Real Estate Passive Losses: Their Tax Benefits & More
Passive losses for rental properties is a tax concept that every seasoned real estate investor needs to familiarize themselves with. In simple terms, passive losses occur when the expenses of owning a rental property exceed the income generated by the property.
This can happen if the investor didn’t correctly analyze a rental property and rental market from the outset, leading to vacancies. It can also result from a recession, or when one or several tenants don’t pay on time.
Regardless of how it happens, the rental income isn’t enough to cover that year’s mortgage, taxes, and other expenses.
To understand what passive loss in real estate is all about, we’ll look at the following;
- The tax benefits of passive loss in real estate
- The difference between active and passive income
- How passive losses occur
- How passive losses can be used to offset passive income
- How to minimize or avoid passive losses
Tax Benefits Of Passive Loss In Real Estate
If your modified adjusted gross income (MAGI) is $100,000 or less, the IRS allows you to deduct up to $25,000 in passive losses from your ordinary income (W-2 wages) under the Passive Activities rule.
This deduction is scaled down to $1 for every $2 of MAGI beyond $100,000 until it is completely phased out at $150,000. Keep in mind, these limitations apply to solo filers as well as married filers filing jointly.
If your passive losses exceed these limits, they can be carried forward to offset passive income in future years.
Difference Between Active & Passive Income
What Is Active Income?
Active income is obtained through actively engaging in a trade or business. If you are a real estate agent, for example, the commission you make from selling a property is considered active income. Or, if an investor also acts as the landlord or property manager, this would also be considered active income.
What Is Passive Income?
Passive income is produced from investments or rental properties where the investor is not actively involved in property management. So, if an investor has a vacation property that they don’t frequently visit, and they’ve outsourced all management and maintenance to a third-party - this would be considered passive income.
How Passive Losses In Real Estate Occur
In real estate, passive losses occur when the expenses of owning a rental property exceed the rental income. These expenses can include:
- Mortgage interest
- Property taxes
- Insurance
- Maintenance and repairs
- Property management fees
If these expenses are more than the rental income, the difference is considered a passive loss.
How Passive Losses Can Be Used To Offset Passive Income
Only passive income can be used to cover passive losses. Accordingly, if you own a rental property that generates a passive loss, you can only use that loss to reduce the passive income from other rental properties or investments. You cannot use that passive loss to offset taxes in any other way.
How To Minimize Or Avoid Passive Losses
While there are tax benefits to passive losses in real estate, you almost always want to avoid these losses. A couple things real estate investors can do to avoid passive losses in the future;
- Proper management of the rental property. This includes;
- Setting a competitive rental rate
- Keeping the property well-maintained
- Actively finding qualified tenants that pay on time.
- Create a portfolio of rental properties.
- This way, if you do experience passive losses from one property, you’ll be able to supplement your income with revenue from the other properties.
Real-World Scenario Of Passive Losses In Real Estate:
John invests in real estate and has a number of rental homes. Due to a shortage of tenants, one of his properties, a 2-bedroom apartment, has remained empty for a while. John has spent money on mortgage interest, property taxes, insurance, and upkeep over this time. When he finally secures a renter, he determines the costs associated with the property and discovers that they exceed the rent. I
John has suffered a passive loss for this rental property in this circumstance. The restrictions imposed by the IRS apply, and he can only utilize this loss to offset passive income from his other rental properties. John can try to find renters more quickly, charge a higher rent, or make investments in buildings that provide more money to prevent this in the future.
With a portfolio of rental properties, passive loss tax credits can be invaluable to investors during an economic downturn or an off-year, so make sure you’re familiar with the concepts.
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