Passive activities are defined as any trade or business activity in which the taxpayer does not materially participate. The deductibility of losses from passive activities is limited to income generated from other passive activities. Any passive losses not allowed are carried forward to subsequent tax years.
Although rental real estate is generally a passive activity, a special loss allowance can be claimed by certain taxpayers which allows for up to $25,000 of passive losses from rental real estate losses to be deducted against non-passive income (e.g., wages or portfolio income). To claim the special allowance:
- The taxpayer must actively participate in the rental activity (this standard is met if the taxpayer owns 10% of the rental property and has substantial involvement in managing it);
- The taxpayer cannot own the activity as a limited partner; and
- The amount of the eligible loss is determined by netting income and losses from all of the taxpayer’s rental real estate activities in which the taxpayer actively participates.
The active participation standard that applies to this special loss allowance is a lower standard of involvement than material participation under the passive activity rules. Active participation requires taxpayers to arrange for others to provide rental services (such as repairs) or to participate in management decisions such as:
- Approving new tenants;
- Deciding on rental terms; and
- Approving capital or repair expenditures.
The $25,000 special loss allowance starts to phase out once a taxpayer’s modified adjusted gross income (“MAGI”) exceeds $100,000 until it is reduced to zero when MAGI reaches $150,000. MAGI is a taxpayer’s regular adjusted gross income without:
- Any net passive activity loss;
- Taxable Social Security or tier 1 railroad retirement benefits;
- Deductions for IRA contributions;
- Series EE U.S. bond interest;
- Income excluded under employer’s adoption assistance program;
- Rental losses allowed from activities involving a real estate professional;
- Losses from publicly traded partnerships; and
- Deductions for self-employment tax, student loan interest, domestic production activities, and qualified tuition and fees.
The deductibility of passive loss activities is a complicated area. Contact Flexible Accounting Services of the Triangle today to see if your rental activities qualify for the special loss allowance, and how much you can claim on your return.