Passive Activity and Passive Activity Loss Limitations in Real Estate

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.

Determining your Real Estate Professional Status

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, to qualify as a “real estate professional”  you must 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.

Tests For Qualifying As Materially Participant In Rental Activity

  1. You actively participated in the management of your properties for more than 500 hours.
  2. Your participation constituted the majority of all individuals' involvement in the activity for the tax year, even those who had no ownership interest.
  3. You participated in the activity for more than 100 hours during the tax year, equal to or exceeding the participation of any other individual, regardless of ownership interest.
  4. The activity is considered a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity refers to a trade or business activity in which you spent over 100 hours during the year, without meeting the material participation tests, except for this particular test.
  5. You materially participated in the activity (excluding meeting the fifth test) for a minimum of five tax years out of the last ten, whether consecutive or not.
  6. The activity falls under the category of a personal service activity, and you materially participated for at least three preceding tax years. Personal service activities include fields like health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business where capital isn't a significant factor in generating income.
  7. Considering all relevant circumstances, you participated in the activity consistently, continuously, and significantly throughout the tax year.

If one spouse meets the 750-hour test, both spouses can combine their time spent on rental properties for material participation purposes. Consequently, losses can be offset against the income of either spouse. This strategy is particularly advantageous for couples in which one spouse is involved in a real estate trade or business, works part-time, or is primarily engaged in investment activities rather than other employment.

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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.

What if you don’t qualify as a “real estate professional”?

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.

About Passive Activity Limits

The passive activity rules impose certain limits on the amount of passive losses you can deduct against your ordinary income (such as W-2 wages). If your modified adjusted gross income (MAGI) is $100,000 or less, you can deduct up to $25,000 in passive losses.

The deductibility of passive losses gradually reduces as your MAGI exceeds $100,000. For every $2 increase in MAGI above $100,000, the deduction is reduced by $1 until your MAGI reaches $150,000, at which point the deduction is fully phased out. These limits apply to both individuals filing as single or married filing jointly.

In order to claim losses against your ordinary income, you must demonstrate active participation in the activity. Active participation entails having a role in making management decisions for the business. This requirement is less stringent than the material participation criteria applicable to real estate professionals, which is discussed separately below.

For instance, if your MAGI is $100,000 and your rental properties generate a net loss of $30,000, you can deduct $25,000 of this loss against your ordinary income as long as you materially participate in the rental activities. The remaining $5,000 will be carried forward to future years.

However, if your MAGI is $125,000, the deductible amount of the loss is reduced to $12,500. Each dollar over $100,000 reduces the deduction by $0.50. If your MAGI exceeds $150,000, you cannot deduct any of these losses against your ordinary income, and the entire $30,000 loss is carried forward to be used in future years.

If you think these rules could apply to your tax situation, consult a tax specialist.

What Is A Passive Loss?

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.

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