One key tax rule that every real estate investor should be familiar with is the passive activity loss rule. This rule has become particularly pertinent due to the growing prevalence of Florida-based short-term rentals on platforms like Airbnb and Vrbo®.
The passive activity loss rule dictates how you report income and losses from real estate investments, significantly influencing your overall tax liability. It is important that you understand the intricacies of this rule, its impact on real estate investments, and strategies to make it work in your favor.
What Is the Passive Activity Loss Rule?
The passive activity loss rule (PAL) was introduced as part of the Tax Reform Act of 1986 and is outlined in Section 469 of the Internal Revenue Code (IRC).
It requires you to be actively involved in a real estate trade or business on a “regular, continuous, and substantial basis” to claim a loss related to that activity. Its primary purpose is to prevent taxpayers from taking a tax deduction for losses related to a trade or business activity in which they did not actively or materially participate.
Who Does the Rule Apply To?
PAL rules apply to individuals who own and actively participate in real estate businesses, including sole proprietors, partners in a partnership, or shareholders in an S corporation. The rule doesn’t apply to the partnership or corporation itself.
Active Losses vs Passive Losses
Active losses are only deductible against active income. Active income (earned income), is the money you’ve earned as an employee or by actively participating in the operation of a trade or business.
Likewise, passive losses can only be deducted against passive income and cannot offset active income. This means that if your passive losses exceed the amount of passive income generated from the same passive activity, you can’t apply the excess losses to offset any of your active income.
Passive Activity and Types of Participation
It is essential to understand the following terms:
The Internal Revenue Service (IRS) in Sec. 469(c)(2) of the IRC classifies rental activities as inherently passive, regardless of the level of involvement by the investor. Therefore, owning rental properties typically falls under the passive activity rules of the IRS.
To be considered “actively participating” in a real estate activity, the taxpayer must have a significant participation in managing the property.
You may qualify as having actively participated if you make genuine and substantial management decisions, such as approving tenants, rental terms, and expenses.
This is a more rigorous level of involvement, often associated with real estate professionals who dedicate a substantial amount of time to their real estate investments.
There are seven tests that the IRS uses for determining material participation. You only have to pass one of the material participation tests, and the most common one is devoting at least 500 hours to the business throughout the year.
Impact of PAL on Real Estate Investors
For real estate investors, the PAL rule can have significant implications, as it limits your ability to offset ordinary income with real estate losses.
Rental Real Estate Losses
Under the PAL rule, losses from rental real estate activities are generally considered passive losses. This means they can only offset passive income, such as rental income. These losses cannot be used to offset active income, like wages or business income.
Exceptions for Active Participation
The IRS provides an exception for individuals who demonstrate active participation in their rental activities. If you meet certain criteria, you can deduct up to $25,000 of passive rental losses against active income.
However, this deduction begins to phase out for taxpayers with a modified adjusted gross income (MAGI) over $100,000 and terminates at the threshold of $150,000 MAGI.
Real Estate Professionals
If you qualify as a real estate professional, you can treat all your real estate investments as non-passive activities. To qualify, you must spend more than 750 hours per year on real estate activities and more than half of your total working hours have to be in your real estate trade.
Carryforward of Losses
If your passive losses exceed the passive income you earned during the current tax year, you have the option to carry those excess losses forward to subsequent tax years and utilize them against future passive income.
Example of the Passive Activity Loss Rule in Real Estate
In 2022, Steve, a single taxpayer not qualified as a real estate professional, received a salary of $72,000 from his job and $11,000 in passive income from a limited partnership. He also incurred an $18,000 loss from his Fort Lauderdale, Florida, beach rental house in which he actively participates.
With a MAGI of $83,000, Steve filed his 2022 tax return and was eligible to deduct $11,000 of his $18,000 rental activity loss to offset the $11,000 passive income that he received from the partnership. Given his active participation in his rental activities, the remaining $7,000 in rental loss was used to offset $7,000 of his active income (e.g., wages).
Strategies for Real Estate Investors
Given the potential limitations imposed by these passive activity loss rules, real estate investors should consider the following strategies:
- Active Participation. Demonstrate active participation in your rental activities to open the door to deducting up to $25,000 in passive losses against non-passive income (if you are not a materially participating real estate professional).
- Real Estate Professional Status. If you are heavily involved in real estate, achieving real estate professional status can be a game-changer. Consult with an expert tax advisor, like Alpine Mar, to determine if you qualify and can treat all your real estate investments as non-passive.
- Optimize Timing. Carefully time your real estate transactions and rental property improvements to maximize deductions in specific tax years when you have passive losses.
- Keep Meticulous Records. Maintain accurate and detailed records of your real estate activities, expenses, and hours spent to substantiate your level of involvement and comply with IRS requirements.
Take Advantage of the PAL Rule in Your Real Estate Activities
The passive activity loss rule is a critical tax regulation for real estate investors to understand. It dictates how you can use losses from passive activities, such as rental activities, to offset income from other sources. By actively participating in your real estate endeavors, seeking professional guidance, and employing smart tax strategies, you can navigate the rules and optimize your tax position.
Remember, tax laws and regulations can be complex, so it’s always wise to consult with a qualified tax professional. This will help you to both ensure compliance and maximize the financial benefits for which you are eligible.