Passive Activity Loss Rules
Passive activity loss rules may limit use of rental real estate losses. Can I deduct losses related to rental real estate for federal income tax purposes? Maybe. Losses from rental real estate may or may not be deductible in the current taxable year. It depends upon the application of the passive activity loss rules to the particular taxpayer’s situation.
General Passive Activity Loss Rule
Generally, the passive activity loss rules permit deduction of passive activity losses to the extent of passive activity gains. “Passive activity” means any activity— (A) which involves the conduct of a trade or business, and (B) in which the taxpayer does not materially participate. Material participation means involvement in the operations of the activity on a (A) regular, (B) continuous, and (C) substantial basis. Federal law provides that the term “passive activity” includes any rental activity, except as provided in Section 469(c)(7).
Material Participation Exception
Section 469(c)(7) of the Internal Revenue Code provides the material participation exception. A taxpayer can materially participate in real estate as a real estate professional if a) more than 50 percent of the personal services performed by the taxpayer are performed in real property trades or businesses in which the taxpayer materially participates, and b) the taxpayer performs more than 750 hours of services within the real property trades or businesses in which the taxpayer materially participates. The term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Rental real estate activity is not a passive activity if a taxpayer meets both of the foregoing tests of material participation. Therefore, deductions for losses related to the rental real estate activity are not subject to the general rule disallowing losses in excess of income from passive activities.
Active Participation Exception
Finally, Section 469(i) of the Internal Revenue Code provides an additional exception to the general rule. It allows deduction of up to $25,000 of rental real estate losses per tax year related to rental real estate activities if the taxpayer “actively participated” during such taxable year. Active participation requires less participation than “material participation.” Active participation may be shown by participating in management decisions such as approving new tenants, deciding on rental terms, approving capital or repair decisions, or similar decisions.
However, the $25,000 passive activity loss deduction phases out by 50 cents per dollar as Adjusted Gross Income exceeds $100,000. The loss deduction allowance phases out completely at AGI of $150,000. Carry forward disallowed passive activity losses to the next taxable year.