One of the great things about investing in real estate is the tax advantages. Even when your rental is generating cash flow, it often can be reported on your tax return as generating a loss, thanks to depreciation. That appreciation comes from gradually accounting for the price you paid for the building, and you get to deduct a little bit of it each year.
But you may find that the losses you are generating don’t always reduce the amount of tax you have to pay on your other income. That’s because, under the section 469 tax code law, real estate rental income is put in the bucket of passive income, and losses from passive income generally can’t be used to reduce other kinds of income, such as your business or job income. Even investment income (also called “portfolio income”), like stocks and mutual funds, is considered to be in a different income bucket, so your rental income can’t usually offset your investment income! So you can’t even deduct your rental income losses from your investment income gains.
These are the three income category “buckets”, and usually losses in one bucket can’t offset gains in a different bucket:
| Ordinary Non-passive Income | Passive Income | Portfolio/Investment Income |
|---|---|---|
| • W-2 job wages • Business income (that you participate in) • Interest and dividends | • Real estate rental income • Income from business partnerships that you don’t actively participate | • Sales of stocks, mutual funds, crypto, etc. |
So generally you can’t deduct losses from rental real estate from other types of income. But luckily there are some exceptions. Let’s take a look at all the ways you can potentially make use of that passive loss.
1. Offset Other Passive Income
Each tax year, all of your passive income and losses get added together, and the total is your net passive profit or loss. These are the types of income that are in the “passive” bucket, so any of these types of income can be netted together to offset each other:
- Other rental real estate. The losses from one rental property will offset profit from any profit from other rentals you own. The only exception would be if you made some of your other rentals non-passive (by qualifying as a real estate professional or the short-term rental loophole).
- Equipment leasing.
- A business you own but don’t materially participate in. If you have a profitable business with employees that do most of the work, if you can keep your participation level below the level of material participation, then your real estate losses will also offset your own passive business income.
- Investments in a partnership or business that you don’t materially participate in. For example, syndicated real estate deals that you invest in as a passive investor.
So if you have passive rental losses that you can’t otherwise make use of using the other strategies below, it may be worth considering whether it would make sense to invest in a business or syndicated real estate deal to make use of your suspended rental losses.
2. The $25,000 Loss Allowance
The first big exception is that if you qualify, you can deduct up to $25,000 per year of rental losses against your other income. Other types of passive income don’t qualify for this exception, this is just for real estate rental income. There are a few qualifications you need to be able to meet for this allowance defined in section 469(i) of the tax code:
- Income limit: Your income must be below $150,000. And if your income is above $100,000, the amount you can deduct is reduced by $1 for every $2 of income you have above $100,000.
- 10% interest: If the investment is shared with other partners, your portion of the investment (including your spouse) must be at least 10% of the rental activity.
- Active participation: You must “actively participate” in the rental. So if you have a property manager that handles everything and you really have no involvement at all in the operations of the rental, then you wouldn’t qualify. But if you are involved in at least making management decisions such as approving new tenants, choosing the rental terms, or approving repairs, then you qualify.
If you meet these qualifications, you can deduct up to $25,000 per year of your rental loss against your other income. This limit applies per tax return, so if you are filing as married filing jointly, that’s $25,000 total for the couple for the year.
Note: If you’re filing as “married filing separately” status, you can’t use this exception if you lived with your spouse at all during the year. And even then, the amount you can deduct is reduced to $12,500 and the income phase out starts at $50,000 instead of $100,000.
3. Real Estate Professional Status
If you qualify as a real estate professional, all losses on your rental property become deductible against your other income. While advantageous, qualifying as a real estate professional is challenging, and most landlords won’t meet the criteria unless they are employed in a real estate profession.
To qualify, you need to spend more than half of your working time in a qualified real estate profession, totaling more than 750 hours per year. You also must materially participate in running the rental property. If you think you may qualify, see our article on the Real Estate Professional Status.
4. The Short-term Rental “Loophole”
There is a significant and often overlooked exception in the tax code that allows you to deduct rental losses for short-term rentals if you meet the qualifications. This is sometimes referred to as the “short-term rental loophole” because properties like those we have today weren’t considered when this section of the tax code was written.
To qualify, your property must meet the tax code’s short-term rental qualifications (7 days or less average stay), and you must invest enough hours to “materially participate” in the rental.
We have a separate article that explains all the details about how to qualify for the STR loophole.
5. Unlock Losses When Selling the Property
If you sell a property, you can deduct any losses from the property that tax year, plus any suspended (carried forward) losses that you weren’t able to deduct for that property in past years, against your regular income. This means that selling a property unlocks any suspended losses, allowing you to use them to reduce your taxable income for the year.
The sale must be to an unrelated third party, it can’t be to your spouse, sibling, ancestor (parents/grandparents), or descendants (children/grandchildren), or a corporation/partnership that you own more than 50% of. And you must sell your entire interest in the property (and any other properties that you elected to group together into one rental activity group, if you made a grouping election).
If you have other suspended passive losses from any other rentals or any other passive income, all current year or suspended passive losses can be used to reduce the capital gains from the sale of a rental property. In other words, selling a rental property lets you unlock current and past suspended losses so that you can use those losses.
For example, if you sell a rental property for a big profit and have $80,000 in capital gains that you would otherwise have to pay taxes on, but you also have $70,000 in suspended passive losses from that property plus some other rental properties, the suspended losses will offset the capital gains on that property. So in that example you would only have $10,000 in capital gains that you have to pay taxes on, rather than the full $80,000.
6. Carry Forward Losses
What if you don’t qualify for any of the other exceptions? The good news is at least you don’t completely miss out on potential benefits from your rental losses. Any suspended losses that you can’t deduct against your income this year will carry forward indefinitely to future tax years until you can eventually use the loss against any future passive income. Or if you sell the property and you still have suspended losses, you can use those losses to reduce your capital gain on the sale of the property.
The tax advantages are among the great perks of being a real estate owner. However, understanding all the nuances and important details is crucial to maximize your tax savings. If you have any questions or need help with your taxes, please contact us for a free tax consultation.
