Rental losses – how they work
It is not unusual to have rental losses, especially in the first years as you may improve and furnish the property for optimum rental. IRS statistics show that over half of those reporting rental income and expenses each year show a loss. If you have a rental loss, welcome to the club. Although losing money is never the primary goal in any business venture, in this case, it can have tax benefits.
If the gross rents can cover (or partially cover) the mortgage payments, you’ve accomplished the first goal of being a property owner:
Goal 1 – Have the tenants purchase the property for you via the rents,
Goal 2- When adding depreciation (a non-cash expense) and one-time capital improvements, you can often generate a tax loss while maintaining positive cash flow. This, plus appreciation, is the great one-two punch rentals provide for tax purposes.
Goal 3- Is to use these losses (albeit often not cash-flow losses), to offset other income and pay less tax while enjoying tax-deferred appreciation.
Now that we have the general goals in mind, let’s look at how they work within the current tax code.
Rule 1-Rental Losses Are Passive Losses
Here’s the basic rule about rental losses you need to know: Rental losses are always classified as “passive losses” for tax purposes. This greatly limits your ability to currently deduct them because passive losses can only be used to offset passive income. They can’t be normally be deducted (subject to the exceptions below) from other income you earn from a job or investments such as stock or savings accounts.
Without passive income, your rental losses become suspended losses you can’t deduct until you have sufficient passive income in a future year or sell the property to an unrelated party. At that point of sale, 100% percent of any and all suspended losses from all prior years become deductible against income.
I mentioned a couple of exceptions to the limits on deducting current passive losses. They are very hard for most clients to meet, but here they are:
There are only two exceptions to the passive loss (“PAL”) rules:
- you or your spouse qualify as a real estate professional, or
- your income is small enough that you can use the $25,000 annual rental loss allowance.
Technically, there is a third way (with what’s called material participation) but it’s really hard for most landlords to meet.
Property owners with modified adjusted gross incomes of $100,000 or less may deduct up to $25,000 in rental real estate losses per year if they “actively participate” in the rental activity. You actively participate if you are involved in meaningful management decisions regarding the rental property and have more than a 10% ownership interest in the property. This allowance is phased out for taxpayers whose MAGI (modified adjusted gross income) exceeds $100,000 and eliminated entirely when it exceeds $150,000. Thus, it is useless for high-income landlords.
The other exception to the PAL rules is the one for real estate professionals. Unlike the $25,000 exception described above, this is a complete exemption from the rules– landlords who qualify as real estate professionals may deduct any amount of losses from their other non-passive income.
To qualify for this exemption, you (or your spouse) must spend more than half of your total working hours during the year in one or more real property businesses–a minimum of 751 hours is required. In addition, you must “materially participate” in your rental activity. This requires that you work a certain number of hours at your rental activity during the year. For example, you would materially participate if you work at least 500 hours during the year at the activity. You can qualify in other ways as well.
Rule 2-Despite the above restrictions, rental real estate offers unique advantages.
The above restrictions are mainly a timing difference. You’ll get the write-off against ordinary income – it’s just a matter of when. A rental offers the unique advantages of:
- Tax-deferred appreciation,
- Offsets against ordinary income,
- Favorable capital gain rates when sold.
Special rules apply to depreciation recapture upon sales et al but this is still one of the better ways to add diversity to your portfolio and protection against inflationary market forces.
All the above applies to properties used 100% for rentals. What happens when you start using the property as a second home part of the time?
If you rent a dwelling unit to others that you also use as a residence, limitations can (and likely will) apply to the rental expenses you can deduct. You’re considered to use a dwelling unit as a residence if you use it for personal purposes during the tax year for a number of days that’s more than the greater of:
- 14 days, or
- 10% of the total days you rent it to others at a fair rental price.
Allocating expenses between business and personal use
If you use the dwelling unit for both rental and personal purposes, you generally must divide your total expenses between the rental use and the personal use based on the number of days used for each purpose. You won’t be able to deduct your rental expense in excess of the gross rental income limitation (your gross rental income less the rental portion of mortgage interest, real estate taxes, casualty losses, and rental expenses like realtors’ fees and advertising costs). However, you may be able to carry forward some of these rental expenses to the next year, subject to the gross rental income limitation for that year. Subject to existing limits, you can partially deduct the taxes and interest that can’t be claimed on the rental as itemized deductions. Special rules apply as to the order that rental expenses are applied to the gross income limitation. Simply put, they require direct expenses (interest, real estate taxes, commissions, and advertising) be applied first.