Generally speaking, a business activity is considered a passive activity if the taxpayer does not materially participate in the activity. Passive activity losses may only be deducted from passive activity income and since rental real estate activities are considered passive activities, even if the taxpayer does materially participate in the activity (except for real estate professionals), losses from such activities are normally not deductible against nonpassive (eg W2) income.
But, there is an exception for small landlords with modified adjusted gross income (MAGI ) under $150,000 ($75,000 if married filing separately) that allows rental losses to be deducted from nonpassive sources of income.
The $25,000 Exception
If you’re not a real estate professional a special rule let’s you take up to $25,000 of rental losses as nonpassive. This means you can deduct up $25,000 of rental losses from your ordinary income and provides a great tax planning tool for rental real estate investors.
Technical Deduction Limits to the $25K Exception
If your modified adjusted gross income (MAGI) exceeds $100,000 ($50,000 for married filing separately), the $25,000 maximum deduction amount ($12,500 if married filing separately) is reduced by 50% of each dollar over $100,000.
For example, if your MAGI is $110,000, the maximum $25,000 deduction amount is reduced by $5,000 (50% x $10,000 = $5,000) leaving $20,000 available to deduct.
If you’re married and file a separte return and you did not live with your spouse at any time for entire year, your maximum deduction would be $2,500
Once MAGI reaches $150,000 the $25,000 deduction is eliminated (50% x $50,000 = $25,000).
Do I Quality for the Special Allowance?
To qualify for the special allowance you must (a) actively participate in the activity and (b) your interest (including your spouse’s) must be at least 10% (by value) of all interests in the activity throughout the year. (This deduction is not allowed for married filing separately.)
What is Active participation?
Active participation is not the same as material participation. Active participation is a less rigorous standard and is intended to make it easier for real estate nonprofessionals and real estate investors to qualify for the special $25,000 rental loss deduction.
As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity. For example, reviewing and approving tenants, establishing the rental terms, approving maintenance and repair expenses. There is no specific hour requirement. However, the taxpayer must be exercising independent judgment and not simply confirming decisions made by a manager.
Please note that just signing off on what a property manager does won’t cut it. Simply reviewing financial statements or conducting analysis that is unrelated to the day-to-day management or operation of the activity is not treated as participation.
What if I Use a Property Manager?
Having a property manager will not prevent you from meeting the active participation test. In other words, your lack of participation in operations does not prohibit qualification as an active participant so long as you are involved in a significant bona fide sense.
Contact us if you want to discuss the tax consequences and/or tax planning involved in your rental property investments.