet the material participation guideline is to work at least 500 hrs. a year at the activity.
Rental losses are a highly audited item on a tax return because more often than not a taxpayer is unable to take the rental loss. In the few situations where a taxpayer is able to take the rental loss, it is important to keep adequate records in case of an audit. Discussing your rental activities with a tax attorney can help you avoid future tax issues.