The Real Estate CPA Explains: Passive Activity Loss Rules

Passive activity loss rules key takeaways:

• Passive Activity Loss Rules stated by Internal Revenue Code section 469 determine the deductibility of tax losses from rentals against other sources of income
• Rentals are considered passive activities and tax losses from these activities cannot be used to offset other sources of income unless an exception applies
• Exceptions include passive losses offsetting passive income, selling a passive activity at a gain, passive activity loss allowance for those earning less than $150,000, and real estate professional status
• To qualify as a real estate professional, a person must spend 750 hours in real property trade or business and participate more in it than in any other activity

Hi, I'm Brandon Hall, a real estate CPA and CEO of Hall CPA, and today we're going to talk about the passive activity loss rules.

The passive activity loss rules are found in Internal Revenue Code section 469, and they're the most important rules for landlords to be aware of. These rules determine whether or not you can deduct tax losses generated from your rentals against your other income such as W-2 income, stock gains, dividends, interest, etc.

The passive activity loss rules were implemented in 1986, and the purpose was to prevent landlords from using depreciation deductions to create large tax losses that they could then use to deduct against their regular income.

The rules accomplish this by creating two buckets of income. The first bucket is the passive bucket, and the second bucket is the non-passive bucket.

All rental activities are considered passive activities and they go into that passive bucket. My other income such as W-2 income, business income, interest, dividends, gain on stock sales, that all goes into the non-passive bucket.

These passive activity loss rules say that if a passive activity - so an activity that's in that passive bucket - generates a tax loss, that tax loss is stuck in the passive bucket and it gets suspended. So you cannot jump this passive tax loss out of the passive bucket and put it into the non-passive bucket to offset your other income - your ordinary income.

So, if I work a full time W-2 job and then I have a couple of rental properties that collectively generate a $10,000 tax loss, that $10,000 tax loss will be suspended as a passive activity loss and it will be carried forward. I will not be able to use it against my W-2 income unless I qualify for one of the exceptions to the passive activity loss rules.

There are a handful of exceptions to the passive activity loss rules.

The first is where passive losses can offset passive income, so if you do have passive losses - and you can generate passive income - those passive losses will offset the passive income.

The second is if you sell a passive activity at a gain, you can use passive losses from other passive activities to offset the one that you sold at a gain.

The third is called the passive activity loss allowance and it's available to anybody that earns less than $150,000 even if you're married filing jointly. You can claim up to a $25,000 passive loss allowance as long as you own at least 10% of the activity and you actively participate by making management decisions. The full $25,000 passive loss allowance is available to those who earn less than $100,000, and it gets phased out as you earn more than $100,000. It's 100% phased out once you reach $150,000 in earnings.

The fourth exception to the passive activity loss rules is something called real estate professional status. If you qualify as a real estate professional, your rentals will be non-passive and any loss that they generate will directly offset your other income such as your W-2 income, business income, interest, dividends and gain on stock sales.

To qualify as real estate professional, you must first spend 750 hours on any real property trade or business and spend more time in those real property trades or businesses then you do anywhere else. So, if you're working a full time job, neither the IRS nor the Tax Court will buy the fact that you can spend more time in real estate than you can at your full time job. Even if you're working part time, it's a little dicey to make that argument.

But, if you are working full time and you're married and your spouse is not working full time - either they're a homemaker or they're working part time - that spouse can qualify as real estate professional, and on your married filing joint tax return you will have a real estate professional status tax return which will allow you to buy a bunch of rentals and offset your W-2 income.

Now I should mention that qualifying as a real estate professional is only step one to making your rentals non-passive. You must also materially participate in the rental activities, and because that gets really complex, my advice is to work with a qualified tax advisor that can help you sift through these rules and understand how to accomplish that.

To demonstrate the power of qualifying as a real estate professional, let's assume that you do qualify as a real estate professional and you buy a handful of rental properties. You run something called a cost segregation study which accelerates the depreciation you can claim in the first year of ownership. And let's assume that that gives you a $100,000 tax loss that you're then able to claim against your regular income to find out how that might help you.

You can multiply $100,000 by your marginal tax rate to get a decent idea of how much this strategy is going to save you in taxes. But again, if you're going to qualify as a real estate professional, don't go at it alone, there are a ton of rules in order to substantiate the position.

I highly recommend that you work with a qualified tax advisor especially given that we expect increased IRS enforcement with their increased budget.

Brandon Hall is a real estate-focused CPA and the CEO of Hall CPA. Learn more about Brandon and his team over at https://www.therealestatecpa.com/