Can You Deduct Passive Real Estate Losses?

Real estate investors take note: the general rule is that only the first $3K of passive real estate losses are deductible each year. But the IRS provides two exceptions:

1. If you’re a real estate professional who materially participates in your business, your passive real estate losses can offset ordinary income.
2. If you actively participate in your business, you can deduct up to $25K of those losses against nonpassive income.

Let’s learn a bit more about these two tax strategies.

Strategy 1: Materially Participating Real Estate Professional

By default, all rental real estate activities are considered passive activities for tax purposes. This poses a problem because losses from passive activities — passive activity losses (PALs) — can only offset income from other passive sources, or up to $3K of income from nonpassive (i.e., ordinary) sources. For example, if a taxpayer had $100K of W-2 income and $50K of passive real estate losses, they could only use $3K of their $50K loss to offset their W-2 income.

Real estate professionals are an exception. A real estate professional may be able to treat their real estate earnings as ordinary income, which would let them deduct those losses fully, offsetting both passive and nonpassive income.

A real estate professional is someone who:

• Spends more than half of their workday working performing services in one or more real property trades or businesses in which they materially participate, and
• Performs more than 750 hours of services each year in real property businesses in which they materially participate

One of the key ingredients in the real estate professional definition is that they must materially participate in their real estate activities. The IRS says a person materially participates if they meet at least one of these seven tests:

1. The individual participates in the activity for more than 500 hours during the tax year.
2. The individual’s participation constitutes substantially all the participation of all individuals involved in the activity.
3. The individual participates in the activity for more than 100 hours during the tax year, and their participation in the activity for the tax year is not less than any other person’s participation.
4. The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during that year exceeds 500 hours.
5. The individual materially participated in the activity for any 5 tax years during the 10 immediately preceding tax years.
6. The activity is a personal service activity, and the individual materially participated in the activity for any three prior tax years.
7. Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis during the year.

In a way, there are actually three factors to consider for a real estate professional to fully deduct losses from a real estate business: (1) how much of their time they spend on real property businesses compared to other businesses, (2) how much time total they spend on real property businesses and (3) whether they materially participate in these activities.

Strategy 2: Actively Participating Real Estate Investor

Taxpayers who cannot meet the material participation test are not totally out of luck. If taxpayers can prove that they actively participate in their real estate business, they are not a real estate professional, and their property is not a vacation rental property, they can offset up to $25K of passive losses against ordinary income.

While material participation requires regular, continuous, and substantial participation from the taxpayer, the bar for active participation is much lower. Active participation only requires the taxpayer to make bona fide management decisions. This may include:

• Approving new tenants
• Determining rental terms
• Initiating background checks
• Scheduling site visits
• Hiring a lawyer to review leases
• Approving large purchases
• Scheduling repairs and maintenance

The one catch with this $25K special allowance deduction is that it gets phased out as income rises. Most taxpayers with AGIs of less than $100K can take the full deduction, but for every $2 that their AGI exceeds $100K, their deduction phases out by $1. This means their $25K loss deduction will be gone once their AGI reaches $150K, depending on filing status.

Below is a chart that shows deductible real estate losses and phase-out limits for all tax filers.

If taxpayers are phased out of this $25K deduction, they can still take the standard $3K PAL deduction for their real estate losses to offset ordinary income.

Know Your Stuff

The $25K passive real estate loss deduction is a godsend for folks who have passive rental properties because it allows them to offset more than just $3K of their earned income with passive losses. The thing to remember when using this strategy is that the onus falls on the taxpayer to prove their participation level. If they materially participate (as a real estate professional) or simply actively participate (as a non-real estate professional), they should have records that prove it.