Passive Activity Loss Limitations And Rental Properties
If you ' ve ever had any losses in real
estate or limited partnerships, you may already have run into the fact that
there is a limit on the amount of losses you can deduct for these passive
activities.
Before 1986, you could use both losses
and credits from sources that did not require your taking an active role
(passive activities such as owning a farm that you do not work on, renting out
a house, or investing in a limited partnership, while letting others run the
business) to offset your income or losses in activities that were not as
passive, such as earning a wage, running your own business, collecting Social
Security benefits, or harvesting interest, dividends, or capital gains on the
sale of property. Shocking as it may seem, some people invested in limited
partnerships handling rental real estate, just to shelter taxable income.
To prevent people from using passive
losses or income to offset active losses or gains, Congress passed a new set of
rules. The Passive Activity Loss (PAL) Limitation rules impacted the rental
real estate markets in the late 80s and early 90s. Taxpayers who had
significant investments in limited partnerships and rental activities found
their income tax circumstances significantly changed and not for the better.
Income sheltering through rental real estate no longer resulted in significant
tax savings every year.
Even now, passive activity losses can
have a significant impact on your income taxes. In this article, you'll learn
how the PAL rules affect your rental properties.
What is a Passive Activity?
Arranging to have your money earn more
money by owning a farm where someone else runs the tractor, investing in a
partnership where other people do the work or by renting out a house usually
does not take a lot of hard work on your part, so the IRS has decided to call
some activities along these lines passive. Special rules apply to whatever
you earn (or lose) in these passive activities.
In the abstract, a
passive activity generates income or losses for you, without you being
physically involved in producing those results, as a worker or as a manager. So
trade or business activity in which you do not materially participate during
the year is passive activity. But so is a rental activity, even if you do
materially participate?with some exceptions.
Most rental properties are, by
definition, passive activities and are subject to PAL rules. But not every
rental property is subject to PAL. There are exceptions for hotels, and similar
businesses.
To escape the grip of PAL, a rental
activity must have a short-term rental period, or the rental activity must be
incidental to a non-rental business.
Examples of short-term rentals:
The average period of
customer use of the property is 7 days or less. This exception eliminates
short-term residence properties such as hotels.
The average period of
customer use of the property is 30 days or less and significant
personal services are provided to individuals as part of the activity. Significant
personal services must be above and beyond the normal services associated with
a rental; cleaning and maintaining the property, for example, are considered
?normal services.? This type of property may include a recreational hotel
facility where people stay for more than one week but less than thirty days.
If you rent out property for longer
periods, or if you fail to meet these criteria in some other way, and if you
suffer losses from its operation, you may not receive much or any current tax
benefit from those losses.
If you have losses
from a passive rental activity, you generally cannot use those losses on the
year is tax return to reduce your income from non-passive sources. (On the other
hand, if you do actively manage your own rental properties, you may get a
break, called the Active Rental Exception.)
Passive losses can
offset or be combined with income from other passive activities. Therefore, if
you have one rental that generates rental income, and another rental that
generates a rental loss, the income and loss from the two properties can be
combined to form net passive income or loss.
If you have a net passive loss in any
year that you re unable to take due to the passive activity limitations, that
loss is generally suspended and carried over to the following year. You don't
lose the loss deduction altogether; its just that you may have to take the
loss in a year later than the year in which the loss actually occurred.
The Active Rental Exception
If you actively participate in a
rental activity and if you also meet certain income-level limitations, you can
deduct up to $25,000 of the rental loss each year, applying it against income
from non-passive sources?if you have the right filing status. This is the
Active Rental Exception to the PAL.
Active Participation
To actively participate you must own
at least 10 percent of the property and make management decisions in a
significant and bona fide sense, such as
approving new tenants and improvements, and the establishing rental terms.
Income-Level Limits
The income-level limits work like
this:
If your Modified
Adjusted Gross Income (MAGI) is less than $100,000, you can deduct up to
$25,000 in passive rental losses against non-passive income.
If your MAGI is over
$100,000, your maximum loss available decreases by $.50 for every dollar over
$100,000.
The maximum loss is
completely phased out at $150,000.
Your Modified Adjusted Gross Income is
most of your non-passive income. You figure your MAGI by calculating adjusted
gross income (line 35 of Form 1040) without taking into account any:
IRA contributions
Taxable Social
Security benefits
Adoption assistance
payments
Income from U.S.
savings bonds that you used to pay higher education tuition and fees
Interest on qualified
student loans
Passive activity loss
in real property businesses
Filing Status
The $25,000 allowed loss and the
$100,000-to-$150,000 phase out limits apply to married individuals filing a
joint return and to single individuals. If you are married, file separately
from your spouse, and lived apart from your spouse at all times during the year, your maximum loss available
is $12,500 rather than $25,000. And, your loss allowance begins to phase out at
$50,000 rather
than $100,000. If you?re married and
file separately, but you didn?t live apart from your spouse at all times during
the year, the allowance is not available to you at all.
