The impact of passive losses on rental property will depend on how much you earn. The general rule is that if you earn over $150,000 per year, you have to take a passive loss. So, if you have a rental property that incurs a $10,000 rental loss, you aren’t eligible to deduct that loss if your modified adjusted gross income, which is the last line on your tax return, is over $150,000.
When Passive Loss Rules Don’t Apply
Rental real estate is considered passive just by definition. For some people, the passive loss rules don’t apply. These are people who have a business in real estate, or who own a lot of real estate, and all they do is real estate. Most people aren’t in that situation, however. If you make under $150,000, you can deduct the $10,000 loss. There’s a phase out; if you make between $100,000 and $150,000, the amount of the $10,000 loss is reduced. For example, if you made $125,000 a year, you could deduct 50 percent of that $10,000 loss, or $5,000.
Deducting the Loss Later
Let’s say you’re subject to the passive loss rule. You make over $150,000, so you cannot deduct your $10,000 loss. You don’t lose the loss, you just can’t deduct it in year one. There are three possible ways to take that deduction eventually:
- In year two of owning your rental property, you use the loss from year one. So, if you have an $8,000 profit with that property, you can use the $10,000 loss from year one to offset that $8,000 income. You can use year one losses in years where you have a profit.
- Maybe you go five years of losing $10,000 every year. So, at the end of year five you have a $50,000 loss. If you sell the property, you’re eligible to deduct all the losses you couldn’t deduct in previous years. So, if you sell in year five, you can deduct all $50,000 in losses.
- When you buy another rental property you can also use the deduction. Maybe in year three, you have a $20,000 loss with the original property but a $6,000 profit with the new property. You can use the loss in the first property to offset the profit in the second.
If you’re not eligible to deduct in year one, don’t panic. It’s a timing issue, and at some point you’ll be able to take advantage of that deduction.