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Passive Activity Loss Rules and Limitations

Posted by Brandon Hall on Jul 19, 2019
Brandon Hall

Landlords and buy and hold real estate investors are often faced with dealing with passive losses generated from their rental real estate activity. Though there are ways to get around the Passive Activity Loss regulations, this article walks you through the rules and limitations associated with passive activity losses.

What is a Passive Activity?

IRS Sec. 469 defines a passive activity as:

  1. Any trade or business of the taxpayer in which the taxpayer does not materially participate, and
  2. Any rental activity of the taxpayer except as provided under Sec. 469(c)(7).

Due to #2, all rental activities are classified as passive activities. Per IRS Regulations, a loss from a passive activity can only offset income from a passive activity.

Why is understanding this important? Because losses from passive activities cannot offset earned income. Losses from passive activities can only offset passive income.

Unless you qualify for an exception

There are two exceptions that allow taxpayers to use passive losses to offset earned income:

  1. The passive loss allowance which allows taxpayers with a Modified Adjusted Gross Income (MAGI) of less than $100,000 to deduct up to $25,000 of passive losses against their other income. This $25,000 deduction is phased out $1 for every $2 that MAGI increases above $100,000. This means that once a taxpayer’s MAGI exceeds $150,000, the passive loss allowance will have been completely phased out.
  2. Qualifying as a Real Estate Professional.

Many of our clients earn above $150,000 and do not qualify as real estate professionals. As a result, if their rentals produce passive losses in excess of passive income, the result is a net passive loss for the rental activities. That loss becomes a suspended passive loss and it is carried forward into the future.

If your MAGI is above $150,000, the only way to avoid passive losses from your rental real estate activities becoming suspended and carrying forward is to qualify as a real estate professional. We talk about that extensively here.

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