Many real estate investors also work full-time jobs. Wouldn’t it be great to reduce wage income (i.e., ordinary income) with rental losses?
It's not uncommon for a rental to produce a loss. This loss is usually a paper loss because of depreciation. In years when a rental produces a loss, can the investor use it to offset their ordinary income?
Some investors will find they can offset ordinary income with rental losses, while others will not be able to. What is the difference between these two types of investors? That's what we'll explore today.
How Are Rental Losses Classified?
Rental income is often passive income. The loss is also passive if the rental didn't earn any income and took a loss. Passive losses can only offset passive income.
Passive income means that someone else is running the business that produces the income. In this case, the investor is just collecting income and not actively involved in the business. If this investment produces a loss, it cannot offset ordinary income. Ordinary income is considered active and can't be offset by passive losses.
But losses don't automatically qualify as passive if you own a rental property. If you are an active participant in the rental property, losses can fall under a special allowance, which offsets ordinary income.
This special allowance is up to $25,000 in losses. However, the investor must meet certain qualifications.
First, the investor must actively participate in the rental. This means 10% property ownership and having made significant management decisions. Significant means approving new tenants, approving expenditures, making repairs, advertising and showing the property, collecting rent, approving rental terms, and similar activities.
The above tasks don't have to be done by the investor. Someone can be hired to do these tasks. An example might be a property management company. Note that this differs from someone else running the business in which they make significant decisions about the business, not the investor.
The second qualification is meeting certain income restrictions. If the investor’s MAGI (modified adjusted gross income) is under $100,000 (less than $50,000 if married filing separately), they can claim the full $25,000. The allowance begins to reduce from $100,000 to under $150,000. $150,000 and above do not qualify for the deduction.
As an example, an investor qualifies for the full $25,000 deduction. She makes $90,000 at her full-time job. After the deduction, the investor’s ordinary income is reduced to $65,000.
The loss is claimed on Schedule E. It goes on line 22. The loss originates from form 8582. The loss flows through to line 26 of Schedule E.
What Happens to Loss if You Don’t Qualify?
What happens if your MAGI is too high, you don’t own 10% of the property, or actively manage it? Does the loss go away?
No. The loss is still declared on Schedule E but doesn't flow down to line 26. It still appears on form 8582. The loss is held there until it can be used later. Perhaps your passive income will be higher at a later date. In that case, the previous rental loss may be able to offset your passive income.
An exception to the rental loss is if you sell the property, you can use the rental loss, including any losses from previous years, assuming they apply to the same property.
Rental losses are different for real estate professionals (REPs). Note that for REPs, rental losses are not considered passive. In this case, all real estate losses can be used to offset other income.
Note that tax reporting for rental losses on form 8582 can get quite complex. It's best to work with a real estate accountant when filing tax returns involving rental properties.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
FAQs
Ordinary income is considered active and can't be offset by passive losses. But losses don't automatically qualify as passive if you own a rental property. If you are an active participant in the rental property, losses can fall under a special allowance, which offsets ordinary income.
Can I use rental losses to offset ordinary income? ›
If qualified, a real estate professional allows individuals to offset ordinary income (e.g., W-2 income) with rental property losses. But because this tax-saving strategy is so popular, it's important to take steps to ensure that you will survive a tax audit.
Can real estate depreciation offset ordinary income? ›
Qualifying as a real estate (RE) professional can offset ordinary income. However, achieving this status is not easy. Two criteria must be met to qualify: Work at least 750 hours per year in real estate-related activities.
Can losses offset ordinary income? ›
If you have more capital losses than gains, you may be able to use up to $3,000 a year to offset ordinary income on federal income taxes, and carry over the rest to future years.
What is the $25,000 rental loss limitation? ›
Special $25,000 Allowance for Real Estate Nonprofessionals
This means you can deduct up $25,000 of rental losses from your nonpassive income, such as wages, salary, dividends, interest and income from a nonpassive business that you own.
Why can't I deduct my rental property losses? ›
Without passive income, your rental losses become suspended losses you can't deduct until you have sufficient passive income in a future year or sell the property to an unrelated party. You may not be able to deduct such losses for years. In short, your rental losses will be useless without offsetting passive income.
How many years can you carry forward a rental loss? ›
They can be carried forward indefinitely into future years until they've been used up against future passive income. There can be exceptions regarding the use of those passive losses against earnings. One is if you're a qualified real estate professional and materially participate in rental operations.
Is it a good idea to depreciate rental property? ›
As a real estate investor, rental property depreciation is an important concept to understand because depreciation can help you keep more money in your pocket by significantly reducing your income taxes.
How much real estate depreciation can you write off? ›
How Much Can You Depreciate a Rental Property? Generally, U.S. rental properties are depreciated at a rate of 3.636% over 27.5 years.
How do you avoid depreciation recapture on rental property? ›
If it's important to you to avoid the depreciation recapture tax, there are several strategies you may want to adopt.
- Take advantage of IRS Section 121 exclusion. ...
- Conduct a 1031 exchange. ...
- Pass on the property to your heirs. ...
- Sell the property at a loss.
Ordinary losses are usually fully deductible when you file a tax return, reducing the amount of tax owed. You can deduct a certain amount when it comes to capital losses, but there is no limit to the amount that can get deducted for ordinary losses.
Can I offset losses against income? ›
Set loss off against other income
You can set the loss from your self-employment against your other taxable income in the same tax year in which you made the loss and/or the tax year prior to that in which you made the loss.
Can I use more than $3000 capital loss carryover? ›
Capital losses that exceed capital gains in a year may be used to offset capital gains or as a deduction against ordinary income up to $3,000 in any one tax year. Net capital losses in excess of $3,000 can be carried forward indefinitely until the amount is exhausted.
Can rental loss offset ordinary income? ›
If you are an active participant in the rental property, losses can fall under a special allowance, which offsets ordinary income. This special allowance is up to $25,000 in losses. However, the investor must meet certain qualifications. First, the investor must actively participate in the rental.
How much loss can you write off on rental? ›
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.
How much passive rental losses can you deduct? ›
Under the passive activity rules you can deduct up to $25,000 in passive losses against your ordinary income (W-2 wages) if your modified adjusted gross income (MAGI) is $100,000 or less. This deduction phases out $1 for every $2 of MAGI above $100,000 until $150,000 when it is completely phased out.
How many years can passive losses be carried forward? ›
Rental property passive losses that are not deductible right away are called suspended passive losses. These deductions are not lost forever. Rather, they are carried forward indefinitely until either of two things happen: you have rental income (or other passive income) you can deduct them against, or.
Can you deduct rental expenses when you have no rental income? ›
If the house is not being rented, there are still many deductions available. Maintenance and repairs are deductible. Additionally, marketing expenses for the rental are deductible as well. Marketing costs include any expenses associated with renting out the home.
Are self-rental losses deductible? ›
Under the self-rental rule, the rental losses are still considered to be passive losses deductible only to the extent of passive income, while rental income generated from self-rentals is treated as “active” income if the taxpayer materially participates, as defined in IRC §469(h), in the activities of the operating ...
Can you offset losses against other income? ›
Tax relief is given by: offsetting a loss arising in a tax year against other taxable income and, in some circ*mstances, capital gains, in either the same or a different tax year, so that. the amount of income or capital gains that is taxable is lower than it would be if the loss was not set off against it.
