One may think that a loss generated by rental real estate will offset other income, but for most real estate investors that is not the case.
Whether the loss is derived from a property owned directly or on a K-1 from a partnership, LLC, or syndication, the tax code treats rental losses with suspicion. There are four separate hurdles that impact how a rental real estate loss affects your tax return. For apartment owners and other real estate investors, those rules can be the difference between a loss reducing this year’s tax bill and one that sits on the books for years waiting for income to absorb it.
This article will explain the ways a rental real estate loss can be limited, the differences between a passive and nonpassive activity, the tests to determine material participation, and real estate professional status.
The Four Hurdles Your Rental Loss Must Clear
The tax code applies four limitations to rental losses. Each criteria must be met before moving to the next. A loss can be suspended at any of the four levels.
- Basis: Your basis is a running total of your financial investment in the activity. For a pass-through activity, such as a partnership or S corporation, your basis is increased by your contributions, income previously taxed, and debt allocated to you. Basis is generally decreased by distributions, losses previously deducted, and debt that is relieved or reduced. Without a positive basis, a taxpayer cannot deduct losses in the current year.
- At-risk basis: A subset of basis tied to your actual economic exposure if the business were to fail. For example, partnership debt you personally guarantee will increase your at-risk basis. An at-risk basis that is lower than your tax-basis can further limit your losses even when your tax basis is still positive.
- Passive activity rules: Passive losses can generally only offset passive income, rather than wages or other active income. Without passive income, passive losses will be suspended.
- Excess business loss (EBL) limitation: After the first three hurdles are cleared, the loss can still be suspended if it is large enough. An excess business loss is the amount by which the total deductions exceed total gross income, plus a threshold amount that is indexed for inflation.
These hurdles are sequential, meaning a loss must clear each one in turn. A loss that fails at basis never gets evaluated against the at-risk rules, and so on. For investors with multiple activities or complex capital structures, working through them in order is the only way to know where a loss lands.
Passive vs. Nonpassive Activities
The passive activity rules determine what income a specific loss can be used to offset. An oversimplified definition of a nonpassive activity is an activity in which you meaningfully participate in operating the business. A passive activity is an activity in which you act as an investor and are not involved in the day-to-day operations of the entity.
The distinction is paramount because of the way losses are used to offset income. A passive loss can only be deducted to the extent of passive income. If your passive losses exceed your passive income, the excess is suspended and carried forward. If passive income exceeds passive losses, prior-year suspended passive losses might become deductible.
Material Participation
There are seven criteria to determine if an activity is nonpassive. Taxpayers that meet at least one of the following criteria are considered materially participating. These criteria are defined in §1.469-5T as:
- You participated in the activity for more than 500 hours during the year.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual, including individuals who didn’t own any interest in the activity, for the year.
- You participated more than 100 hours in the activity, making it a “significant participation activity,” and your total hours across all significant participation activities exceed 500.
- You materially participated in the activity in any 5 of the prior 10 tax years.
- The activity is a personal service activity (e.g., health, law, accounting, etc.) and you materially participated in any 3 prior tax years, not necessarily consecutive.
- Based on all facts and circumstances, you participated on a regular, continuous, and substantial basis during the year.
If a single activity can’t meet any of these tests on its own, you may be able to group activities together for purposes of measuring material participation.
The Rental Activity Rule
Rental activities involving real property, such as buildings and other permanently affixed structures, are treated as passive by default, even if you manage the property.
There are few exceptions where rental property isn’t considered passive:
- Rentals with an average customer use period of 7 days or less, known as short-term rentals.
- Rentals with an average customer use period of 30 days or less with significant personal services included, such as housekeeping, meals, or medical services.
- Rentals that include extraordinary services, like nursing homes or boarding schools.
Majority of long-term real estate investors’ portfolios do not meet the above exceptions. By default, the activity is passive, and so are the losses.
A real estate owner can have a well-performing asset, generate positive cash flow, yet show a paper loss for the year. The most common cause of paper loss is depreciation. Many owners’ natural assumption is to offset other income on their return with this loss. However, the rental loss is passive therefore wages and portfolio income, like interest and dividends that are nonpassive and won’t be offset. Instead, the loss is suspended and carried forward, sometimes for years, until either the owner generates enough passive income to absorb it or sells the property outright.
Suspended passive losses can remain unused for years, making active participation and real estate professional statuses attractive to investors looking to utilize their suspended losses.
Active Participation: A Limited Exception
The tax code offers a partial escape from the passive activity rules for taxpayers who actively participate in their rental. Active participation is not synonymous with material participation and has a lower threshold to meet the requirements. Active participation means making management decisions like approving tenants, setting rents, and approving repairs.
