If you own rental properties that lose money, your losses are classified as passive losses for tax purposes. They are deductible only against other passive income you earn during the year. So, if you don’t have sufficient rental income or other passive income (income from a business in which you don’t actively participate), you can’t deduct these losses in the year you incur them—bad news taxwise.
There are two exceptions to this rule. One is for real estate professionals. They are allowed to deduct unlimited rental losses against any income they earn. The other exception is in the form of a special rental loss offset that permits landlords with incomes up to $100,000 to deduct up to $25,000 in losses each year (the offset is gradually phased out for landlords with incomes over $100,000 and up to $150,000).
Rental property passive losses that are not deductible right away are called suspended passive losses. These deductions are not lost forever. Rather, they are carried forward indefinitely until either of two things happen:
The tax rules provide that you may deduct your suspended passive losses from the profit you earn when you sell your rental property. To take this deduction, you must sell "substantially all" of your rental activity. If you own only one rental property and sell it, then you can take the deduction because that property is your entire rental activity. The same holds trule if you own several properties and treat them each as separate activities for tax purposes. However, many landlords with multiple properties elect to combine them as one activity for tax purposes. In this event, if you own several rental properties and only sell one, you can't take the deduction because you won't have sold "substantially all" of your interest in your rental activity.
In addition, you must sell the property to an unrelated party—that is, a person other than your spouse, brothers, sisters, ancestors (parents, grandparents), lineal descendants (children, grandchildren), or a corporation or partnership in which you own more than 50%. And, the sale must be a taxable event—that is you must recognize income or loss for tax purposes. This means tax-deferred Section 1031 exchanges don’t count, except to the extent you recognize any taxable income. (I.R.C. §469(g).)
Unfortunately, some landlords who incur rental losses every year end up losing their properties through foreclosure because they can’t afford to pay their mortgages. Does a foreclosure on a rental property qualify as a fully taxable disposition that frees up any previously suspended rental losses? The IRS Office of Chief Counsel has recently said “yes.”
The case involved a landlord who bought real property for $1 million and financed the purchase with a $1 million mortgage. The rental property accumulated net passive losses of $100,000 over three years that the landlord could not deduct because he had no passive income. Thus, the losses were suspended and carried forward to be used in future years. Four years later, the landlord defaulted on the mortgage and the lender foreclosed. At the time of the foreclosure the building was worth less than the landlord paid for it. As a result, the lender ended up cancelling $75,000 of the landlord’s debt after the foreclosure.
The IRS Chief Counsel advised that the foreclosure qualified as a taxable disposition of substantially all of the landlord’s interest in the property. Thus, the $100,000 of suspended passive losses could be treated as losses that are not from a passive activity—in other words, they were deductible from the landlord’s other nonpassive (nonrental) income. This was true even though $75,000 of the landlord’s indebtedness was cancelled by his lender. (The landlord was able to exclude the $75,000 from his income because he was insolvent at the time of the foreclosure.) (IRS Chief Counsel Advice 201415002.)