Can Landlords Deduct Unpaid Rent?

Renters sometimes fall behind on their rent payments. Some don't pay any rent for months. Many landlords will never get paid all the rent they're owned.

Can You Deduct Unpaid Rent From Your Taxes?

If you're a landlord and a tenant fails to pay rent, can you deduct the unpaid rent from your taxes? The short answer is "no." Unpaid rent isn't a tax deductible rental expense.

Unpaid Rent Is a Bad Debt

Unpaid rent is a debt your tenant owes you. However, it ordinarily isn't deductible as a bad debt.

IRS regulations provide that a worthless debt arising from unpaid rent is deductible only if you report the amount of rent you were supposed to be paid as income for that year (or a prior year). (IRS Reg. 1.166-1(e).) Landlords who can report this kind of yet-uncollected rent are operating on an accrual accounting basis. (If you are an accrual basis taxpayer, you report rent as income as it becomes due, not when it's actually paid).

The majority of residential landlords operate on a cash basis, which means they report rent as income only when it is actually paid to them by their tenants. Because cash basis landlords don't report rent that has never been paid on their tax returns, it's not deductible.

So, to deduct unpaid rent, you must report unpaid rent as income on your tax return for the year the rent was due. In other words, you'd have to adopt an accrual method of accounting. However, the deduction merely offsets the income you've already reported. So, there's no point in switching to the accrual method of accounting just to be able to write off unpaid rent. You won't save an extra penny in taxes. Nor can you deduct unpaid rent as a casualty loss.

On the plus side, unpaid rent isn't taxable as income and isn't reported on your tax return.

Deducting Rental Losses Due to Unpaid Rent

Although you can't directly deduct the full amount of unpaid rent, it can result in rental losses that are deductible. You have a rental loss if the total annual expenses you incur for your rentals (mortgage, taxes, utilities, insurance, maintenance, depreciation, and other expenses) exceed your total rental income (which doesn't include unpaid rent).

Example. Landlord Larson owns a rental home he rents for $2,000 per month. His tenant was unable to pay the rent for 10 months leaving $20,000 in unpaid rent. Larson's annual rental expenses (including depreciation) are $14,000. Because he received only $4,000 in rent, he had a $10,000 rental loss for the year.

Unfortunately, rental losses like Larson's are always classified as passive losses for tax purposes. Subject to two important exceptions, passive losses are deductible only from passive income--income from rental activities and from businesses in which you do not materially participate.

Passive losses aren't deductible from salary, self-employment earnings, or investment income from dividends or interest. So, unless one of the following two exceptions applies, Larson may not deduct his $10,000 loss from his employee salary or investment income.

$25,000 Allowance for Rental Real Estate

Landlords with relatively modest incomes may deduct a limited amount of rental losses from nonrental income. If your modified adjusted gross income for the year is under $100,000, you may deduct up to $25,000 in total annual rental losses from your nonpassive income, provided that you actively participate in the management of your rentals (an easy standard to meet).

This deduction is phased out if your modified adjusted gross income is over $100,000, and is lost entirely when it exceeds $150,000.

So, if Larson's modified adjusted gross income is less than $100,000 he may deduct his entire $10,000 loss from his employee and investment income. If his income is over $150,000, this exception doesn't apply.

Real Estate Professional Exemption from Passive Loss Rules

There's another way you might be able to deduct your rental losses from nonrental income: the real estate professional exemption from the passive loss rules.

If you qualify as a real estate professional and materially participate in your rental activity, you may treat rental losses as nonpassive and deduct them from all other nonpassive income without limit

Either you or your spouse will qualify as a real estate professional for the year if you or your spouse spends:

• more than half your personal service work time in real property trades or businesses in which you materially participate, and
• more than 750 hours of your personal service work time and investment analysis time in real property trades or businesses in which you materially participate.

In addition, you and your spouse must materially participate in your rental activity. There are various methods to establish material participation. The two most common are working over 500 hours at the activity during the year, or working 100 hours and more than anyone else.

People with full-time jobs outside of real estate can rarely qualify as real estate professionals.

If Larson qualifies as a real estate professional, he can deduct his entire $10,000 rental loss from his nonrental income no matter how high his total income for the year.