As a landlord or rental home owner, you may be familiar with the concept of passive income. However, you may not be as familiar with the IRS rules that govern passive activity losses. These rules can have a significant impact on your tax situation, so it's important to understand them. In this blog post, we'll break down what you need to know about passive activity loss rules and how they apply to you as a landlord or rental home owner.
What Are Passive Activity Loss Rules?
Passive activity loss rules are IRS rules that limit the use of losses from passive activities to offset income from non-passive activities. Passive activities are those in which the taxpayer does not materially participate, such as rental properties or limited partnerships. Under these rules, passive losses can only be used to offset passive income, and any unused losses may be carried forward to future years to offset future passive income.
How Do Passive Activity Loss Rules Apply to Landlords and Rental Home Owners?
As a landlord or rental home owner, your rental activities are considered passive activities, even if you are materially involved in the operation of the property. This means that any losses from your rental activities can only be used to offset passive income, such as rental income from other properties. If you have no passive income in a given year, you may not be able to deduct any losses from your rental activities.
How Can You Determine Material Participation in Rental Activities?
Material participation is the key factor in determining whether you can use passive losses to offset active income. The IRS defines material participation as involvement in the operation of a trade or business activity on a regular, continuous, and substantial basis. There are seven tests that can define material participation, but the most common one is working at least 500 hours in the business in the course of a year.
It's important to note that rental activities, including real estate rental activities, are considered passive activities even if there is material participation. This means that if you materially participate in the operation of your rental property, you may not be able to use any losses from that property to offset active income from other sources.
Seven ways a taxpayer can be considered a material participant according to the IRS:
- Work more than 500 hours in the activity. Spouses' participation is also counted.
- Do substantially all of the work in the activity.
- Work more than 100 hours in the activity and no one else works more than the taxpayer.
- Have significant participation in the activity and the taxpayer's total time in all significant participation activities exceeds 500 hours.
- Materially participate in the activity in any five of the prior ten years.
- Materially participate in a personal service activity for any three prior years.
- Participate in the activity on a regular, continuous, and substantial basis during the year based on all facts and circumstances.
If your passive activity loss isn't allowed for the year, you might need to allocate the disallowed portion among different activities and deductions. The ratable portion of a loss from an activity is computed by multiplying the disallowed portion by the fraction obtained by dividing the loss from the activity for the tax year by the sum of the losses for the tax year from all activities having losses for the year. You can use Part VII of Form 8582 to figure out the ratable portion of the loss from each activity that’s disallowed.
What Happens If Your Passive Activity Loss Isn't Allowed for the Year?
If your passive activity loss isn't allowed for the year, you may need to allocate the disallowed portion among different activities and deductions. This can be a complex process, but it's important to get it right to avoid any penalties or interest charges.
To illustrate how this works, let's take a look at an example. Say if you own three rental properties, A, B, and C, and the gross income and deductions for each property for the taxable year are as follows:
A: Gross income - $7,000, Deductions - ($16,000), Net Loss - ($9,000)
B: Gross income - $4,000, Deductions - ($20,000), Net Loss - ($16,000)
C: Gross income - $12,000, Deductions - ($8,000), Net Income- $4,000
In this case, your passive activity loss for the year is $21,000, which is disallowed. This means that a ratable portion of the losses from activities A and B is disallowed. The disallowed portion of each loss can be calculated by multiplying the disallowed portion by the fraction obtained by dividing the loss from the activity for the tax year by the sum of the losses for the tax year from all activities having losses for the year.
For example, the disallowed portion of the loss from activity A would be calculated as follows:
A: $21,000 x ($9,000 / $25,000) = $7,560
The disallowed portion of the loss from activity B would be calculated in a similar way. The total disallowed loss would still be $21,000.
In conclusion, passive activity loss rules can be complex, but they're important to understand if you earn passive income from rental properties or other investments. By keeping track of your losses and gains and ensuring you meet the material participation requirements, you can maximize your tax benefits and avoid any penalties or interest charges. If you're unsure about how these rules apply to your situation, don't hesitate to reach out to us.