Can Real Estate Losses Offset Ordinary Income?

Real estate investments offer significant tax benefits, especially when losses occur. Many investors wonder if these losses can offset taxable income from wages or business earnings. The answer depends on the nature of the investment and the investor’s level of involvement.

Passive vs Non-Passive Real Estate

The IRS categorizes real estate activities as passive or non-passive, which determines how losses can be applied against other income. Passive activities typically involve rental properties where the owner does not materially participate in daily operations. Even if an investor manages a property, they must meet specific thresholds to be considered non-passive.

Material participation is defined by IRS guidelines, such as spending more than 500 hours per year on the activity or being the primary manager. If these criteria are met, the investment is classified as non-passive, allowing losses to be deducted against other income without limitation.

For those who do not meet the material participation requirements, rental real estate is considered passive. Losses from passive activities can only offset passive income, such as earnings from other rental properties or limited partnership investments. If passive losses exceed passive income, they are carried forward to future years rather than applied against wages or business profits.

Eligibility Criteria for Offsetting Losses

The ability to use real estate losses to reduce taxable income depends on factors beyond activity classification. One key factor is the investor’s adjusted gross income (AGI). Individuals with an AGI of $100,000 or less may deduct up to $25,000 in passive real estate losses against non-passive income. This benefit phases out between $100,000 and $150,000 of AGI and disappears entirely above that threshold.

Ownership structure also affects loss deductibility. Real estate held in sole proprietorships, single-member LLCs, or partnerships flows through to the owner’s personal tax return, making losses subject to passive activity rules. Properties owned by C corporations are not bound by these restrictions, though corporate tax treatment introduces complexities such as double taxation on profits.

Debt financing influences deductible losses as well. If a property is leveraged with a mortgage, interest expenses contribute to deductible losses. However, the at-risk rules limit deductions to the amount an investor has personally at risk, meaning losses cannot exceed their cash investment and personally liable debt. If non-recourse financing is used, where the lender’s only recourse is the property itself, deductions may be further restricted.

Real Estate Professional Classification

Investors seeking maximum deductions often aim to qualify as real estate professionals for tax purposes, a designation that exempts them from passive activity loss limitations. To qualify, individuals must meet IRS requirements under Section 469(c)(7) of the tax code. They must spend more than 750 hours per year materially participating in real estate activities, such as property development, management, leasing, or brokerage. Additionally, these activities must make up more than half of their total working hours for the year.

Meeting these criteria allows real estate losses to be deducted against all forms of income. However, proving eligibility requires detailed recordkeeping. The IRS scrutinizes claims of real estate professional status, particularly for individuals with full-time jobs in other industries. Maintaining logs of hours worked, tasks performed, and involvement in each property is necessary to substantiate claims in an audit. Courts have frequently ruled against taxpayers who fail to provide adequate documentation.

Spouses can also help meet the required thresholds. If a married couple files jointly and one spouse qualifies as a real estate professional, rental losses may still be fully deductible, even if the other spouse has a separate career. However, the qualifying spouse must independently satisfy the hour and material participation requirements.

How Losses Apply to Taxable Amount

Real estate losses must be classified as deductible under general tax principles. Rental activity losses must be considered “ordinary and necessary” expenses related to the investment, including depreciation, property taxes, mortgage interest, repairs, and maintenance. Depreciation is particularly significant, as it reduces taxable income without requiring an actual cash expenditure, creating a paper loss that can be leveraged for tax purposes.

Once deductible losses are identified, they first reduce any passive income generated within the same tax year, such as rental revenue or gains from other qualifying investments. If losses exceed rental income, they may be used to offset other taxable income, provided the investor qualifies under applicable tax provisions. Reducing AGI through real estate losses can also make taxpayers eligible for deductions and credits that phase out at higher income levels, such as the child tax credit or education-related tax benefits.

Carryover of Surplus Deductions

When real estate losses exceed the amount that can be deducted in a given tax year, they are carried forward to offset future taxable income. The treatment of these surplus deductions depends on whether they originate from passive activities or a real estate professional designation.

Passive losses that cannot be deducted due to income limitations or insufficient passive income are carried forward under the passive activity loss (PAL) rules. These losses accumulate and can be applied in subsequent years when passive income becomes available or when the property generating the losses is sold. Upon the sale of a rental property, any unused passive losses are fully deductible in that tax year, regardless of income classification. Investors may time property sales to maximize deductions against high-income years.

For real estate professionals, losses that exceed total taxable income may be carried forward as net operating losses (NOLs). Unlike passive losses, NOLs can offset all types of income and may be carried forward indefinitely under current tax law. Before the Tax Cuts and Jobs Act of 2017, NOLs could be carried back two years, but this provision was eliminated for most taxpayers. Investors with significant real estate losses should track carryforward amounts to ensure they are used in the most tax-efficient manner possible.