- Written by Julie Welch
Although the deduction of most “passive” losses is limited, you can reduce your taxable income by deducting up to $25,000 of losses from rental real estate. In 1986, Congress stepped up its attack on tax shelters (investments that produce tax losses) with the enactment of the “passive loss rules.” Before 1986, many people invested money in tax shelters, such as real estate ventures, oil and gas operations, and farming businesses. The people did not get personally involved in the tax shelters, but they did use the losses from the tax shelters to reduce the tax on their salary and investment income.
The passive loss rules stop you from using losses from tax shelters to reduce your income from wages, interest, and dividends. If you have a loss from a passive investment (an investment that you spend less than 500 hours per year managing), you can only deduct the loss if you have income from another passive investment. Any losses you cannot deduct in the current year are suspended and carried over to the following year. The loss is deductible in a future year when you have passive income or sell the passive investment. In other words, the passive loss rules do not take away your loss; they just postpone the deduction to a future year.
With the rental real estate exception, you can deduct a loss equal to your passive income plus $25,000 every year. Naturally, there are several conditions you must meet before you can take this rental real estate deduction. First, you must own more than 10% of the real estate investment for the entire year. Thus, if you are a limited partner in a real estate partnership and you own 5% of the partnership, you cannot use the special $25,000 deduction.
Second, you must “actively participate” in the rental of the real estate. Active participation is not measured in hours. It is determined by the decisions you make. If you approve new tenants, decide rental terms, collect and deposit rent checks, and approve expenditures for repairs and improvements, you actively participate in the rental of the real estate.
Third, the $25,000 loss you can deduct is reduced by one-half of your adjusted gross income (AGI) over $100,000. In other words, if your AGI is less than $100,000, you can use the full $25,000 special deduction. If your AGI is between $100,000 and $150,000, the $25,000 loss you can deduct is reduced by 50% of your AGI over $100,000. Thus, if you have $130,000 of AGI, your loss deduction is limited to $10,000 ($25,000 - ((130,000 - 100,000) x 50%)). Finally, if your AGI is more than $150,000, you cannot use the $25,000 exception at all ($25,000 - ((150,000 - 100,000) x 50%) = $0). Any losses that you cannot deduct because of this AGI limitation are suspended and carried over for deduction in future years.
You are single with $75,000 in AGI. You own a duplex that you rent to two tenants. You actively participate in the management of the rental property. Your income and deductions for the year are described below:
Real estate tax (4,000)
Repairs and miscellaneous (2,000)
Depreciation (200,000 x 3.636%) (7,272)
Total deductions (30,472)
Loss from rental (6,472)
Tax rate (Federal and State) x 32%
Tax savings $2,071
Cash flow from the duplex:
Rental income $24,000
Tax savings 2,071
Principal (assumed) (1,200)
Real estate taxes (4,000)
Repairs and miscellaneous (2,000)
Net cash flow $1,671
On paper, the rental of the duplex shows a loss of $6,472. However, the loss is the result of your depreciation deduction of $7,272. Depreciation is an expense you can deduct for the wear and tear on your rental property. You can depreciate a residential rental property over 27.5 years. The deduction has nothing to do with an actual change in the value of the property. Also, except for the initial purchase price of the property, depreciation does not require a cash outlay.
Your cash flow, after considering the tax savings from the loss you deduct on your tax return, is a positive $1,671. If you pick the right property,
• You have an investment that is giving you cash.
• Your tenants are paying the mortgage and other expenses for you.
• The value of the duplex is increasing.
If you are a real estate professional, such as a developer, and operate your rental properties as a business, you can deduct the full amount of your real estate losses. In other words, you avoid the $25,000 limitation discussed above. To qualify, both of the following must apply:
• You spend more than half of your time in real property trades or businesses.
• You spend more than 750 hours during the year in real property trades or businesses.