As part of the crackdown on tax shelters, Congress has severely limited the ability of investors in "passive activities" to deduct losses from those investments against other kinds of income. Rental real estate is specifically labeled a passive activity.
That could have been a knockout blow for a lot of landlords who count on claiming tax losses to make their real estate investments financially feasible. But the law includes a major exception to the passive-loss rules that makes rental real estate an oasis in the otherwise barren tax-shelter landscape. And there's also special relief for real estate professionals. First, the basic break, then a look at the rule for real estate pros.
If you qualify, you can continue to deduct up to $25,000 of rental real estate losses against other income, such as your salary or interest and dividends.
To qualify, you must actively participate in the management of the property. Fortunately, the demands for passing that test aren't particularly onerous. You don't have to be on call for middle-of-the-night repairs, or to cut the grass and collect rents. The IRS rules don't say exactly what you do have to do, but even if you hire a management firm to handle day-to-day matters, you can be actively involved as long as you approve tenants, set the rent and okay capital improvements.
The $25,000 exception isn't for fat cats, though, no matter how actively they're involved. It is phased out as adjusted gross income (which is your income before subtracting itemized deductions, exemptions and rental losses) moves between $100,000 and $150,000. The $25,000 loss allowance is reduced by 50% of your AGI over $100,000.
This is how the tax break evaporates as your gross income rises:
If your adjusted gross income is $150,000 or more, you may not deduct any rental losses.
The $25,000 allowance and the phase-out schedule are the same whether you are married filing a joint return or single filing an individual return. If you are married filing separately, however, and you and your spouse lived together at any time during the year, neither spouse gets a loss allowance. In other words, although filing separately might pull AGI on one or both returns below the $150,000 level, the maneuver won't work to revitalize passive losses that would be denied on a joint return.
If you are married and live apart from your spouse for the entire year, you can deduct up to $12,500 of otherwise disallowable losses if you file a separate return.
The $25,000 allowance doesn't protect losses generated by a limited partnership or any rental property in which you own less than 10%. But keep in mind that passive losses that you can't deduct immediately are not useless. They are suspended rather than obliterated. You can store the losses for future years and deduct them when you have passive income to shelter. And when you ultimately sell the rental property that generated the passive losses, any unused losses are liberated to be deducted against any type of income, including your salary.
Some real estate professionals are free of the rule that makes real estate automatically a passive activity. To qualify, basically, more than half the time you spend working during the year (and a minimum of 750 hours) has to be in the real estate business—defined to include property development, rental, management and brokerage business. If you qualify, you can deduct real estate losses against other kinds of income. But, beware, a 2005 court case makes clear that you need strict proof that the time tests are met. While a logbook documenting the number of hours worked is not required, taxpayers must have calendar entries or similar evidence, the court said., or their losses will be treated as passive.