Avoiding passive loss limitations on rental real estate losses

Rental properties are generally considered passive activities, regardless of whether the taxpayer materially participates (Secs. 469(c)(2) and (c)(4)). Thus, losses from rental real estate are subject to the limitations on passive activity losses (PALs). 

The Code provides two special passive loss relief provisions specifically aimed at rental real estate activities. These are (1) the $25,000 allowance for certain individuals and, for a limited time after an individual’s death, the individual’s estate, under Sec. 469(i) and (2) the exception to the general rule for real estate professionals under Sec. 469(c)(7). Planning for the $25,000 allowance is discussed here, as well as how certain taxpayers with rental real estate losses can deduct the losses by changing how the property is owned. For more on real estate professionals and additional considerations for taxpayers in a rental real estate activity, see Hesse, “The Maze of Real Estate Rentals,” 51 The Tax Adviser 658 (October 2020). 

The Code provides certain exceptions to the definition of what constitutes a rental activity. Rental real estate activities that meet any of these exceptions are normally subject to the regular passive activity rules, which are based on whether the taxpayer materially participates in the activity. When a taxpayer materially participates in a rental real estate activity and it produces a loss, they may want it to meet one of these exceptions so they can deduct the loss against ordinary income. Conversely, these exceptions can be a trap when a taxpayer has a rental activity that either produces income that would offset a passive loss or has a loss that would otherwise be eligible for the special $25,000 rental real estate loss allowance. 

Maximizing the use of the special $25,000 rental real estate loss allowance 

Even though rental income or loss generally is 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 that recognition is sought, if different (under the carryover provisions). 

Ownership: A taxpayer will not be considered an active participant in a rental real estate activity if, at any time during the tax year, their 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: 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, reprinted in 1986-3 C.B. Vol. 3, 737 (May 29, 1985)). 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. Active participation — managing the property: 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. Does F actively participate in this rental property? 

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. Active participation — silent partner fails test: 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 regarding the renta property. He 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. Do F and D actively participate in this rental property? 

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. D actively participates in the rental property since he makes all management decisions. 

Limited partnership exclusion: 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)). 

Phaseout of deduction: 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 amount is totally phased out when the taxpayer’s modified AGI reaches $150,000. Modified AGI is AGI calculated without considering: 

• Individual retirement account deductions; 
• Interest deductions on higher education loans; 
• Taxable Social Security benefits; 
• Any passive losses allowed under the exception for real estate professionals; 
• The Sec. 250 deductions for foreign-derived intangible income and global intangible low-taxed income; and 
• Any overall loss from a publicly traded partnership.

Also added back to income is: 

• The Sec. 164(f) deduction for one-half of self-employment tax; 
• Income excluded for U.S. savings bond interest used for higher education expenses; 
• Any tax-free Olympic and Paralympic medals and prize money (determined without regard to the Sec. 74(d)(2)(A) $1 million AGI threshold); and 
• Amounts received from employer-provided adoption-assistance programs (Sec. 469(i)(3)(E) and Publication 925, Passive Activity and At-Risk Rules). 

For the phaseout, special rules apply for married taxpayers who are filing separately (Sec. 469(i)(5)). 

Strategies to maximize the $25,000 rental real estate loss allowance: 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, tax-payers with income within or around this range can maximize the allowance with careful tax planning. Because the phaseout is AGI-sensitive, only strategies that increase either above-the-line deductions or shift income from one year to another will affect the deduction. 

To properly plan for the allowance, the following must be done before year end: (1) analyze the taxpayer’s active rental real estate activities and projected income and losses; and (2) estimate the taxpayer’s AGI. Strategies that reduce AGI may help increase the allowable deduction when taxpayers are subject to the phaseout. Deductible contributions to Keogh and simplified employee pension (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 certificates of deposit and Treasury bills) will 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. 

Contributing rental loss activities to profitable closely held C corporations 

Individuals must apply the PAL rules to activities they hold personally and in passthrough entities (partnerships, S corporations, and limited liability companies). In addition, the passive loss rules apply to activities held by closely held corporations and personal service corporations (PSCs) (Sec. 469(a)(2)). 

While both closely held corporations and PSCs are subject to the PAL rules, closely held corporations are afforded more favorable treatment. Closely held corporations (other than PSCs) can use passive losses to offset net active income, but not portfolio (e.g., interest, dividends) income (Sec. 469(e)(2)). Thus, these corporations do not have to generate passive activity income before passive losses can be deducted. 

When applying the PAL rules, a closely held corporation is a C corporation that at any time during the last half of the tax year is owned more than 50% in value (directly or indirectly) by five or fewer individuals. Also, the corporation must not qualify as a PSC. A PSC is a C corporation that satisfies a principal-activity test (i.e., rendering of personal services in certain fields), a substantial-performance-by-employee-owners test, and an ownership test (see Secs. 469(j)(2) and 269A(b) for the definition of a PSC). 

Example 3. Shifting passive activity losses to a closely held corporation: J owns a 50% interest in a general partnership that owns a 50-unit apartment complex. J’s share of the partnership’s rental loss is about $50,000 a year. He actively participates in the management of the property. He has no other passive income or losses. J also owns 100% of T Co., a manufacturer of specialty sporting goods. He is a full-time employee of T Co., which operates as a C corporation. In the current year, J anticipates having AGI of $200,000 ($175,000 salary and $25,000 interest and dividend income). T Co. will have current-year net income of approximately $250,000.

J is unable to benefit from the special $25,000 rental real estate loss allowance since his modified AGI exceeds the phaseout threshold of $150,000. This situation is likely to continue in the future, so the losses from the apartment complex will be suspended under the PAL rules. 

In this situation, J might find it advantageous to contribute his partnership interest in the apartment complex to T Co., using a Sec. 351 tax-free exchange. Although the corporation is closely held and subject to the PAL rules, it can offset net active income with passive losses. This enables the passive losses to be deducted currently. If J has any suspended losses at the time the transfer is made, they remain suspended since a Sec. 351 transfer is not a taxable transaction. He can utilize the suspended losses against any future passive income he generates or deduct them when the corporation disposes of the partnership interest to an unrelated party. 

Note: Before transferring passive activities to closely held corporations, taxpayers must consider the tax consequences of conducting business in C corporations (e.g., double taxation).

Contributor 

Patrick L. Young, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Individual Tax Planning topic. Published by Thomson Reuters, Carrollton, Texas, 2024 (800-431-9025; tax.thomsonreuters.com).