As a general rule, rental real estate losses are deductible up to $25,000 in a property that you “materially participate” (the rules for this will be covered in a future blog) in without having to have other passive income to offset them. Where taxpayers run into an issue is when income is too high. Once income exceeds $100,000 the ability to deduct rentals losses starts to be phased out. This phase out is complete at $150,000 of income and no losses are allowed to be deducted. These losses are suspended, carried forward, and can only be deducted when:
(1) There is other passive income to offset them
(2) Income dips below $150,000 in future years
(3) The property is sold
This results in clients in their working years who earn over $150,000 having to carry tax losses from rental properties that they cannot use for years to come. Unfortunately, many do not know about this income limitation and buy rental real estate hoping for a tax shelter for their ordinary income. The only way around this limitation is for real estate professionals. The real estate professional exception does not limit losses to $25,000 and the income limitations do not apply. The incentive to take advantage of this exception is huge!
Living in a coastal community with a large opportunity for both short-term and long-term rental real estate properties we get a lot of questions regarding the real estate professional designation. What a lot of individuals do not realize is that having a real estate license is not enough to classify you as a real estate professional for purposes of deducting rental losses. To make sure this exception is only used by real estate professionals there are two tests that must be satisfied:
(1) Individuals must spend more than 50% of their time dedicated to work on real estate activities than non-real estate activities. This proves that the majority of your living is earned in the real estate business.
(2) Individuals must spend more than 750 hours on real estate services during the tax year. This rule eliminates some retirees from qualifying by doing real estate activities on a part time basis.
Of course time spent on “real estate activities” does not have to be limited to rentals. It can include property management, leasing, constructions, development, etc.
The rules for this qualification are complex and we recommend consulting a tax professional if you want to qualify for this exception.