What Real Estate Investors Should Know About Passive Loss Rules

Real estate investor studying passive loss rules

Passive loss rules were established by the IRS back in 1986, and they are something that all rental property owners need to know about.

Passive Income vs. Active Income

When you own an income property and are earning your income through monthly rent payments, this is considered “passive income” by the IRS. This is different than typical “active income” that would come with a standard job wages earned through physically working a certain amount of time each year. In the business world, someone must be actively involved in a business for at least 500 hours in a calendar year to be considered an “active income” earner from that business.

When you have passive income from your real estate investment properties, the passive loss rules state that you can only deduct so much of your passive losses against your passive income. As an investor, having passive losses on certain properties can be very beneficial come tax season. Before the passive loss rules were put into place, high-income individuals were taking advantage of all the loopholes and writing off as many passive losses as they could against their active incomes.

The IRS effectively closed those loopholes with these passive loss rules. However, you can still use passive losses in your favor if you know what you are doing.

What Are Passive Losses?

First, it helps to understand what passive losses represent. Rental properties often provide large depreciation deductions. These investments can show losses, even if you actually earned a profit. Net losses are especially easy to prove in the earliest years of property ownership when repair and renovation expenses are at their highest.

The IRS allows these passive losses to be deducted only against your passive income. If you own several rental properties, then you will have a lot of passive income. Even if you just own the one, all your tenant’s rent payments are considered passive income for the calendar year those payments are made.

Suspended Passive Losses

The good news is that any unused passive losses can be deferred indefinitely and used toward the passive income of future years. If you experience high passive losses on a property in its first year, but aren’t able to write it all off that year, then you can apply it the following year or carry it over as long as you need to. What you don’t want to see is your suspended passive loss ledger going up every year. That may mean you have bad investments that keep losing, and obviously you won’t be able to utilize all your passive losses if they keep building up.

There are two exemptions where passive losses can be used toward your primary adjusted gross income:

  • Active Participant—You are not hiring a property management company, but actually participating in all the aspects of managing your rental(s), including tasks like tenant screening, rent collection, repairs and other things yourself. If you are an active participant and your modified adjusted gross income (MAGI) is less than $100,000 for the year, you are allowed to deduct up to $25,000 of your passive rental income losses toward that total. The deduction percentage goes down the more you make, and disappears entirely once you exceed a MAGI of $150,000.
  • Licensed Real Estate Professional—If you are a licensed real estate professional who spends more than 751 hours a year working in the real estate business, then you are exempt from passive loss rules. This is more than just going and getting your license. You have to actively participate in ALL of your rental properties. Some investors will have a spouse who has their license and meets the activity requirements, thus allowing the couple to deduct passive losses against their combined MAGI.

Do Your Homework

When it comes to passive income and passive loss rules, there is a lot more you will need to know as a real estate investor. We’re just covering the basics here. It’s important that you take the time to understand the passive loss rules and how they affect your tax liabilities as a rental property owner. Talk with your financial advisor or tax specialist and develop a tax plan that prepares for passive losses and helps you get the most out of your real estate investments.