When Can You Use Real Estate Losses?
Can you use real estate to reduce your tax liability?
For those paying upwards of $70,000+ per year in tax, I’m sure you’ve asked yourself this before.
You feel like you’re doing everything you can and you’re looking for new ways to reduce what you’re paying Uncle Sam.
You’ve heard whispers about the writes offs real estate offers like depreciation, mortgage interest, taxes, insurance, etc. and wonder if this is right for you.
Like all great complex questions… the answer begins with, it depends.
But it doesn’t end there.
Real estate investing can be separated into three areas:
Capital appreciation
Rental income
Tax losses
Many recognize that real estate can both appreciate in value over time and pay for itself (& potentially more) with a tenant.
But when it comes to tax losses, the IRS is particular about who can deduct real estate losses.
There’s three tax classifications with associated rules to determine your ability to deduct real estate losses:
Passive
Active
Real estate professional
Based on how you qualify under which classification will determine your ability (or inability) to deduct investment real estate loss.
Passive = a trade or business activity in which you did not materially participate during the year (or its rental activities, even if you do materially participate in them, unless you’re a real estate professional).
This leads us to idea of material participation which is defined by the IRS as:
Typically, you’re able to claim material participation if you participated on a “regular, continuous, and substantial basis.”
Note: just because you have a large financial interest in the business doesn’t mean you materially participate.
Further, it’s on you as the taxpayer to have the documentation through time reports, logs, etc. to show proof you did in fact materially participate.
Rental activity by the IRS is deemed to be passive.
This means that any loss generated in real estate cannot be offset against your active income (think W2/1099 earnings or business profit).
So, unless you’re an active or real estate professional, tax losses don’t apply to you.
However, when you sell the business you passively participated in, you can use the losses at that time to offset active income.
But in the meantime, that doesn’t make passive losses useless, passive losses can be used to offset other forms of passive income.
Passive income could be stock dividends, bond interest, real estate investment trusts (REIT), or checking/savings account interest.
Active = you’re making genuine and significant management decisions (ex: approving new tenants, deciding on rental terms, approving capital expenditures, coordinating with professionals for repairs or improvements, etc.) then the activity is considered active (note: this is less stringent than material participation and there is no time commitment requirement).
Caveat here is that if you must be a greater than 10% owner in the property.
Being classified as an active investor comes with a special $25,000 loss (or $12,500 for married filing separate tax filers).
This special loss rule states that if you or your spouse actively participated in a passive rental real estate activity then you can deduct up to $25,000 of the loss from the activity from your nonpassive income.
Big win!
But there’s a catch:
There’s an income phaseout.
For single & married filing joint tax filers, the benefit begins to phase out at modified adjusted gross income of $100,000 and ends at $150,000.
For married filing separate tax filers, the benefit begins to phase out at modified adjusted gross income of $50,000 and ends at $75,000.
Note: there is an exception with a higher phaseout if the rental activity loss is from rehabilitation investment credits and there’s no phaseout for low-income housing credits.
Income phaseout permitting, being classified as an active real estate investor is your best bet to utilize real estate losses (if being a real estate professional isn’t an option).
So this then brings us to the big kahuna - being a real estate professional.
Real estate professional = qualification through meeting both of the following tests:
More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
For many, unless you’re in the business of real estate, it’s HARD to be classified as a real estate professional.
This means if you’re not a real estate professional this makes your odds of being able to deduct losses slim.
Sad, I know.
But there two workarounds:
If you’re a household where one spouse makes significantly more than the other. Or your spouse doesn’t work, having them work to be classified as a real estate professional would allow for the deductibility of losses.
Utilize a short-term rental strategy. If the average rental days is 7 days or less, you do not need to qualify as a real estate professional to claim your losses from your short-term rental. You do need to prove that you materially participated in the short-term rental activity for losses to be considered non-passive (great for vrbo & airbnb users).
So there’s hope!