Examples of Active Rental Exceptions: Qualifying for the
exception:
John and Brenda have MAGI of $90,000
and a rental loss of $23,900. They manage the property themselves. Because they
meet both the active participation and the gross income tests, they are allowed
to deduct the full rental loss.
Not qualifying for the exception:
Kevin and Kim separated in February
and are planning to divorce. They jointly own a rental that Kim manage. This
rental generated a loss of $7,500 for the year. Kim filed using a ?married
filing separate? filing status and reported the rental loss
on her return, which showed a modified
adjusted gross income of $45,000. Although Kim meets both the active participation
rule and the gross income test, she is not allowed to deduct any of the loss
from the rental this year because she did not live apart from Kevin at all
times during the year. So her loss is considered a ?suspended passive activity
loss? and is carried over for use in a future year.
Qualifying but not entirely this year
Rob and Paula have MAGI of $140,000
and a rental loss for the year of $18,000. Since their MAGI is $40,000 over the
base limit of $100,000, they must reduce their maximum allowable rental loss by
$20,000 (($140,000 - 100,000) x .50). Their maximum allowable loss therefore is
$5,000 ($25,000-20,000). Of their $18,000 loss, $5,000 is currently deductible and
the balance of $13,000 is considered a ?suspended passive activity loss? and is
carried over for use in a future year.
Allocating and Carrying over Rental Losses
If you wind up with a suspended
passive loss (a loss you re not able to deduct because of the loss limitation
rules), your loss will be carried over until it can be used against income on
your tax returns for future years. If you sell the rental property, you can
deduct whatever is left of the suspended loss at that time.
If You Have One Rental Property
If you have only one rental property,
all of your loss is attributed to that property. And when you sell the
property, you get to deduct any suspended loss that you have had to postpone.
If You Have Several Rental Properties
If you have several rental properties,
then you have to allocate the losses among the various properties, like this:
1. You combine the income and loss
from all your rental properties to calculate the total loss limitation.
2. You allocate the limited losses to
each property based on the relative size of its original loss.
But if you sell one of your properties
in a later year, that property's portion of the suspended loss can be fully
deducted in that year. So, to do your taxes properly, you must track the losses
for each property separately.
Using PALs
There are three situations in which
you can use suspended passive losses from rental properties:
When your rental
properties generate a net passive income during the year. (You are finally
making some money on the rental properties).
When you can deduct
passive losses pursuant to the Active Rental Exception.
When you dispose of your entire
interest in a particular rental property, usually by selling it off.
Net Passive Income
Eventually, we hope, a rental property
will generate income for you. This income is termed ?net passive income?. When net
passive income is generated for the year, suspended losses from earlier years
can be used to offset the current year?s net passive income.
Active Rental Exception
You may be able to deduct passive
losses based on the active rental exception rules (up to $25,000 in most
cases). Assume that this year the loss you?re allowed to deduct (say, $25,000)
is greater than the loss you incurred on your rentals for that year (say,
$13,000). Further assume that you have $10,000 in losses from earlier years
that you weren?t able to deduct on those earlier years? returns. Because you?re
not using the entire $25,000 loss allowance this year, you may take all of your
suspended losses from prior years ($10,000) on this year?s return as well as
your current $13,000 loss!
Selling the Rental Property
When you sell a passive rental property,
you can use the suspended passive losses from earlier years to offset the gain generated
by the sale. If the suspended loss allocated to that
property is greater than the gain on sale, the entire suspended loss allocated
to that property may be deducted. It's deductible regardless of whether there
is a net overall suspended loss for the property.
If the gain on sale
of the property is in excess of the suspended loss allocated to the property,
losses allocated to other properties can be applied. Why? Because your gain is
treated as passive activity income and is therefore available to offset other
passive losses.
Allocation
of allowed passive loss based on percentage of overall
more information than most people
would possibly want, see the IRS publication, Passive Activity Losses Reference
Guide.
If you are a Real Estate Professional
If you sell, manage, develop or
otherwise spend a significant amount of your time and efforts in the real
estate arena, you may be exempt from the Passive Activity Loss Limitation
rules. To qualify as a real estate professional, you must have spent more than
half your time materially participating in real property trades or businesses,
totaling more than 750 hours.
For more information regarding this
important exception, see IRS Publication 925: Passive Activity and At-Risk
Rules, and Exception for Real Estate Professionals in IRS Publication 527:
Residential Rental Property.