Deducting your rental property tax losses against your other income is tricky, as you likely know. You have to get the tax law to treat you – let us say a computer engineer, a nurse – as a tax-code defined real estate professional.

Assuming that the code treats you as a real estate professional. Does that status allow immediate use of suspended passive losses? Unfortunately, the answer is no. However, many times, some tax preparers deduct all rental losses against their income from their wages. Here’s why.

Understanding Passive Loss Rules

Passive losses adhere to the following three principles: Passive losses offset only passive income; 2) Excess passive losses are disallowed and carried forward to offset passive income in future tax years; and 3) Carried-forward passive losses are released in a complete disposition, allowing them to offset both passive and non-passive income.

Thus, the tax code limits passive loss deductions to passive income, with any excess carried forward to future years. You release the carried-forward losses when you

  • have offsetting passive income from the same or other passive activities, or
  • completely dispose of the activity generating the loss.

Example. John, a doctor earning $500,000 annually in non-passive income, generates a $50,000 loss from his rental property in Year 1. He cannot offset this loss against his medical income due to the passive loss rules. In Year 2, he sells the property for a $100,000 capital gain. As a result: John deducts his $50,000 suspended ordinary loss against his high ordinary income (e.g., his medical practice income). John pays taxes on his $100,000 capital gain at the more favorable capital gains tax rate.

Key factors to remember: For John to deduct the $50,000 loss in Year 1, he would have to 1) be a tax code–defined real estate professional and who 2) materially participated in his rental property activity. 

Real Estate Professional Status

Qualifying as a real estate professional under IRS rules requires meeting two tests annually:

  • Spend more than 50 percent of your work time in real property trades or businesses.
  • Perform at least 750 hours of your work in real property trades or businesses.

The Internal revenue Code section 467(c)(7)(C) defines “eligible real property businesses” as those engaged in development or redevelopment, construction or reconstruction, acquisition, conversion, renting or leasing, property management, or brokerage.

Example. Debbie, a real estate broker earning $500,000 in non-passive income, incurs $100,000 in rental losses. Her real estate brokerage firm, which she owns, helps her pass the tax code–defined real estate professional test. She also passes the material participation test because she is the only person who works on the rentals. Accordingly, she deducts the $100,000 in losses against her non-passive brokerage income. 

Material Participation

Additionally, you must materially participate in the rental activity to create non-passive losses.

The Two-Part Solution

Meeting (1) the real estate professional test and (2) the material participation standard allows current-year rental losses to offset non-passive income, such as wages or business income.

Impact on Prior Passive Losses

Qualifying as a real estate professional is not retroactive. Suspended passive losses from prior years remain subject to the original rules. You can use the prior suspended losses in the following ways:

  • To offset passive income from the same or other passive activities
  • When you completely dispose of the activity that created the suspended passive losses

Real estate professional status offers valuable tax benefits for your rental properties but does not free up prior passive losses. Annual testing is required to maintain this status. 

 Hiring a tax resolution expert is the best action a taxpayer could take in a tax matter before the IRS or a state Department of Revenue. 

We offer FREE initial consultation!!!

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