Rental Activities: Limitations of Loss from Passive activity
If you incur more rental expenses than your rental income, you have a loss from your rental real estate activity which might not be deductible. Two sets of rules may limit the amount of loss you can deduct.

1- The At-risk Rules

Over the years, Congress has attempted to limit deductions from activities that involve little risk or taxpayer investment.

A taxpayer’s loss from an activity is limited to the amount that (s)he has at risk in the activity. Amounts “at risk” include cash contributed to the venture, the adjusted basis of property contributed and other contributed cash or property financed with loans that the taxpayer is personally liable for.

Any losses disallowed because of the at-risk rules may be deducted in future years when the at-risk amount increases due to either additional contributions, additional profits in the venture, or reclassification of non-recourse debt as recourse debt.

The at-risk rules apply to most activity and are applied before the passive activity rules.

2- The passive activity limitations – in general

Income is classified by the IRS as belonging to one of three categories:

  • Active income: trade or business in which the taxpayer materially participate
  • Passive income: trade or business in which the taxpayer does not materially participate
  • Portfolio income: investment income such as interest, dividends and royalties

In general, deductions from passive activities are limited to incomes from passive activities; in other words, net passive losses may not offset active or portfolio incomes.

There are two kinds of passive activities.

  • Trade or business activities in which you do not materially participate during the year.
  • Rental activities, even if you do materially participate in them, unless you are a real estate professional.

Definition of Passive Income: Earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not actively involved. As with non-passive income, passive income is usually taxable as ordinary income.

Generally, losses from passive activities that exceed the income from passive activities are disallowed for the current year. Any losses from passive activities that are not currently deducted may be carried over indefinitely and used when passive income exists to absorb the losses, or the activity that generated the losses is disposed of in a taxable transaction.

3-The passive activity limitations – Real Estate Exceptions

  • The $25,000 Residential Real Estate Exception: if you or your spouse own at least 10% interest without limited liability in residential real estate and actively participated in a passive rental real estate activity, you can deduct up to $25,000 of disallowed loss against any type of income. (the deduction is reduced if you file separate return and/or if your modified adjusted gross income exceeds certain amounts).

Active participation includes management decisions in a significant sense, such as approving new tenants, deciding on rental terms, approving expenditures.

Your activity is not a rental activity if any of the following apply: the average period of customer use of the property is 7 days or less. The average period of customer use of the property is 30 days or less and you provide significant personal services with the rentals.

The passive activity rules apply to individuals, estates, trusts (except grantor trusts), closely held corporations, and personal service corporations.

  • The Real Estate Professional Exception: Taxpayers who participate in a number of real estate ventures may qualify for a special professional real estate exception to the passive activity rules. The two conditions to qualify for the exception:

More than 50% of all the individual’s personal services are performed during the tax year in real property trades or businesses in which the taxpayer materially participates; and

The individual performs more than 750 hours of personal services during the tax year in real property trades or businesses in which the taxpayer materially participates.

Material participation can be proven through various documentary evidences such as:

•Cell phone (billing statement) call records
•Emails
•Travel itineraries and receipts
•Credit card charges
•Affidavits from customers

I created this blog to help understand certain basic aspects of U.S. tax law. Of course, each situation is unique and nothing that is on this site will ever replace the expert advice of a tax professional.

Please do not hesitate to contact me should you have any question

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