Rental Real Estate and the $25,000 Special Loss Allowance (2024)

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Generally, a trade or business activity is considered a passive activity if the taxpayer does not materially participate in the activity. This means, passive activity losses may only be deducted from passive activity income and not from nonpassive activity sources of income, such as wages or income from a business you materially participate in.

Rental Real Estate

Since rental real estate activities for real estate nonprofessionals are considered passive activities, even if the taxpayer does materially participate in the activity, losses from such activities are normally not deductible against nonpassive income.

But, there is an exception for small landlords with modified adjusted gross income (MAGI ) under $150,000 ($75,000 if married filing separately) that allows rental losses to be classified as nonpassive losses and deducted from nonpassive income.

Modified adjusted gross income is simply the exclusion of certain items that were included in your adjusted gross income (see below).

Special $25,000 Allowance for Real Estate Nonprofessionals

If you're not a real estate professional, a special rule let's you classify up to $25,000 of rental losses as nonpassive. This means you can deduct up $25,000 of rental losses from your nonpassive income, such as wages, salary, dividends, interest and income from a nonpassive business that you own.

Deduction Limits

If your modified adjusted gross income (MAGI) exceeds $100,000 ($50,000 if married filing separately), the $25,000 maximum deduction amount ($12,500 if married filing separately) is reduced by 50% of each dollar over $100,000 ($50,000 if married filing separately).

For example, if your MAGI is $110,000, the maximum $25,000 deduction amount is reduced by $5,000 (50% x $10,000) leaving $20,000 available to deduct.

Once MAGI reaches $150,000 the $25,000 deduction is completely eliminated (50% x $50,000 = $25,000).

Qualifying for the Special Allowance

To qualify for the special allowance you must (a) actively participate in the activity and (b) your interest (including your spouse's interest) must be at least 10% (by value) of all interests in the activity throughout the year.

Married Filing Separately:

The special allowance is not available if you were married, lived with your spouse at any time during the year, and are filing a separate return.

Active Participation:

Active participation is not the same as material participation. Active participation is a less stringent standard and is intended to make it easier for real estate nonprofessionals to qualify for the special $25,000 rental loss deduction. There is no specific hour requirement to meet the active participation test.

However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager. Merely signing off on what a management agent does or merely reviewing financial statements or conducting analysis that is unrelated to the day-to-day management or operation of the activity is not treated as active participation.

As long as a taxpayer has more than a 10% ownership interest in the property and participates in the property's management decisions in a bona fide sense, the taxpayer is considered to actively participate in the real estate rental activity. For example, approving leases and tenants, setting the rental terms, approving maintenance and repair expenses.

Using a Property Management Company:

Using a property management company will not prevent you from meeting the active participation test as long as you are involved in a significant bona fide sense in the management of the property. For example, you approve leases of prospective tenants, you approve the selection of service vendors provided by the property management company and approve maintenance expenses.

Note that you don't have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way. You or your spouse (if married) may be treated as actively participating if you make management decisions in a significant and bona fide sense.

Finding Your Modified AGI

To figure your modified AGI, combine all the amounts on your IRS Form 1040 that you used to calculate adjusted gross income, except for the following:

1. Taxable Social Security and tier 1 railroad retirement benefits
2. Deductible contributions to individual retirement accounts (IRAs) and Section 501(c) (18) pension plans (trust funds by employees only formed prior to June 25, 1959)
3. The exclusion from income of interest from qualified U.S. savings bonds used to pay qualified higher education expenses
4. The exclusion from income of amounts received from an employer’s adoption assistance program
5. Passive activity income or loss included on Form 8582
6. Any rental real estate loss allowed because you materially participated in the rental activity as a real estate professional
7. Any overall loss from a publicly traded partnership
8. The deduction for one-half of self-employment tax
9. The deduction for domestic production activities
10. The deduction allowed for interest on student loans
11. The deduction for qualified tuition and related expenses