Understanding Passive Activity Losses with Real Estate Investments

This comes up a lot when I’m talking with real estate investors and building owners whether they be owners and investors in residential or commercial property. The information below is just a quick summary. It does not and should not be considered tax advise. I am a real estate and cost segregation professional and note a tax pro.

Many people buy rental property or buy a commercial building but they have another full time job. That income derived from that investment is considered passive of course. The IRS separates active income from passive income unless you happen to qualify as a full time real estate professional. Then all your income is considered active. Understanding how the IRS classifies and defines passive income and how that affect your tax return is important as an investor. Here’s the link to the IRS Publication 925 (2020), Passive Activity and At-Risk Rules. It has some excellent examples so you can see how you might be able to still take advantage of passive losses against your active income.

What many people tend to not realize is that there is a special $25,000 allowance. It reads as follows from the IRS site:

“Special $25,000 allowance. If you or your spouse actively participated in a passive rental real estate activity, the amount of the passive activity loss that’s disallowed is decreased and you therefore can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing the passive activity loss. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.
If you’re married, filing a separate return, and lived apart from your spouse for the entire tax year, your special allowance can’t be more than $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you can’t use the special allowance to reduce your nonpassive income or tax on nonpassive income.”

The $25,000 Allowance is subject to the Phase Our Rule of course…. again to quote the IRS:

“The maximum special allowance of $25,000 ($12,500 for married individuals filing separate returns and living apart at all times during the year) is reduced by 50% of the amount of your modified adjusted gross income that’s more than $100,000 ($50,000 if you’re married filing separately). If your modified adjusted gross income is $150,000 or more ($75,000 or more if you’re married filing separately), you generally can’t use the special allowance. This is because the special allowance is reduced to $0 since the modified adjusted gross income is over the $100,000 amount.”

If you’re a W-2 employee and own investment real estate, realize that you might qualify for some or all of this $25,000 allowance depending upon your income. Also realize that if you have not done a cost segregation study on your investment property / commercial building, you may want to take a look at that as it will generate additional depreciation expense for you to deduct against your income. It’s a strategy the big property investors utilize but many of the smaller investors and building owners are not aware of it. It’s also something that many CPAs just don’t address for whatever reason. But I can help you with that if you’d like to talk. The fees are quite reasonable compared to the tax savings you will see. Reach out if you’d like to talk about evaluating if cost segregation is right for you. As with all things with taxes, please be sure to consult your tax professional.

Here’s an additional article on how passive losses can benefit real estate investors.