Understanding Passive Activity Limits and Passive Losses [2023 Tax... (2024)

As a rental property owner, it’s not uncommon for your properties to produce a net loss for tax purposes thanks to depreciation and other operating expenses.

The treatment of these losses is often misunderstood by investors for various reasons, so we’ll use this article to clear up common misconceptions of these IRS standards. For additional information on reducing your tax bill as a larger-scale investor, check this out.

Losses from rental property are considered passive losses and can generally offset passive income only (that is, income from other rental properties or another small business in which you do not materially participate, not including investments).

If these passive losses exceed your passive income, they are suspended and carried forward indefinitely until future years, when you either have passive income or sell a property at a gain.

This is good news because a net loss (for tax purposes) means you aren’t paying taxes on your rental income today, even if you have positive cash flow.

Generally, the only time passive losses will offset your ordinary income from a W-2 job or another trade or business is under one of the circ*mstances discussed below.

Passive Activity Limits

Under the passive activity rules you can deduct up to $25,000 in passive losses against your ordinary income (W-2 wages) if your modified adjusted gross income (MAGI) is $100,000 or less.

This deduction phases out $1 for every $2 of MAGI above $100,000 until $150,000 when it is completely phased out. These limits apply to both those filing single or married filing joint.

To take losses against your ordinary income, you must demonstrate active participation in the activity. This is less stringent than the material participation requirement for real estate professionals found below, and generally means you play a role in making management decisions of the business.

Example

Your MAGI is $100,000 for the year and your rental properties produce a net loss of $30,000. As long as you materially participate in your rental activities, you’ll be able to deduct $25,000 of this loss against your ordinary income. The remaining $5,000 will be carried forward.

Let’s say, however, your MAGI was $125,000. In this case you can deduct only $12,500 of the loss because each dollar over $100,000 reduced the amount you could deduct by $0.50. If your MAGI was over $150,000 then you can’t deduct any of these losses against your ordinary income and the entire $30,000 is carried forward.

The Real Estate Professional Status

The real estate professional status historically allowed real estate investors to take unlimited rental losses against their ordinary income. However, there may be some limitations to this under the excess business loss limits found in The Tax Cuts and Jobs Act, but we won’t go into that here.

In order to qualify as a real estate professional, you must spend at least 750 hours in a real estate trade or business and more than half your total working hours must be in a real estate trade or business. Due to these requirements, many investors who work a full-time job or full-time in another business not real estate-related will have a hard time qualifying as a real estate professional.

That said, simply meeting the above requirements will not necessarily allow you to deduct your rental losses against your ordinary income. You must also materially participate in the rental activity using the tests mentioned below. But it is most commonly done by electing to aggregate all your rental properties as one activity and then working 500 or more hours in this single activity per year.

1. You participated in the activity for more than 500 hours.
2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
7. Based on all the facts and circ*mstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

If one spouse qualifies for the 750-hour test, both spouses’ time on the rental properties count toward material participation, and losses can then be taken against either spouse’s income. This is a great strategy for couples where one spouse works in a real estate trade or business, works only part-time, or not at all outside of your investment activities.

In any year you elect to be treated as a real estate professional for tax purposes, you’ll need to keep a log of all hours worked within a real estate trade or business. It is also prudent to keep a log of hours spent in non-real estate trades or businesses, if applicable to ensure you’re spending more than half your total working time in a real estate trade or business.

Check out more topics on rental property tax deductions:

• Rental Property Accounting Basics
• 10 Common Landlord Tax Deductions
• Business Travel Expenses for Rental Owners
• Pass-Through Deductions and Casualty Losses
• Rental Property Depreciation Overview
• Capital Improvements vs. Repairs and Maintenance Expenses
• Capital Gains, Depreciation Recapture, and 1031 Exchange Rules
• Short-Term Rentals and Related Taxes

While reasonable efforts were taken to furnish accurate and up-to-date information, we do not warrant that the information contained in and made available through this guide is 100% accurate, complete, and error-free. We assume no liability or responsibility for any errors or omissions in this guide.