How Do I Know If I Have a Passive Activity Loss?

What is a Loss From a Passive Activity

Many people think that owning rental property is one of the best ways to hold an appreciating asset while generating losses for tax purposes.  This is true in some circumstances, but many investors are in for a rude shock after they purchase the property and attempt to write off deductions related to the property.

Section 469 of the Internal Revenue Code places important restrictions on deductions for rental activity.  The section covers losses from passive activities.  Generally, a passive activity is a business venture in which someone, but not you, materially participates.  Rental activity is deemed to be a passive activity unless the owner of the property meets the real estate professional exception, discussed further below.

The general rule is you can only deduct losses from a passive activity to the extent you have income from a passive activity.  There is an exception for losses from rental real estate if the owner actively participates in management of the property.  If this exception applies, the owner can deduct up to $25,000 of rental losses each year even if there is no income from a passive activity.  However, if the owner’s adjusted gross income, excluding passive losses, exceeds $100,000 then the $25,000 exception is reduced by one-half of the amount of income over $100,000.  When adjusted gross income reaches $150,000 this exception is completely eliminated.  Since most people who can afford to invest in rental real estate have adjusted gross incomes of more than $150,000, this exception is of limited use.  Any losses that are not used are suspended and may be used when income dips below $150,000, when there is income from a passive activity or when the passive activity that generated the losses is fully disposed of in a taxable transaction.  Knowledge of the rules for freeing suspended passive losses can result in significant reductions in tax.

How Can You Benefit From Passive Losses

One way to use the losses is to invest in passive activities.  Interest and dividend income do not constitute passive income.  Income generated by limited partnerships or general partnerships in which the owner does not materially participate is passive income and can be used to free up suspended passive losses from other passive activities, such as rental property.  A word of caution: income from publicly traded limited partnerships cannot be used to free up suspended losses from other activities.

If a passive activity is fully disposed of in a taxable transaction all of the suspended losses from that activity are immediately available for deduction.

An important rule to remember is that gain on sale of a passive activity is income from a passive activity.  Therefore if rental property is sold at a gain, the gain can be used to free up suspended passive losses not only from that activity, but also for other passive activities.  It is also important to know that the gain from sale of an activity will generally be a capital gain, while the losses that are freed up by the gain are generally ordinary.  The gain is not reported net of the losses; both are reported separately.  This means that any long term gain is taxed at the preferential rates for capital gains while the suspended losses are used to reduce ordinary income.  Under the present tax structure, this means the income is taxed at 15 percent while the losses may be reducing income that would otherwise be taxed a 35 percent.

What is The Real Estate Professional Exception

One way to avoid the harsh treatment under Section 469 is to qualify under the real estate professional exception.  Under that exception rental real estate will not be deemed a passive activity if the owner performs more than half of all of his or her service hours during a year in real property trades or businesses and he or she performs more than 750 hours during the year in real property trades or businesses.  Note that services performed in real property trades or businesses include not just managing rental property, but also includes other activities related to real property.  For example a realtor or real estate agent who spends 730 hours in the business of listing, showing and selling real estate and who also spends 21 hours managing a rental unit does not have to apply the restrictions in Section 469 as long as he or she does not spend more than 750 in any other trade or business.

Investors should be aware that owning rental real estate can be an opportunity, but the tax benefits may not be realized for many years.