In general, rental activities are considered to be passive activities, which means losses incurred in rental activities are not deductible against active or portfolio income. There are two exceptions to this general rule.
Real Estate Professionals
Real estate professionals who materially participate in real estate activities are not subject to the passive activity loss limitations. Material participation for this exclusion means that the taxpayer:
- Performs more than ½ of the taxpayer’s personal services in real property trades or businesses, including development, construction, acquisition, rental, property management and brokering real property, OR
- Performs more than 750 hours of service during the taxable year in real property trades or businesses, including real estate construction, development, rental, property management and brokering real property.
For example, Jack Brown is a licensed real estate broker and he heads up his own home selling team and works full time listing and selling real estate. In addition to his realtor activities, he also owns rental property and invests in rental real estate partnerships. Jack qualifies as a real estate professional, and as such, any losses he incurs on his rental activities are fully deductible and not subject to the passive activity loss limitation rules.
Other Rental Real Estate Activities
A $25,000 exception to the passive loss rules exists for certain individuals actively participating in real estate activities. In order to qualify, the individual must own at least 10% of the value of the activity for the entire tax year and have an AGI less than or equal to $100,000. To the extent AGI exceeds $100,000, the taxpayer has to reduce the $25,000 exemption for 50% of the excess of AGI over $100,000. As a result, at AGI of $150,000, no loss is allowed. The loss is carried forward to future years until AGI is less than $100,000 or until the property is sold.
This provision requires active participation. Active participation is a less stringent requirement than material participation discussed in a prior blog post. In order to be an active participant, the taxpayer must participate in making management decisions or arranging for others to provide services. For example, if you have a rent house and you are responsible for renting it out, advertising, repairs and maintenance and the like, you would qualify for the active participation requirement. In addition, if you contract with a rental management company, you would still qualify as long as you are active in making management decisions.
The purpose behind this exception is to allow a taxpayer with one or two rental houses they manage themselves, or use a real estate management company, to be able to deduct losses associated with that rental activity, as long as their AGI is $100,000 or less.