You have a rental loss if all the deductions from a rental property you own exceed the annual rent and other money you receive from the property. It is extremely common for landlords to have rental losses, especially in the first few years of owning rental property. Indeed, IRS statistics show that in one recent year, over half of the filed Schedule E forms reporting rental income and expenses showed a loss. This translated to over 5.2 million taxpayers showing a loss on rental property.
Ordinarily, business and investment losses are deductible from your other income. However, this is not always the case for losses from real estate rentals. Special passive activity loss rules prevent many landlords from deducting their rental losses from other non-rental income such as salaries or investment income. This is particularly common for higher income landlords. The result is that many landlords can only deduct their rental losses from passive income--that is, rental income or income from other businesses in which they are not actively involved.
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.
If you're in this boat, what should you do? The answer: Generate more passive income to soak up your passive losses. There are two ways to do this:
- invest in a rental property or other businesses that produces passive income (only businesses in which you don’t materially participate produce passive income), or
- sell your rental property or another passive activity you own, such as a limited partnership interest.
Some investments are especially designed to produce passive income to soak up passive losses—these are called passive income generators—PIGs for short. Limited partnerships that invest in real estate that generates substantial annual income, such as conference centers, golf courses, and ski resorts, often fall into this category. Such PIGs are syndicated—that is, they’re offered to the public through public offerings—and are actively marketed by brokers. If you’re interested in investing in a PIG, you’ll have no trouble finding out about them from stockbrokers, financial planners, financial publications, or the Internet. Of course, you should be careful when making any investment.
One way you cannot generate more passive income to absorb your rental income is to rent to a business you own or materially participate in. Under the “self-rental rule,” such income is recharacterized as nonpassive and can’t be used to offset real estate rental losses. (Beecher v. Comm’r., 481 F.3d 717 (9th Cir. 2007); Treas. Reg. 1.469-2(f)(6).)
Example: Gary and Dolores Beecher are a married couple who owned two corporations engaged in the business of repairing automobile interiors and exteriors. They also owned five rental properties that resulted in substantial annual losses. The Beechers had a great idea: Because they worked out of their home, they would lease their home office to their corporation. They would use this lease income—ordinarily, passive income—to offset the losses from their rentals. As a result of this combination of income and losses, the Beechers paid no tax on the rental income paid to them by their corporations—this amounted to over $85,000 of tax-free income over three years. Unfortunately, the IRS audited the Beechers and recharacterized their rental income from their corporations as active, not passive, income. Thus, it could not be used to offset their rental losses. Under the self-rental rule, income from the rental of property for use in a trade or business in which the taxpayer materially participates is treated as nonpassive income. The courts upheld the IRS’s ruling.
See the Nolo article Can You Deduct Your Rental Losses? for more information on how passive loss rules affect landlords. And for a more detailed discussion of the topic, see Every Landlord's Tax Deduction Guide and IRS Publication 925, Passive Activity and At-Risk Rules.