Deducting Rental Property Losses: Not So Simple!

Just when you thought that being a landlord couldn’t get any more complicated, you’ve heard that you might not be able to deduct your rental property losses on your tax return. What??

Many landlords experience rental property losses, especially right after they buy the property, when they have lots of costly repairs, or when their rental unit is vacant for an extended period. If this sounds like you, don’t despair. You’re not alone.

Generally, a small business owner can deduct losses from various types of income they or their spouse (on a joint return) have earned, such as wages or investment income. But the Internal Revenue Service (IRS) doesn’t treat rental property losses in the same way that they treat other business losses.

Where to Report Your Rental Property Losses

IRS Schedule E, Supplemental Income and Loss, is where you report income and deductible expenses from your rental property.

If operating expenditures for your rental property total more than the income it brings in, that is a rental property loss. If you are the owner of more than one property, you would combine the income and expenses for all properties to see what your annual gain (or loss) was from all of your properties for the tax year.

It is common for landlords to show a loss on their tax returns, even though their income might exceed their expenses. The reason? Depreciation. Landlords get to deduct (depreciate) some of their rental property cost annually in addition to their operating expenses.

It’s All About Passive Income and Passive Losses

The IRS considers rental property losses “passive losses”. Passive losses counterbalance passive income. Passive losses can’t be subtracted from what the IRS considers active income such as earned wages, a business that you actively manage, or investments like stocks or mutual funds.

The IRS considers “passive income” to be income from your rental property and other activities in which you don’t “materially participate” for a threshold amount of hours a year – usually at least 750 hours.

If you don’t have passive income, rental property losses can’t be applied until you either have excess future passive income in a tax year or an unrelated buyer purchases the property.

But wait!! There are EXCEPTIONS.

For every rule, there is an exception. These are the exceptions to the passive loss rule.

Real estate professionals – Landlords who meet the IRS qualifications to be considered  real estate professionals can subtract their losses from any type of income – both passive and non-passive. You or your spouse (on a joint tax return) have to devote more than half of your working hours during the year to real property businesses. There is a requirement of at least 750 hours needed to qualify for this exception.

Also, you have to “materially participate” in your own rental property business, actively working at it for at least 500 hours during the year. If you are the owner of two or more rental properties, the IRS mandates that you materially participate for the minimum number of hours at each property unless you notify the IRS that you are electing to combine your properties and consider them together as a single activity.

Income limits – Landlords with modified adjusted gross incomes (MAGI) of $100,000 or less can subtract rental property losses up to $25,000 each year if they “actively participate” in the rental business. The landlord has to own more than 10% interest in the rental property, and make substantial management decisions about it.

High-income landlords don’t qualify for this exemption that phases out for those with MAGI over $100,000 and is eliminated at $150,000.