How to Deduct Loss on Rental Property

How to deduct a loss from residential rental property you own and are renting out?

On a tax return, rental activities generally fall into the category of “passive” activities and get special tax treatment from the IRS. This special treatment could be very favorable for taxpayers seeking to deduct losses on rental property that they own.Rental losses incurred each year can be deducted currently only against passive income and not against nonpassive income, such as your wages or investment income. This would be very helpful to someone who owns multiple rental properties. If you have a loss from your rental real estate activity, two sets of rules may limit the amount of loss you can deduct. You must consider these rules in the order shown below. Both are discussed in this section.


How to Deduct Loss on Rental Property

  1. At-risk rules. These rules are applied first if there is investment in your rental real estate activity for which you are not at risk. This applies only if the real property was placed in service after 1986.
  2. Passive activity limits. Generally, rental real estate activities are considered passive activities and losses are not deductible unless you have income from other passive activities to offset them. However, there are exceptions.


How to get rental property tax deduction?

The fact is, that in order to get the loss on rental property tax deduction, you have to “actively participate” in the residential rental activity. If you are actively participating in rental activities, you may be able to deduct a loss of up to $25,000 in a tax year against nonpassive income.

However, before you meet this requirement, you must pass the actively participating in rental activity test. You actively participate in the rental activity if you make key management decisions. These decisions might be approving new tenants, deciding on rental terms, approving capital expenditures. This is a fairly easy test in order to meet. You also can show active participation by arranging for others to provide services. You need not have regular, continuous, and substantial involvement with the property. A taxpayer may have another job and still qualify for a deduction on rental property if they are involved in the property management.


Satisfying the Active Participation Test

To satisfy the active participation test, you (together with your spouse) must own at least 10% of the rental property. Ownership as a limited partner does not count toward this test. There are more complex rules on how the deductions will work when there are more than one owner that are beyond the scope of the brief article on rental property tax deductions.

If you meet the above tests, you can claim up to $25,000 in losses against nonpassive income ($12,500 if you’re married, file separately, and live apart from your spouse for the entire year). If you’re married, file separately and don’t live apart from your spouse for the entire year, you’re not eligible for this break at all.


Phase-out on Deducting Rental Property Losses

However, there is a phase out for this tax deduction. This will apply to taxpayers in higher tax brackets.

  • If your adjusted gross income (AGI) is above $100,000, the $25,000 allowance amount is reduced by 50% the excess over $100,000.
  • If you’re married, file separately and are eligible for the break, the $12,500 allowance amount is reduced by one-half the excess over $50,000.

This basically means that if a taxpayer has an AGI over $150,000, the amount is reduced to zero. You would file this deduction along with your Schedule E which is used to show rental income/expenses. It is also important to note that AGI is a little different than the standard definition.


Losses on Rental Property

Losses on rental property that are not allowed in the current tax year can be carried forward.  They are carried forward and can be deducted against nonpassive income in future years if you continue to actively participate in the rental real estate activity that generated the losses, subject to the $25,000 limit.

Remember that if you stop actively participating, the carried-forward losses are treated as passive activity losses that may only be used to offset passive activity income. You can then only use the passive losses when you dispose of the rental property.