Plan Your Passive Activity Losses for Tax-Deduction RelevanceTax Planning
In 1986, lawmakers drove a stake through the heart of your rental property tax deductions.
That stake, called the passive-loss rules, causes myriad complications that now, 38 years later, are still commonly misunderstood.
In 1986, lawmakers made you shovel your taxable activities into three basic tax buckets. Looking at the buckets from a business perspective, you find the following:
- Portfolio bucket for your stocks and bonds
- Active business bucket for your material participation business activities
- Passive-loss bucket for your rentals plus other activities in which you do not materially participate
This article explains three escapes from the passive-loss trap so that you can realize the tax benefits from your rental losses.
Escape 1: Get Out of Jail Free
Lawmakers allow taxpayers with modified adjusted gross incomes of $100,000 or less to deduct up to $25,000 of rental property losses. Once your income goes above $100,000, the get-out-of-jail-free loss deduction drops by 50 cents on the dollar and disappears altogether at $150,000 of modified adjusted gross income.
Example. You have $90,000 of modified adjusted gross income, all of which comes from your business. You also have a $23,000 rental property loss for the year. Good news. You apply the $23,000 of rental losses against all your income and you realize your full rental-tax-loss benefits this year thanks to the $25,000 rule.
Escape 2: Changes in Operations
If you, or you and your spouse, have modified adjusted gross income that exceeds the threshold, you need a different plan to obtain immediate benefit from your rental property tax losses.
To begin, let’s review how the tax-benefit dollars get trapped in the first place. As you may remember from prior articles, to benefit from your rental property tax loss, you must
- either have passive income from other properties or another source, or
- both qualify as a real estate professional and materially participate in the rental property.
Example. Say the taxable income on your Form 1040 is $200,000 and you have one rental property. Say further that rental has produced a tax loss of $10,000 a year for the past six years, none of which you have been able to deduct because you have no other passive income and you do not qualify as a tax-law-defined real estate professional.
So here you sit: $60,000 in tax deductions trapped in the passive-loss bucket—not available for deduction against the income from the other buckets.
Not Lost, Just Waiting
This is sad, no doubt, but there’s some good news even in this bucket as you now see it. The $60,000 is not going to drown, disappear, or otherwise lose its tax-deduction attributes. That $60,000 simply waits in the bucket for you to give it an escape route.
Here are four possibilities for the escape route:
- Generate passive income.
- Change the character of the rental to non-passive.
- Change your status to that of a real estate professional and pass the material participation test for this property.
- Sell the property, as explained in Escape 3 below.
Generate passive income. Say you change the structure of your rental and it now produces $7,000 of passive income. Thank you, thank you; $7,000 of trapped passive losses now escape and offset that passive income. The $53,000 that remains trapped in the bucket is simply waiting for more passive income to enable its escape.
Change character of rental. Say you own 100 percent of your rental and 100 percent of your business and you now move your business into half of the rental property. The 50 percent business use of this former rental property frees $30,000 (50 percent) of those trapped losses for use against the business income. You have to think, “Is this cool or what?”
S corporation. If the rental or the business is in a separate legal entity (say an S corporation), you will need to make the self-rental election to apply that $30,000 against your business income.
Change your status. First, a short refresher: You establish your participation in the rental each year.6 For example, your rental could be passive in one year and non-passive in another.7 Say that today, perhaps by marriage or changing what you do, you are able to both qualify as a real estate professional and materially participate in your property.
Achieving real estate professional status does not automatically free the $60,000 trapped in the bucket—that takes passive income or a disposition (discussed next). But it does mean that the current-year loss of $10,000 escapes the passive-loss bucket and offsets your business and portfolio income.
Escape 3: Total Release
The $60,000 that’s trapped in the passive-loss bucket is like money in the bank. You can tap the trap when you want to release the deductions. It’s really quite easy.
Here we are talking about releasing the entire $60,000 at once (a major jailbreak). You might want to do this right now. or you can wait. You have many options, and the good news is that you are the one in charge of this total release of your passive losses.
To release the losses, you need to make a complete disposition. For example, say you sell 100 percent of the property to a third party. Presto! You now deduct the entire $60,000 in trapped passive losses.
Let’s examine how this sale might look on your tax return:
- Your capital gain or loss goes on IRS Form 4797 as a Section 1231 capital gain or loss, where it combines with other gains and losses. If you have a net gain, your gain is taxed at tax-favored capital gains rates. If a loss, the loss is limited to $3,000, with any excess carried over to future years.
- Your gain attributable to real-property depreciation also goes on IRS Form 4797, where it ultimately lands on Schedule D and gets taxed at real-property depreciation recapture rates of up to 25 percent (officially, this recapture tax is called a tax on your unrecaptured Section 1250 gain).
- Your current-year tax loss of $10,000 goes on Schedule E.
- Your prior-year tax losses of $60,000 go on Schedule E and combine with the $10,000. Then the $70,000 travels to the front of your IRS Form 1040, where it offsets all forms of income (hurray, hurray!).
In other words, at the time of complete disposition, you treat the gain or loss on the sale of this property as you would any gain or loss—that is, as if no passive-loss rules existed. And then that $60,000 of passive losses that were trapped in prior years and your current year passive loss combine and become totally deductible against all your other income.
The passive-loss rules are bad news, no question about it.
Also true, this article uses only one property in its examples. We did that for a reason: clarity. But put this in your mind: if you have multiple properties, you can make a tax-law election to group the properties and then apply the identical strategies above to the group.
The one thing to know is that if you have rental property losses that are trapped by the passive-loss rules, you can use the strategies you just learned to create an escape for those trapped losses.