Figuring losses on rental property
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Dear Tax Talk,
I know about the $25,000 cap on net losses for rental property, and it’s my understanding that the $25,000 is per person, regardless of the number of properties I own. What happens if there is one rental property owned by two people? It doesn’t seem reasonable that the deduction is still $25,000 per person (for a total of $50,000 on one property).
— Bob Kressen
You’re looking at it wrong. The law isn’t interested in the property deductions; it’s interested in limiting the deductions one individual can claim. Many years ago, wealthy individuals sheltered positive sources of income with losses from rental activities. The positive sources of income were salaries, business profits, pensions, dividends, interest and capital gains derived from investments that produced dividends and interest. This type of income is now known as nonpassive income, even though dividends and interest would be considered passive in a general sense.
Rental activity profits and losses are known as passive income or loss. Back in 1986 when the law was changed, an exception was carved out that allowed individuals with a modified adjusted gross income of less than $100,000 to claim up to $25,000 in passive losses against nonpassive income. The $25,000 cap is reduced $2 for every $1 MAGI exceeds $100,000, so at $150,000 in MAGI, no passive losses are allowed.
Let’s point out some inequities. The $100,000 and $150,000 thresholds apply the same to a married couple as nonmarried individuals. The thresholds have not been indexed for inflation. The cap applies to all passive losses from actively managed real estate, regardless of the size of the investment or the amount of the loss.
Lastly, as you point out, it can apply to jointly-owned property, regardless of the number of owners. For example, if you had a mega shopping mall or a quaint duplex with four unmarried owners, each active in the rental activity, they could claim up to the $25,000 limit if the property generated that much in losses.
One way to get around these rules is to become a real estate professional, which is someone whose profession is actively engaging in real estate activities such as managing, developing or brokering. Losses of a real estate professional from rental activities are allowed against nonpassive income.
If you can’t qualify as a real estate professional, the losses from the rental activity are carried forward to be used against future profits or upon the disposition of the underlying investment.
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.