For those who qualify, up to $25,000 of rental losses can offset nonpassive income each year. That sounds promising, but the benefit phases out between $100,000 and $150,000 of adjusted gross income (AGI), disappearing entirely above $150,000.
Most real estate investors holding meaningful rental portfolios will reach the upper limit of the phase out rather easily. Which is why, for higher-income investors, the conversation turns to real estate professional status.
Real Estate Professional Status (REPS)
Real estate professional status (REPS) is determined on an annual basis and requires meeting a participation test and two time-based tests.
Qualifying as a real estate professional is the most consequential exception to the passive activity rules for real estate investors. For investors who qualify, rental losses are treated as nonpassive, meaning they can offset wages, self-employment income, and other active income. For a high-income investor with significant rental holdings, this conversion of rental losses from passive to nonpassive can generate substantial tax savings each year.
Participation Test
You must participate in your rental activities by meeting one of the seven material participation tests mentioned previously. This can be done activity by activity, or by making a formal election to treat all your rental real estate as a single activity for purposes of measuring material participation. The grouping election is critical for investors with multiple properties because without it, the hours spent on each individual property must clear the tests separately. After the grouping election is made, total hours across all properties get counted together.
Grouping Election
Despite a taxpayer qualifying as a real estate professional, each activity is treated independently by default. Therefore, for each activity, the taxpayer must still meet material participation on a per activity basis. To better assist real estate professionals who may have multiple entities holding real estate, taxpayers may elect to aggregate all interest in real estate as if it were a single entity. The taxpayer must meet material participation for the aggregate of all activities; otherwise, all rental activities will remain passive.
Time-Based Tests
You must also meet both of the following time-based requirements:
- More than 50% of your total hours worked in all trades or businesses must be performed in real property trades or businesses. If you’re a full-time W-2 employee in an unrelated field, this requirement will be difficult to meet. In that case you would have to spend more time on real estate activities than on your day job.
- You must perform at least 750 hours of services in real property trades or businesses during the tax year.
Real property trades or businesses are defined broadly and include development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, and brokerage.
Spousal Rule
For married couples filing jointly, only one spouse needs to qualify as a real estate professional, but the qualification is measured individually. One spouse’s hours can’t be combined with the other to meet the 50% and 750-hour tests. As long as one spouse qualifies, the couple will be able to benefit from the nonpassive treatment on their joint return.
A Common Misunderstanding
Qualifying as a real estate professional doesn’t automatically make rent losses nonpassive. It removes the automatic passive classification, which means rentals are no longer treated as passive by default. However, each rental activity still has to clear material participation on its own, or in the aggregate under the grouping election, to be treated as nonpassive. It is possible for a real estate investor to qualify for real estate professional status and without the grouping election does not meet the per-property hours. In this case, there would be no material participation, and any losses would remain passive. Proper planning and organization are paramount to take advantage of REP status.
REPS analysis is annual. A taxpayer’s status can change year-to-year as other work commitments change, if the taxpayer’s rental portfolio grows or shrinks, or if their time allocation shifts. The qualification a taxpayer earned in years prior does not carry over automatically.
Recordkeeping Matters
The burden of proof is on the taxpayer. This means the IRS expects taxpayers to substantiate both material participation and real estate professional status, and contemporaneous records must be kept as the work happens, not reconstructed at filing time. The best practices include:
- Time logs showing dates, tasks performed, and hours spent.
- Travel documentation for trips to properties or related activities.
- Emails and correspondence with tenants, contractors, property managers, and others.
- Detailed receipts and credit card statements tied to the activity.
The more documentation you keep, the stronger the position you can take if your classification is questioned.
Final Thoughts
The difference between passive and nonpassive treatment can quietly determine whether years of rental losses will reduce your tax bill or sit suspended on your return, waiting for income that may never come. The default passive treatment is unfavorable; the active participation exception phases out for most serious investors, and real estate professional status, while powerful, has technical requirements that are difficult to meet.
Here are some questions worth raising with your tax advisor:
- Are you currently claiming losses you’re not actually able to deduct, or carrying suspended losses you didn’t realize were there?
- If you have multiple rental properties, have you made the grouping election that lets you measure material participation across the portfolio?
- If you or your spouse may qualify as a real estate professional, are your records strong enough to support the position in an examination?
- Has your situation changed in a way that affects your REPS qualification this year: a new job, sale of one or more properties, a shift in how you spend your time?
REPS analysis is annual, but the planning opportunities can shift year to year. If you haven’t reviewed your position recently, or if you’ve never explicitly walked through whether you qualify, it’s worth a conversation. Your Aprio tax advisor can help you understand where your losses land, and whether there is a planning opportunity available to put them to better use.
To discuss your situation, reach out to your Aprio tax advisor or contact our real estate tax team directly at Aprio.com.