Maximizing the Use of the Special $25,000 Rental Real Estate Loss Allowance

Editor: Albert B. Ellentuck, Esq.

Even though rental income or loss is generally passive, a special rule allows qualifying individuals and estates to offset up to $25,000 of nonpassive income with rental real estate losses and credits. To qualify for the $25,000 deduction, the taxpayer must own at least 10% of the value of all interests in the activity at all times during the tax year and must actively participate in the operations of the rental property in both the year the loss is incurred and the year recognition is sought, if different (under the carryover provisions).

Ownership and Active Participation

A taxpayer will not be considered an active participant in a rental real estate activity if, at any time during the tax year, his or her ownership in the activity drops below 10% of the value of all interests in the activity (Sec. 469(i)(6)(A)). When measuring an individual’s ownership in a rental real estate activity, any spousal interest is also included.

Active participation is a less stringent standard than material participation and does not require regular, continuous, and substantial involvement in the operations. Rather, the taxpayer must participate in a significant way, such as making management decisions or arranging for others to provide services (S. Rep’t No. 313, 99th Cong., 2d Sess. 737, 1986-3 C.B. 737). Management activity that qualifies under the active participation test would include approving new tenants, setting rental policies and terms, and approving capital expenditures or repairs (Madler, T.C. Memo. 1998-112).

Example 1: F lives in Texas but owns 100% of a rental property in Arkansas. He receives all rent through the mail and has not been to Arkansas to see the rental property for more than a year. If problems with the property occur or repairs are needed, he hires someone in Arkansas to perform the work. F continues to set the policy on rentals and approves tenants when vacancies occur.

Because F owns at least 10% of the real estate rental activity, makes all management decisions, and provides for others to perform services for the property in his absence, he actively participates even though he does not visit the property.

Example 2: F and his cousin, D, are equal shareholders in an S corporation that owns an apartment building in Las Vegas. D lives in Las Vegas, while F lives in Dallas. D makes all management decisions about the rental property. She inspects it on a regular basis and collects all rents. F has had no contact with the property since he invested in it several years ago.

Both F and D meet the ownership test under Sec. 469(i)(6). However, since F has had no contact with the property and makes no management decisions, he does not actively participate in the rental property. Because D makes all management decisions, she actively participates in the rental property.

Limits on the Allowance

A taxpayer who owns rental real estate through an interest in a limited partnership will not be considered to actively participate in the rental real estate activity for the $25,000 offset (Sec. 469(i)(6)(C)).

Furthermore, the $25,000 maximum amount that can be deducted from nonpassive income is reduced by 50% of the amount by which the taxpayer’s modified adjusted gross income (AGI) exceeds $100,000 (Sec. 469(i)(3)(A)). Therefore, the $25,000 is totally phased out when the taxpayer’s modified AGI reaches $150,000.

Modified AGI is AGI that is calculated without considering IRA deductions, interest deductions on higher education loans, deductions for domestic production activities, tuition and fees deduction, taxable Social Security benefits, or any passive losses allowed under the exception for real estate professionals, and adding back income excluded for U.S. savings bond interest used for higher education expenses and employer-provided adoption assistance programs (Sec. 469(i)(3)(F)). Special rules apply to married taxpayers filing separately (Sec. 469(i)(5)).

Maximizing the Available Allowance

To properly plan for the allowance, a taxpayer should analyze his or her active rental real estate activities and projected income and losses, and estimate his or her AGI, before year end.

Because the $25,000 loss allowance begins being phased out when modified AGI exceeds $100,000 and is completely phased out when modified AGI exceeds $150,000, taxpayers with income within or around this range can maximize the allowance with careful tax planning. Because the phaseout is AGI-sensitive, only strategies that either increase above-the-line deductions or shift income from one year to another will affect the deduction.

Strategies that reduce AGI may help increase the allowable deduction when taxpayers are subject to the phaseout. Deductible contributions to Keogh and SEP retirement plans may help self-employed taxpayers reduce their AGI. Investing in tax-exempt securities or investments that defer income to later years (e.g., short-term CDs and Treasury bills) will also reduce AGI. Similarly, self-employed taxpayers using the cash method can shift income from one year to another by timing when they bill and collect revenue.

EditorNotes

Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.