The list of tax rules favorable to rental property owners is long. Ample deductions, depreciation, capital gains tax rates, 1031 exchanges and passive activity loss rules all stem from a framework of policies that promote real estate investment. If you own rental property or are thinking about buying some, bone up on these rules to understand the effects on your bottom line. The passive activity loss rule, in association with its active participation requirement, is particularly valuable for new investors who may show a loss their first year in the game.
When you make money through rental property rents, it is generally considered passive income. It arises more out of the property itself than a service you are providing. If you lose money, it’s a passive income loss or, simply, passive loss. A gain is taxed as ordinary income. How a loss is handled depends on whether you actively participated in the rental activities. If you did not actively participate in the rental business, you may only deduct passive losses from passive gains, such as from other rental property. If you do not have passive gains, you can carry the passive loss backward or forward to other tax years in which you do have passive gains to offset. If you did actively participate, as of 2014, you are able to deduct up to $25,000 in passive loss from non-passive income, such as wages from your job.
Minimum Co-Ownership Requirement
You must own at least 10 percent of the property showing a passive loss to meet the active participation test and be able to deduct passive losses from non-passive or active income. There are no exceptions to this rule. If you did not own at least 10 percent of the property, you cannot deduct passive losses from anything other than passive gain, although you are still allowed to carry the loss backward or forward into other tax years.
In addition to owning at least 10 percent of the rental property to meet the active participation test, you must have actively participated in the property’s management, specifically in management decisions. The Internal Revenue Service provides examples of active participation as advertising units, collecting rents and making or arranging for repairs. It clarifies, however, that the term “active participation” is a less stringent standard than “material participation” applicable to real estate professionals. To actively participate you do not have to handle every aspect of management. If you approve new tenants, determine rental terms and approve expenditures, you have met the test.
Limitations on High-Income Earners
The full $25,000 deduction of passive loss from non-passive income is only available to taxpayers with a modified adjusted gross income of $100,000 or less ($50,000 or less if married filing separately). It phases out above $100,000 and ends entirely for earners with incomes of $150,000 and above.