It is extremely common for landlords to have rental losses, especially in the first few years they own a property. Indeed, IRS statistics show that over half of the filed Schedule E forms reporting rental income and expenses each year show a loss. If you have a rental loss, you have plenty of company.
Losing money in any business venture is never fun, but it can have tax benefits. As a general rule, you may be to deduct your losses from other income you have, such as income from a job or other investments.
Unfortunately, this general rule does not apply to rental losses. Complex IRS rules may prevent you from deducting all or part of your rental losses from the other income you earn during the year, which could end up costing you thousands of dollars in extra taxes. However, there are also important exceptions to the rules that were created to help small landlords and others in the real estate industry.
You have a rental loss if all the operating expenses from a rental property you own exceed the annual rent and other money you receive from the property. If you own multiple properties, the annual income or losses from each property are combined (netted) to determine if you have income or loss from all your rental activities for the year. You report your rental income and deductible expenses on IRS Schedule E.
Often, you have a loss for tax purposes even if your rental income exceeds your operating expenses. This is because you get to depreciate (deduct) a portion of the cost of your rental property each year without having to lay out any additional money.
Here's the basic rule about rental losses you need to know: Rental losses are always classified as "passive losses" for tax purposes. This greatly limits your ability to deduct them because passive losses can only be used to offset passive income. They can't be deducted from income you earn from a job or investments such as stock or savings accounts.
Passive income is the income you earn from rental real estate or other passive activities. An activity other than real estate is considered passive if you don't "materially participate" in it--that is, work at it for a minimum number of hours each year--usually 750 hours. Passive income does not include income from a job, a business you actively manage, or investment income. Thus, for example, you'd have passive income if you earn a profit from one or more rentals.
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.
There are only two exceptions to the passive loss ("PAL") rules:
Property owners with modified adjusted gross incomes of $100,000 or less may deduct up to $25,000 in rental real estate losses per year if they "actively participate" in the rental activity. You actively participate if you are involved in meaningful management decisions regarding the rental property and have more than a 10% ownership interest in the property. This allowance is phased out for taxpayers whose MAGI exceeds $100,000 and eliminated entirely when it exceeds $150,000. Thus, it is useless for high-income landlords.
The other exception to the PAL rules is the one for real estate professionals. Unlike the $25,000 exception described above, this is a complete exemption from the rules--that is, landlords who qualify as real estate professionals may deduct any amount of losses from their other non-passive income.
To qualify for this exemption, you (or your spouse) must spend more than half of your total working hours during the year in one or more real property businesses--a minimum of 751 hours is required. In addition, you must “materially participate” in your rental activity. This requires that you work a certain number of hours at your rental activity during the year. For example, you would materially participate if you work at least 500 hours during the year at the activity. You can qualify in other ways as well.
If you own more than one rental property, you are required to materially participate for each rental property you own unless you file an election with the IRS to treat all your properties together as one single activity. This way, you can combine the time you spend working on each rental property to satisfy the material participation test. If you fail to file the election, you’ll have to materially participate for each rental property you own. For most landlords, this is impossible to do, which makes filing an election very important.
For detailed guidance on this complex area of tax law, refer to Every Landlord's Tax Deduction Guide, by Stephen Fishman (Nolo).