Rental Property Losses Can Be Deductible If you own rental property and meet some specific requirements, you may be eligible to deduct up to $25,000 in related losses against your ordinary income. This loss allowance is an important exception to the passive-activity loss rules, which generally prohibit deducting rental property losses from other non-passive income. Defining passive income Passive income generally includes ventures in which you do not actively participate, which can include limited or general partnerships, shareholder interest in a closely held corporation, or other investment-oriented approaches to business enterprises. Gains or losses from real estate investments, regardless of your participation level, are generally treated as passive—with this one $25,000 exception. Qualifying for the rental property loss allowance Simply owning rental property does not automatically mean that you can use this deduction. In order to qualify for the loss allowance, you must: • play an active role in the rental process • establish at least a 10 percent ownership interest in the property • show an adjusted gross income of less than $100,000, for full participation, or less than $150,000 for partial participation Actively participating in the rental process involves making key decisions, such as establishing the rental terms, selecting tenants and approving major capital expenses. Active participation also requires that you, together with your spouse if you are married, own at least a 10 percent share in the property. Finally, to qualify for the maximum $25,000 loss allowance, your adjusted gross income must fall below $100,000. An income above $100,000 reduces your maximum loss allowance by half of the surplus amount. For example, if your income is $130,000, one-half of the excess is $15,000. To calculate your maximum allowable deduction, subtract $15,000 from $25,000, for a maximum allowance of $10,000. If your adjusted gross income exceeds $150,000, the deduction phases out completely. To calculate your adjusted gross income for this purpose, you exclude taxable Social Security income and Individual Retirement Account deductions. There is one additional twist for married couples. If you file federal income tax returns separately, your maximum adjusted gross income and corresponding maximum deduction are reduced by half. However, only married couples who live apart for the entire year qualify for this reduced loss allowance. If you live with your spouse during any part of the year but file separate tax returns, you completely forfeit the allowance. Banking excess losses If your rental property losses exceed $25,000 during a given year, you may carry the additional amount forward to future years. However, you must continue to qualify as an active participant or the accumulated losses will be reclassified as passive losses, which cannot be used to offset other non-passive income. A professional tax advisor can help you determine if you qualify for the loss allowance deduction or if you must reclassify your losses and use them to offset passive income or, if applicable, to offset gains from the sale of your rental property. David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor. Please consult your tax advisor for details and assistance in applying this general information to your specific situation.