Can Rental Losses Be Carried Forward?

Rental properties often generate income, but they can also incur expenses that sometimes exceed revenue, resulting in a rental loss. The Internal Revenue Service (IRS) has specific rules governing how and when these losses can be deducted. Understanding these regulations helps property owners manage their tax obligations effectively. This article explores how rental losses are handled for tax purposes, focusing on carrying them forward.

Passive Activity Loss Rules

The IRS classifies most rental real estate as a “passive activity,” regardless of the owner’s level of involvement. This classification dictates how losses from these activities can be used. Generally, losses from passive activities can only offset income from other passive activities. This means a rental loss cannot be used to reduce active income sources, such as wages or business profits where the taxpayer materially participates.

The primary purpose of passive activity loss (PAL) rules is to prevent taxpayers from using losses from investments where they are not actively involved to shelter their regular income. A passive activity loss occurs when deductions and expenses associated with a passive activity exceed the income it generates. Passive activity income includes earnings from rental properties or other businesses in which the taxpayer does not materially participate.

Material participation, as defined by the IRS, involves being involved in the operation of an activity on a regular, continuous, and substantial basis. Rental activities are considered passive by default, even if the taxpayer is significantly involved, unless specific exceptions apply.

Carrying Forward Unused Rental Losses

When a passive activity loss, such as a rental loss, cannot be fully deducted in the current tax year due to insufficient passive income, the unused portion is “suspended” and carried forward indefinitely to future tax years. This carryforward mechanism allows taxpayers to potentially utilize these losses later, when they have sufficient passive income.

These carried-forward losses are tracked on specific tax forms, such as Form 8582, Passive Activity Loss Limitations. This form helps taxpayers determine the amount of passive loss allowed for the current year and the amount that must be carried over. In subsequent tax years, these accumulated losses can only be used to offset future passive activity income.

The process involves applying the carried-forward losses against any passive income earned in the subsequent year. If the passive income in a future year is less than the carried-forward losses, the remaining balance continues to be carried forward. This continues until the losses are fully utilized or until the taxpayer disposes of the entire interest in the passive activity. Proper record-keeping is important to accurately track and apply these suspended losses.

Specific Scenarios for Rental Losses

Several scenarios and exceptions can alter how rental losses are treated, modifying passive activity loss rules and their carryforward implications. These exceptions allow taxpayers to deduct rental losses against non-passive income under certain conditions.

Active Participation Exception

An exception allows certain taxpayers who “actively participate” in rental real estate activities to deduct up to $25,000 annually against non-passive income. Active participation is a less stringent standard than material participation; it means the taxpayer is involved in making management decisions, such as approving new tenants, rental terms, or repairs. Owning at least a 10% interest in the activity is also required.

This $25,000 deduction is subject to a Modified Adjusted Gross Income (MAGI) phase-out. The allowance phases out when MAGI exceeds $100,000 and is eliminated at $150,000. The deduction reduces by 50 cents for every dollar of MAGI over $100,000. For married individuals filing separately who lived apart all year, the maximum allowance is $12,500, phasing out between $50,000 and $75,000 MAGI. Any losses not deductible under this exception remain subject to passive activity loss rules and can be carried forward.

Real Estate Professional Status

A more extensive exception applies to taxpayers who qualify as a “real estate professional.” If specific criteria are met, their rental real estate activities are not considered passive, allowing them to deduct losses against any income, including wages. To qualify, an individual must satisfy two tests: more than half of personal services performed in all trades or businesses during the tax year must be in real property trades or businesses with material participation, and the taxpayer must perform over 750 hours of services in real property trades or businesses during the tax year.

Real property trades or businesses include development, construction, acquisition, conversion, rental, operation, management, and brokerage. Material participation is also required, often met by participating over 500 hours during the year. If a taxpayer qualifies as a real estate professional, previously carried-forward passive losses from those activities can be offset against any income, freeing them from passive loss limitations.

Disposition of Passive Activity

When a taxpayer disposes of their entire interest in a passive activity in a fully taxable transaction, any unused carried-forward passive losses from that activity become fully deductible. These accumulated losses can first offset any gain from the property’s disposition. If losses remain after offsetting the gain, they can then offset other passive income from other activities.

If any losses remain after offsetting all passive income, they can be deducted against non-passive income, such as wages. A “fully taxable transaction” involves a sale to an unrelated party where all gain or loss is recognized. This rule ensures taxpayers can eventually benefit from legitimate losses incurred in passive activities, even if suspended for many years.