Passive Activity Losses
Line 23 of Schedule E cautions you that, for some people, real estate losses are limited regardless of the at-risk rules.
In contrast to the at-risk limitations, the passive activity loss rules apply to a larger group of taxpayers. They generally prevent taxpayers with adjusted gross income (AGI) above $100,000 ($50,000 if married filing separately) from deducting some or all losses from real estate rentals, other than the rental of your home that was also used for personal purposes.
There are two kinds of passive activities:
- trade or business activities in which you do not materially participate during the year
- rental activities, even if you do materially participate in them, unless you are a real estate professional.
A real estate professional is one who spends more than 750 hours per year and more than half their working time in developing, managing, and/or selling real estate.
A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional. There are a few limited exceptions to the rule that a rental activity is a passive activity. Rental activity isn't a passive activity (and, therefore, is not subject to the passive activity loss rules) in the following cases:
- The average period of customer use of the property is 7 days or less.
- The average period of customer use of the property is 30 days or less and you provide significant personal services with the rentals (such as cooking meals or cleaning the space that is rented, not the common areas).
- You provide extraordinary personal services in making the rental property available for customer use.
- The rental is incidental to holding the property in order to realize a gain from its appreciation or for use in a trade or business (other than property rental) and the gross rental income from the property is less than 2 percent of the smaller of the property's unadjusted basis or fair market value.
- You customarily make the rental property available during defined business hours for nonexclusive use by various customers.
- You provide the property for use in a nonrental activity in your capacity as an owner of an interest in the partnership, S corporation, or joint venture conducting that activity.
Active Participation. "Active participation" means that you have significant participation in making management decisions or arranging for others to provide services. These management decisions might include approving new tenants, deciding on rental rates and terms, and approving capital or repair expenditures. However, you're not considered to have "actively participated" if you own less than 10 percent of the property.
"Modified AGI" means your AGI as shown on Form 1040, Line 37, without taking into account any passive activity losses, taxable Social Security benefits, deductible IRA contributions, the deduction for one-half the self-employment tax, and the exclusion for amounts received under an employer's adoption assistance program. Also, if you filed Form 8815, Exclusion of Interest from Qualified U.S. Savings Bonds, you must add back the savings bond interest excluded on Line 14 of that form.
Your losses may be limited if:
- your modified AGI is more than $100,000
- you don't materially participate
- you have more than $25,000 in real estate losses, or
- you are carrying over any losses that were not allowed in previous years
Generally, the rule is that you can deduct passive losses to the extent that you have passive income from other activities, and all rental real estate activities are treated as passive. See our discussion of which trade or business activities are treated as passive.
Special $25,000 allowance. Although all real estate losses are considered passive losses and, therefore, deductible only to the extent of passive activity income, there is a special break if you actively participated in the rental activity.
If you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000 of loss from the activity from your nonpassive income. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception. If you are married and file a separate return, your losses are limited either to $12,500 if you lived apart from your spouse for the entire year, or to $0 if you lived with your spouse at any time during the year.
If you have more passive losses from real estate than you have passive income, your deduction of $25,000 will shrink as your AGI rises. You'll lose $1 of the deduction for every $2 that your AGI rises above $100,000; if your modified AGI is $150,000 or more, you can't deduct any excess passive losses this year.
If your losses are limited under any of these rules, you must complete Form 8582, Passive Activity Loss Limitations. The allowed loss, if any, shown on the bottom of Form 8582 is transferred to Line 23 of Schedule E.
Losses that cannot be deducted in the current year are carried over to later years until they can be offset by passive income, until you can use the special $25,000 deduction, or until you sell your entire interest in the property to an unrelated third party.
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Warning
Beginning in 2013, a new 3.8 percent net investment income tax may be imposed on individuals whose modified adjusted gross income exceeds $250,000 for joint filers, $125,000 for married taxpayers filing separately, and $200,000 for others. Trusts and estates with income over a certain amount are also subject to the NII tax. Form 8960, Net Investment Income Tax— Individuals, Estates, and Trusts is attached to the tax return. For 2013, the IRS has provided taxpayers the ability to rely on more than one set of net investment income tax rules. The best choice varies by taxpayers and depends on the taxpayer's unique situation. Consult your advisor to determine which approach would be best for you.
Also, note that the IRS has issued new depreciation regulations that generally apply to tax years beginning on or after January 1, 2014. But, for 2012 and 2013, it also provided taxpayers with the ability to elect certain regulations. The best choice for each taxpayer depends on the taxpayer's unique situation. Consult your advisor to determine which approach would be best for you and your business.
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