Generally, the IRS deems rental income as passive. This means as a landlord you'll likely be subject to passive activity loss limitations.
If you are materially active, and qualify as a real estate professional you may be able to deduct your real estate expenses against your ordinary income. Meaning you can deduct it against income earned elsewhere. However, if it only qualifies as passive income then you can only deduct your passive losses against your passive income. Additionally, passive losses are limited.
You may be thinking at this point that because you self-manage, because you use a property management software like Landlord Studio because managing your rentals is in no way a passive endeavor, that you might qualify as being materially active in the management of your properties and not be subject to passive activity loss limitation rules. Generally speaking, however, the IRS deems rental property income as passive, even though it is anything but. As such, you likely will, be subject to passive activity loss limitation rules.
In this article, we go into details as to how you can establish which real estate activity status you qualify for, the passive activity rules, and review the passive activity loss limitations.
The IRS allows those that are deemed to be “real estate professionals” to take more or less unlimited deductions against their income – and not just their real estate income. However, qualifying as a real estate professional isn’t as easy as having or managing a few rental properties.
Rather, being a “real estate professional” means you need to spend at least 750 hours in a real estate trade or business and more than half your total working hours must be in a real estate trade or business. This essentially means, if you have a day job that isn’t in real estate, then you are going to have a hard time qualifying as a “real estate professional”.
This is the underlying rule, however, as with most things where the IRS are involved it’s not that simple. Along with the above, you must materially participate in your rental activity.
According to IRS Topic No. 425, “material participation” is involvement in the operation of a trade or business activity on a “regular, continuous, and substantial basis.” Meaning, even if you’re a real estate professional by day, if you own rentals but have a property manager you won’t qualify.
In any year you elect to be treated as a “real estate professional” for tax purposes, you’ll need to keep a log of all hours worked within a real estate trade or business. It is also prudent to keep a log of hours spent in non-real estate trades or businesses, if applicable, to ensure you’re spending more than half your total working time in a real estate trade or business.
All is not lost. As long as you partake in the management of your properties you can still access the benefits of the sizeable tax advantages available for real estate investors, such as depreciation, mileage, and maintenance expenses.
However, there are limitations and loss rules that apply when your real estate income is deemed by the IRS to be passive, we go through these below.
If your income is deemed by the IRS to be passive, then according to the IRS guideline you cannot deduct any losses from your real estate business against your ordinary income.
Rental activity, even if you are a material participant is deemed by the IRS as being passive unless you are, as discussed above, deemed a “real estate professional”.
Passive activity losses can only be deducted against the current year, capped at $25,000 and can only be deducted against passive income.
If you have deductions of more than this you can carry them forward without limitation and apply them to the following tax year; they can’t be carried back.
Also, you can’t deduct any expenses against your ordinary income meaning if you had expenses of $15,000 in one year, but only had a taxable passive income from your rentals of $10,000 in that year you, would have to roll the extra $5,000 onto the following year and would not be able to apply these losses to your ordinary income.
There are detailed rules about how much in passive losses is deductible; the Tax Cut and Jobs Act of 2017 changed some of these numbers.
If you think these rules could apply to your tax situation, consult a tax specialist.
A passive loss is any financial loss incurred with an investment in a trade or business enterprise where the investor is not materially participant. However, as stated above, the IRS deems real estate, even if the investor is materially participant as passive.
Passive losses can come from a number of activities such as the following:
If you are unsure whether a loss should be classified as passive or not, it is advisable to consult with a professional accountant to ensure your taxes are being filed correctly.
Most landlords don’t qualify as real estate professionals. As such, it’s important for them to understand the relevant passive activity loss limitations. Everyone’s situation is different, and if you think any of the above applies to you it’s recommended that you consult with your CPA or a licensed tax professional.