IRS Sec. 469 defines a passive activity as:
- Any trade or business of the taxpayer in which the taxpayer does not materially participate, and
- 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. Losses from passive activities cannot offset earned income.
There are two exceptions that allow taxpayers to use passive losses to offset earned income:
- 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.
- 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.