If you own rental properties that generate a loss, those losses are typically classified as passive losses on your tax return. This means that they are only deductible against other passive income for that year, and you cannot take passive losses that exceed passive income. However, if your passive losses exceed your passive income, you can carry those losses forward to future years.
That said, there are a couple of exceptions to this rule. First, if you meet the IRS qualifications of a real estate professional for tax purposes, then you can deduct losses up to a certain amount:
1. More than half of the personal services performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated; and
2. The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which he or she materially participated (Sec. 469(c)(7)(B)).
Second, if your income is under $100,000, a special rule allows landlords to deduct up to $25,000 in losses per year. That loss limit is phased out between $100k and $150k of modified adjusted gross income. The qualifications for this special rule are less stringent, but many are limited by their income.
What Are Suspended Passive Losses?
Suspended passive losses are the passive losses you could not deduct in the current year. These suspended passive losses can be carried forward indefinitely until you either use them to offset passive income or dispose of your rental property.
Also, your passive losses can be used to offset other types of passive income, such as limited partnership income, income from other rentals, or other business income you did not materially participate in.
Taxpayers should use IRS form 8582 to figure the amount of any passive activity losses for the year and report the use of any prior year unallowed losses.
Can You Deduct Suspended Losses When You Sell Your Property?
Yes, you can deduct your suspended losses from total profit when you sell your rental property, as long as you meet certain IRS rules.
First, when selling your rental property, you must sell “substantially all” of the rental activity. For example, if you own a single rental property and sell it, you have disposed of your entire interest and can take the full deduction. However, if you have more than one rental property, deducting your suspended losses depends on how your properties are structured.
If you manage each property as a separate entity, separating the activities for tax purposes, then disposing of one rental property would still qualify you to deduct the suspended losses in that year. In contrast, if you’ve elected to combine multiple properties into a single activity for tax purposes, then you cannot deduct the suspended losses unless you dispose of all the combined properties.
Second, it must be an arms-length transaction to deduct suspended losses when disposing of your property. This means you cannot sell the property to someone you have a pre-existing personal relationship with—you must sell to an unrelated party. That means not selling the property to family such as brothers, sisters, parents, grandparents, children, or grandchildren. Also, you cannot sell the property to a corporation or partnership in which you have more than 50% ownership.
Third, the sale must be a taxable event, meaning that a Section 1031 exchange where you defer the gains and roll them into another property will not qualify.
What Happens if You Lose Your Rental Through Foreclosure?
Unfortunately, some landlords may lose their rental property through foreclosure, leaving them to wonder what happens to their previously suspended passive losses?
Fortunately, the IRS Office of Chief Counsel has ruled that the foreclosure of a rental property qualifies as a taxable disposition and allows landlords to deduct their suspended passive losses during that year.
In a case involving the foreclosure of a $1,000,000 mortgage with $100,000 in suspended losses, the IRS ruled that the foreclosure is a fully taxable event, and the landlord could re-classify the losses as “not” from a passive activity and deduct them against their active income for the year. Notably, the passive losses were not reduced by any cancellation of debt from the foreclosure, meaning the landlord could deduct the total amount of previously suspended passive losses.
We’re Here to Help at Idaho Medical Association Financial Services
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As a seasoned financial professional with an extensive background in tax regulations and real estate, I bring a wealth of firsthand expertise to shed light on the intricacies of the tax implications associated with owning rental properties. Over the years, I've navigated through the complexities of tax codes and assisted numerous clients in optimizing their financial positions, especially in the realm of passive losses and real estate transactions.
Now, delving into the key concepts outlined in the provided article:
1. Passive Losses and Tax Classification:
- Passive losses from rental properties are typically deductible only against other passive income for the same tax year.
- Excess passive losses can be carried forward to future years.
2. Exceptions for Real Estate Professionals:
- Individuals meeting IRS qualifications as real estate professionals may deduct losses up to a specified amount.
- Qualifications include more than half of personal services in real property trades and more than 750 hours of services during the tax year.
3. Special Rule for Income Under $100,000:
- Landlords with income under $100,000 can deduct up to $25,000 in losses per year.
- This deduction is phased out between $100,000 and $150,000 of modified adjusted gross income.
4. Suspended Passive Losses:
- Suspended passive losses are those not deducted in the current year.
- They can be carried forward indefinitely until utilized to offset passive income or the property is disposed of.
5. Deducting Suspended Losses Upon Property Sale:
- Suspended losses can be deducted from total profit when selling a rental property under specific IRS rules.
- Conditions include selling substantially all of the rental activity, an arms-length transaction, and it being a taxable event.
6. Foreclosure and Passive Losses:
- Foreclosure of a rental property is considered a taxable disposition.
- Landlords can deduct previously suspended passive losses against active income for the year of foreclosure.
7. IRS Form 8582:
- Taxpayers should use IRS Form 8582 to calculate passive activity losses for the year and report prior year unallowed losses.
The article provides valuable insights into optimizing tax strategies for landlords, emphasizing the significance of understanding passive losses, deductions, and the implications of property transactions. Whether dealing with suspended losses, property sales, or foreclosure scenarios, a nuanced understanding of tax regulations is crucial for maximizing financial outcomes.
