If you have an investment property, second home or vacation home that you rent out, or if you rent out part of your residence, your rental income is subject to U.S. federal income tax and you can also claim the expenses you incur in the rental activity as tax deductions. But since renting real estate is considered a passive activity for tax purposes, if you have a net loss from the rental, the loss you can claim on your income tax return may be subject to the passive activity limits.
You can generally offset losses from rental activities only against other passive income you report on your tax return, such as income from a limited partnership or from some other trade or business in which you did not materially participate. But there are two exceptions that allow you to offset losses from rental activities against other income on your tax return. One is if you qualify as a real estate professional, and the other is if you actively participate in the rental activity.
Real estate professional
According to the IRS, there are two requirements you have to meet in order to qualify as a real estate professional for tax purposes. The first is that more than half of all the services you perform during the year must be in real property trades or businesses in which you materially participate. These include real estate development, construction, acquiring and converting real property, renting or leasing real property, operating or managing real property, and working as a broker. The second requirement is that you must work more than 750 hours during the year in real property trades or businesses in which you materially participate.
If you are not considered a real estate professional, but you actively participate in the rental activity, you can deduct losses in the rental activity up to $25,000 ($12,500 if married filing separately). Active participation for tax purposes means that you own at least 10% of the real property and you make management decisions, such as setting rental terms, approving tenants, approving expenditures, and arranging for others to provide services such as repairs.
This $25,000 special allowance for deducting losses on a rental activity applies if your modified adjusted gross income (MAGI) is not more than $100,000 ($50,000 if married filing separately). If your MAGI is more than $100,000, the allowance is reduced by 50% of the amount by which your MAGI exceeds $100,000. If your MAGI is $150,000 or more, you generally cannot take the special allowance for active participation in a real estate activity. If your loss on the rental activity exceeds your special allowance, you can carry over the excess loss to the following tax year.
As indicated in an article in the Journal of Accountancy, the IRS has been stepping up its audits of tax returns with real estate rental income. In order to substantiate your material participation in a rental activity as a real estate professional or your active participation to qualify for the $25,000 special allowance, you should keep records of your participation. These records could include calendars, appointment books, and summaries of your activities, including dates and the number of hours you spent on the rental activity.
The types of expenses you can claim for tax purposes include depreciation of the property, interest on mortgage or other loans or credits, repairs and maintenance, utilities, insurance, independent contractor services, legal and professional fees, advertising, commissions, and local and long distance travel related to your rental activity. If you are renting out a condominium that you own, the management association dues or maintenance fees you pay also constitute a rental expense.
Publication 527 – Residential Rental Property – Internal Revenue Service
Publication 925 – Passive Activity and At-Risk Rules – Internal Revenue Service
Elizabeth Murphy and Keith Gunter, “Real Tax Savings in Real Estate” – Journal of Accountancy