I was talking to a group of friends the other day, and someone mentioned that they were considering purchasing a rental property as an investment for the “tax advantages.” Although I don’t have many friends in the stage of life where they are looking for this type of investment, I thought it might be a good topic to discuss.
If you receive rental income for the use of a dwelling, such as a house or an apartment, you deduct certain expenses that correlate to this dwelling on your tax return. These expenses may include:
- mortgage interest;
- real estate taxes;
- casualty losses;
- maintenance and repairs;
- insurance; and, depreciation.
These expenses are netted against the rental income you received in order to reduce the amount of rental income that is subject to tax. If the purpose of your rental is to make a profit, and do not use the dwelling unit as a personal residence, then your deductible rental expenses can actually be more than the rental income – which creates a loss. I know what you’re thinking….”this sounds pretty great! A loss that will reduce the amount of taxes I pay!!!” However, you should read on, because depending on how your rental activity is classified, your tax picture can look very different!
Passive vs. Active - What's the Difference?
Income and losses on your tax return are divided into two categories:
Non-passive – Defined as businesses in which the taxpayer materially participates; and,
Passive – Rentals and businesses without material participation.
This classification is KEY!
The IRS’s Passive activity rules prevent investors from deducting passive activity losses from their non-passive sources of income. In other words, passive activity losses may only be netted against passive activity income. So if you have a passive rental loss, and no other passive active income, your losses generally are limited by the "at-risk" rules and/or the passive activity loss rules.
But Wait, There are exceptions to this Rule!
rental real estate allowance under IRC § 469(i)(8)
A taxpayer may deduct up to $25,000 in rental real estate losses as long as the taxpayer actively participates and has less than $100,000 in income. The $25,000 rental real estate allowance under IRC § 469(i)(8) allows individuals to offset losses from rental real estate without necessarily having passive income, but once your income goes over $100,000, the $25,000 offset is limited.
Short-term rentals with material participation
As most people know, the tax code is extremely complicated, with very specific definitions.The activity is not deemed a rental property (and therefore, not passive income) if:
- The average period of customer use is 7 days or less; OR,
- The average period of customer use is 30 days or less and significant personal services are provided (such as maid service, cleaning services, etc.)
If either of the above apply to your rental property, the activity is not considered passive rental activity. It is treated as a business. If you have material participation in the business, your losses are not limited.
There is a qualifying disposition under IRC § 469(g).
If you do not have passive income in a year that you have passive activity losses, your loss is carried forward so that you can apply your passive activity losses in future years that you may have passive activity income. When you sell that rental property, any gain on the sale of that property is classified as passive income, so those carried forward losses can finally be used!
The taxpayer meets the requirements of IRC § 469(c)(7) for real estate professionals.
This is a very specific definition, but if you, or your spouse, meet these requirements, your losses are also not limited.
The IRS definitely has many definitions and rules around these requirements, so speak with one of our tax professionals to see if you may fall into one of the exceptions noted above!