One thing we learned about investing in real estate over the last few years is that it can be quite volatile at times and requires sufficient capital and planning to be successful. Rental properties are traditionally long term investments and losses may occur during the holding period. Investors should make an effort to become familiar with the issues related to the deductibility of such losses.
IRS passive loss rules dictate that passive losses from real estate can only be offset by passive income and can only be carried forward not back. Generally, losses from real estate rental activities are considered passive losses unless you are a real estate professional. Even if you actively or materially participate in the management of the rental property any resulting losses would still be passive losses if you are not a real estate professional. Active participation and material participation are not the same. Active participation is a less stringent standard and requires that you be involved in significant and bonafide management decisions including tenant approval, rental terms and expenditures. To meet the material participation standard your management efforts must be on a substantial, continuous and regular basis and meet additional IRS requirements beginning with a minimum of 500 hours spent on rental activities.
There are exceptions to this rule. If you own at least 10% of a rental property and actively participate in its management then you may be able to deduct up to $25,000 of passive losses even if you don’t have any passive income. Under this rule you can offset passive income from the rental property with your non-passive income such as wages, interest and dividends etc. Since this is intended to be a break for smaller landlords the deduction amount gets reduced after your modified AGI exceeds $100,000. You lose $1 of offset for every $2 over MAGI which reduces the offset to $0 when MAGI reaches $150,000. See Passive Loss Rules for Rental Property.
Real estate professionals are able to treat losses as non-passive and offset other income if they materially participate in the real estate management activities. This requirement applies to each rental property individually so some properties owned by a real estate professional could qualify while others do not. To be considered a real estate professional you would need to spend more than 50 percent of your time and more than 750 hours annually on real estate activities. This standard must be met every year so one year you may qualify as a real estate professional and the next you don’t. See Professional Real Estate Rules for Rental Property.
Passive losses that cannot be offset because of a lack of passive income and don’t meet other deductibility requirements become deferred or “suspended” and are carried forward indefinitely until passive income becomes available or the entire rental property investment is sold.
Given the complexity of the rules regarding real estate rental properties and the usual long term holding periods you must maintain good records over the life of the investment and possibly long after it is sold if carry-forwards are involved. Obviously, this can get pretty onerous when you have multiple properties and your own personal involvement in each one can change from year to year which changes the tax treatment. Aside from purchase cost information you need to keep receipts for all expenses related to your properties and keep track of rents received. Depreciation schedules should be kept for the property structures and any capital improvements. Be sure and keep a logbook to document your time spent on rental property to show active or material participation or that you are a real estate professional.
Redmond CPA+John Huddleston has written extensively on tax related subjects of interest to small business owners. He is a graduate of Washington State University and the University of Washington School of Law.