Understanding Passive Loss Rules for Rental Property Owners

February 22, 2023
  • facebook
  • linkedin
  • twitter
  • google plus

Passive loss rules have been commonly misunderstood by rental property owners since they were first introduced in 1986. Today, we want to provide a better explanation of passive loss rules and how you can use the current tax laws to realize tax benefits from any rental losses.

The passive loss rules essentially make rental property owners separate taxable business activities into three different categories:

  1. Portfolio for stocks and bonds
  2. Active business activities requiring material participation
  3. Passive losses and activities which don’t require material participation

Dealing with passive losses can get complicated and the wrong tax strategy could backfire. It’s important to work with your tax advisor to understand the rules and look for opportunities where you can take advantage of passive losses. Here are a few great solutions to consider:

Solution #1 – Get Out of Jail Free

Lawmakers allow taxpayers with modified adjusted gross incomes of $100,000 or less deduct up to $25,000 of rental property losses. This is known as the “get out of jail free” deduction by tax experts. The deduction drops by 50% once your MAGI goes above $100,000 and is not available to anyone making more than $150,000.

Solution #2 – Changes in Operations

If your modified adjusted gross income exceeds the $150,000 threshold, you will need a different plan to obtain immediate tax benefits from your rental property tax losses. There are two important qualifications to remember if you want to claim rental property tax losses:

  1. Have passive income from other properties or another source; or
  2. Both qualify as a real estate professional and materially participate in the rental property.

Let’s say your MAGI is $200,000 and you own one rental income property. However, that rental has produced a tax loss of $10,000 a year for the past six years. You have not been able to deduct any of these losses because you did not meet the qualification criteria.

The good news is that $60,000 deduction could still be available to you with the right escape route. Here are four solutions that could enable you to claim your past $60,000 in losses, along with any future passive losses:

  1. Generate passive income.
  2. Change the character of the rental property to non-passive.
  3. Change your status to that of a real estate professional, and meet the material participation requirements.
  4. Sell the property (see below). 

Solution #3 – Total Release

Essentially, that $60,000 in unclaimed passive losses is like money in the bank. You can utilize it whenever you want to release the deductions. You can do it all now or wait until later. You actually have many options available to you, and you are the one in charge of this total release of your passive losses. You simply have to make a complete disposition by selling 100% of the property to a third party. This will enable you to immediately deduct the entire $60,000 in trapped passive losses.

As you can see, there are numerous strategies to consider and they all have complications that take an expert’s knowledge to navigate. If you are a rental property owner and are looking to make the most of your tax situation, contact Illumination Wealth and let our team help you optimize your plan.