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.
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.
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.
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.
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.
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
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.
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.
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.
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.
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.
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.
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!
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.
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.