Why Can't I Deduct My Rental Property Losses on My Taxes?

Real estate investment sometimes looks like a game of balancing between revenue and expenses. Most of our clients owning properties believe that if their expenses on renting properties are higher than their revenue from renting out properties, they could just offset it and pay less taxes on their normal salaries. It seems reasonable. If you lost money, you should pay less taxes.

Property management in Midwest City can add unique considerations to these calculations, especially when dealing with a rental loss deduction.

Unfortunately, tax time often holds a rude surprise. You may submit your paperwork to your accountant, only to be told you can’t deduct those losses against your other income. From our experience as property managers, we see the confusion caused by this every year. The truth is, the IRS treats rental income in a manner unlike any other business, and it’s essential you understand the differences.

Why can't I deduct my rental property losses? This is a question we hear often at First Class Property Solutions, particularly when clients are looking to optimize their rental property loss tax deduction.

The Barriers of Passive Activity Loss Rules

The first reason you probably cannot deduct your rental loss is because the IRS considers your rental real estate to be a "passive activity." The IRS uses different "baskets" to classify your income. Your salaries, tips, and business income are placed into the "active" basket. Your rental business is placed into the "passive" basket.

The first rule in this area is that losses can only be offset by income in the same basket. This means that you cannot use the loss in your passive basket to offset income in your active basket. When you have a loss in my rental business, and you have no income in your passive basket to offset it with, the loss is deferred. This means it is carried forward to be offset by future income in the rental business or released when you sell the property.

The Active Participation Exception

There is, however, some good news for those in the middle who invest. We frequently assist our clients in using the "active participation" exception. This exception allows you to deduct up to $25,000 of your losses on your rental activity against your non-passive income, such as your wages reported on your W-2.

To qualify, you would need to have at least 10% ownership in the property and be actively involved in its management. By actively being involved, you don’t necessarily have to be swinging hammers and fixing toilets. It simply entails that you make major management decisions. This would entail approving new tenants, terms of tenancy, and spending on repairs.

However, there is a catch concerning your income level. This $25,000 tax allowance begins to phase out as soon as you exceed a modified adjusted gross income of $100,000. However, for each two dollars that you exceed the income level, the tax allowance is reduced by one dollar. This means that as soon as you exceed $150,000 in income, the tax deduction is completely eliminated.

Qualifying as a Real Estate Professional

Perhaps your income level disqualifies you for the Active Participation exemption? In this case, you may consider the status of a Real Estate Professional. This allows you to deduct your rental expenses as non-passive income, which means you could deduct them freely.

Obtaining real estate professional status is hard for anyone who has a full-time occupation unrelated to real estate. You have to devote more than half of your overall working time to real estate business activities in which you have participated. Moreover, you have to work more than 750 hours of service in real estate. If you work a regular 40-hour week as an engineer or a physician, for example, it would be extremely hard to satisfy the IRS that you also work full-time in real estate.

At-Risk Limit

Even if you understand the rules of passive losses, you still need to be mindful of the rules on “at-risk” funds. These restrictions will not allow you to claim a deduction of more than the actual amount of money you have at risk in the investment. For instance, if you acquired an asset using a non-recourse loan, where you do not have any personal liability on the loan, your deduction of the loss may be limited by the amount of cash you have invested in the asset.

When navigating the complexities of rental property loss deduction, it's important to consult with an expert who can help you make the most of every tax benefit.

Let Us Help You Maximize Your Investment

The tax codes are complex and ever-changing, but the point of real estate investment is typically to create wealth, which means profits, and definitely not losses. It is great to have tax benefits as a buffer, but cash flow is the wealth creator. We are experts in taking the theoretical loss and making it a real gain for you.



If you are having difficulty understanding your property's financial performance, please get in touch with our team of experts at First Class Property Solutions today. Our team can help you ensure that your property is working as hard as you are!