Plan Your Passive Activity Losses for Tax-Deduction Relevance

Plan Your Passive Activity Losses

In 1986, lawmakers drove a stake through the heart of your rental property tax deductions.

That stake, called the passive-loss rules, causes myriad complications that now, 37 years later, are still commonly misunderstood.

The Trap

In 1986, lawmakers made you shovel your taxable activities into three basic tax buckets. Looking at the buckets from a business perspective, you find the following:

1. Portfolio bucket for your stocks and bonds
2. Active business bucket for your material participation business activities
3. Passive-loss bucket for your rentals plus other activities in which you do not materially participate

This letter explains three escapes from the passive-loss trap so that you can realize the tax benefits from your rental losses.

Escape 1: Get Out of Jail Free

Lawmakers allow taxpayers with a modified adjusted gross income of $100,000 or less to deduct up to $25,000 of rental property losses. Once your income goes above $100,000, the get-out-of-jail-free loss deduction drops by 50 cents on the dollar and disappears altogether at $150,000 of modified adjusted gross income.

Escape 2: Changes in Operations

If you, or you and your spouse, have modified adjusted gross income that exceeds the threshold, you need a different plan to obtain immediate benefit from your rental property tax losses.

To begin, let’s review how the tax-benefit dollars get trapped in the first place. As you may remember, to benefit from your rental property tax loss, you must either

1. have passive income from other properties or another source, or
2. both qualify as a real estate professional and materially participate in the rental property.

Example. Say the taxable income on your Form 1040 is $200,000 and you have one rental property. Say further that rental has produced a tax loss of $10,000 a year for the past six years, none of which you have been able to deduct because you have no other passive income and you do not qualify as a tax-law-defined real estate professional.

So here you sit: $60,000 in tax deductions trapped in the passive-loss bucket—not available for deduction against the income from the other buckets.