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Rental Property Investors: What are the IRS Rules Allowing Deductibility of Losses against Ordinary Income?

House Flip | Layman & Nichols Law

In the past few years, the IRS has been taking an increased interest in real estate investors. Typically, for landlords at least, every deduction claimed usually has something to do with the operations of the property. However, the Tax Reform Act of 1986 created a section of the Internal Revenue Code that prevents “passive investors” from claiming investment losses against their other income (salary, interest, dividends or retirement payments). Rental income is considered to be passive, so real estate investors cannot offset a loss against their other income. These losses are deferred until you sell the property.

There are two exceptions, however, to this limitation on your loss deduction.

  1. Exception for Median Income Taxpayers

For couples or individuals whose modified adjusted gross income is $100,000 or less, you can deduct your rental loss up to $12,500-$25,000 on real estate you actively manage.  Any excess losses would remain suspended until you have rental income to offset them or until the property is sold.

  1. Become a Full-Time Real Estate Professional

If your primary source of income is your real estate investments, then you may considered to be a real estate professional, as opposed to someone who is a passive investor. In addition to this title, if you materially participate in the operations of your real estate, then you are able to deduct all of your expenses pertaining to the real estate you own and manage.

So how does one qualify as a real estate professional? According to the IRS, you need to spend over 750 hours per year, or at least 51% of your total working hours, on real estate. Additionally, to materially participate in your invested properties you must contribute over 500 hours working on each property unless you make an election to aggregate all interests in rental real estate as a single real estate activity. To document your time, create a contemporaneous log book for recording all of your hours and for detailing the work performed. Also, retain other records such as invoices, toll receipts, etc. that substantiate your time log.

Even though many landlords commonly have rental losses, complex IRS rules must be applied to determine if you can deduct your rental losses from your income. If the deduction is allowed, you can realize tax savings but, if not allowed, those tax savings will be deferred until later. This short blog serves as an overview only. To navigate the IRS rules and be prepared to substantiate your compliance if audited, please consult your tax professional.

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