Depreciation and repairs often leave a rental property with a tax loss even when it produces cash. Whether that loss reduces the tax on your salary or investment income depends on Section 469, the passive activity rules. Rental real estate is passive by definition, and passive losses can only offset passive income. There are three ways around that, and each has its own test and its own paperwork.
The default: rental losses are passive
Under Section 469(c)(2), a rental activity is passive regardless of how much work you put into it. A passive loss can offset income from other passive activities, and any excess is suspended and carried forward on Form 8582 until there is passive income to absorb it or you sell the property. Suspended losses are not lost. On a fully taxable sale of the property to an unrelated party, Section 469(g) releases all of the suspended losses from that activity against any kind of income. Until then, they sit.
The $25,000 allowance
Section 469(i) gives individual landlords a limited exception. If you actively participate in a rental real estate activity, you can deduct up to $25,000 of rental losses per year against wages and other non-passive income. Active participation is a low bar: approving tenants, setting rents, approving repairs, and making the management decisions, even if a property manager does the day-to-day work. You must own at least 10 percent of the property, and limited partners do not qualify.
The catch is the phase-out. The allowance shrinks by 50 cents for every dollar of modified adjusted gross income above $100,000 and is gone at $150,000. Those figures are written into the statute and have not changed since 1986, so a two-earner household in the New York area usually finds the allowance is worth nothing. Married taxpayers filing separately generally cannot use it at all.
The real estate professional test
Section 469(c)(7) lets a taxpayer who works primarily in real estate treat rentals as non-passive. Two tests, both required, every year:
- More than half of all the personal services you perform in trades or businesses during the year are in real property trades or businesses in which you materially participate.
- More than 750 hours of services in those real property trades or businesses during the year.
Real property trades or businesses include development, construction, acquisition, rental, management, leasing, and brokerage. Work as an employee counts only if you own more than 5 percent of the employer. On a joint return, one spouse must meet both tests alone; the hours of both spouses cannot be added together for this step.
Someone with a full-time job outside real estate almost never passes the more-than-half test, and this is the most frequent failure the Tax Court sees. The second most frequent failure is proof. The IRS expects a contemporaneous log of hours, with dates and what was done. Reconstructed logs built after an audit notice have been rejected repeatedly. If you intend to claim the status, keep the log as you go.
Passing the test does not finish the job. Each rental must still meet a material participation test under Reg. 1.469-5T, such as 500 hours in the activity, or more than 100 hours and more than anyone else. That is where the grouping election comes in.
Grouping and the aggregation election
By default, each rental property is its own activity, and a professional with six properties would need to materially participate in each one separately. Reg. 1.469-9(g) allows an election to treat all rental real estate interests as a single activity, so the hours across the portfolio are combined. The election is a written statement attached to a timely filed return, and it is binding for future years unless there is a material change in facts. Late elections can sometimes be fixed under Rev. Proc. 2011-34, but only if the returns were filed consistently with having made it.
A separate set of rules under Reg. 1.469-4 governs grouping a rental with a non-rental business, for example a building you own that houses your own company. Grouping there is allowed only in narrow cases, usually when the rental is insubstantial relative to the business or the ownership is identical. Groupings must be disclosed on the return under Rev. Proc. 2010-13, and a grouping that was never disclosed can be disregarded on audit.
Two related points
Short-term rentals where the average guest stay is seven days or less are not rental activities under the regulations. They are treated as a business, so material participation alone makes the loss non-passive, without the real estate professional test. That is the rule behind most of the short-term rental strategies circulating online, and the material participation hours still have to be real.
The net investment income tax of 3.8 percent applies to passive rental income. A real estate professional who materially participates in the rental may be outside it. For an owner with substantial rental profits, that can matter more than the loss rules.