Rental Losses: Deductions, Suspensions, and Exemptions
Rental losses are common in the real estate investment industry. In fact, over 50 percent of the Schedule E forms filed annually show a loss. Although rental losses aren’t unusual, many investors aren’t sure how to handle them when tax time arrives. To clear up this confusion, today we’re answering the top five questions related to real estate losses.
What Are Rental Losses?
Let’s start with what a real estate loss is. When your operating costs are more than the annual income generated by your rental, you have a loss. If you have multiple units, combine your yearly profit or loss from each unit to determine your overall profit or loss.
Operating at a loss is normal when a property is in its early years. For tax purposes, though, even seasoned property owners with long-term units can have a loss. The depreciation for your property increases your deductions. Since depreciation isn’t a cash outlay, it’s possible to have positive cash flow but still have a net loss to report on your tax return. That’s a beneficial situation since you won’t need to pay taxes on your rental income.
Are Rental Losses Deductible?
You can claim real estate investment losses in some situations. You can report a loss, then suspend it to use in later years. When you have a profit to report in the future, you’ll apply the loss that you’ve carried forward. A loss now means you’ll reduce your future taxable income.
However, there are limits on how you can deduct losses because of how the IRS classifies rental income.
What Are Passive Activities?
Most times, the IRS counts rental revenue as passive income generated by a passive activity. That’s an action that provides income with relatively little effort on your part. Rental properties, book royalties, or businesses you don’t actively participate in all count as passive activities.
Active income includes salaries, wages, commissions, or tips that you earn because of your active participation in a business. You have active income if you receive a paycheck from a job.
Here’s where the limit comes in: the IRS only permits the deduction of passive losses from passive income. You may have a job not related to your investment property. Or you may have portfolio income, such as revenue from dividends or capital gains. Unfortunately, your rental losses can’t offset that income.
Remember, though, those losses won’t go to waste. You can suspend losses for years until your passive income offsets the deduction. And If you sell the property, you can fully deduct the loss, even if it is sold at a loss.
Does Rental Income Ever Count as Active Income?
The IRS recognizes rental income as active income in certain situations. For your rental investments to count as an active concern, you or your spouse must count as real estate professionals.
This is a special designation that signifies more than owning rental property, and it has strict requirements. If you have a full-time job or work in another industry besides real estate, qualifying may be difficult.
To learn more about the designation, review our related article. For now, note that real estate professionals are exempt from IRS passive loss rules. They may deduct their rental losses from other active income.
Is There an Exemption from Passive Loss Rules?
The IRS has an option in place that allows rental property owners to deduct part of all of their losses: the real estate loss allowance.
When your income is under a certain threshold, you may qualify for the real estate loss allowance. If your gross adjusted income is $100,000 or less, you may deduct up to $25,000 of rental losses. But for you to use this allowance, you must actively participate in the rental, among other conditions.
As your income increases, the amount you’re able to deduct decreases. Once your gross adjusted income is $150,000 or more, you won’t qualify for the deduction.
House hackers, take note: This allowance only applies to rental activities that are separate from your home. When you rent out your personal dwelling, the guidelines for losses change. (See section 5 of IRS Publication 527 for details.)
Have you set up your rental business as a pass-through entity, like an LLC or sole-proprietorship? If so, you may qualify for a 20 percent deduction because of the Tax Cuts and Jobs Act. Talk to your tax adviser to see if you meet the criteria.
Takeaways
Rental losses are common for real estate investors, and come tax time, having a loss isn’t necessarily bad. The tax code and its exemptions are complex. Rental property losses are deductible when they’re applied to passive income, and you can carry them forward from year to year. In some situations, rental revenue counts as active income, but this is less common. If you think you qualify for the rental real estate loss allowance or qualify as a real estate professional, check with your tax adviser.
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