If your rental property or limited partnership shows a loss, you cannot automatically deduct it against your wages or other business income. Under IRC Section 469, losses from passive activities can only offset passive income. Understanding this rule is essential for landlords, limited partners, and real estate investors.
What Counts as a Passive Activity?
A passive activity is any trade or business in which you do not materially participate. Rental activities are also passive per se under IRC Section 469(c)(2), regardless of your involvement, unless you qualify as a real estate professional.
Common passive activities include:
- Rental real estate (houses, apartments, commercial property)
- Limited partnership interests
- S-corp or LLC interests where you fail the material participation tests
The Seven Material Participation Tests
You materially participate in an activity if you satisfy any ONE of these IRS tests:
- You participated more than 500 hours during the year
- Your participation was substantially all of the participation by anyone in the activity
- You participated more than 100 hours and no one else participated more than you
- The activity is a significant participation activity and all such activities combined exceed 500 hours
- You materially participated in any 5 of the preceding 10 taxable years
- The activity is a personal service business in which you materially participated in any 3 prior years
- Based on all facts and circumstances, you participated on a regular, continuous, and substantial basis
Most rental property owners do not meet these tests, so rental losses remain passive.
The $25,000 Rental Loss Allowance
Congress created a special exception for active participants in rental real estate. If your modified adjusted gross income (MAGI) is under $150,000, you may deduct up to $25,000 in rental losses against non-passive income, even though rentals are ordinarily passive.
To qualify for this allowance:
- You must actively participate: approve tenants, set rents, make management decisions (a lower bar than material participation)
- You must own at least 10% of the rental property
- This exception does not apply to limited partners or entities
Phaseout calculation: The $25,000 allowance phases out between $100,000 and $150,000 MAGI. For every dollar of MAGI above $100,000, the allowance decreases by $0.50.
At $130,000 MAGI: $25,000 - 50% x ($130,000 - $100,000) = $10,000 allowable rental loss.
At $150,000 MAGI and above: the allowance is $0.
For married filing separately who lived apart all year, the maximum is $12,500 with a $50,000 phaseout starting point. Married filing separately who lived together at any point receive no allowance.
What Happens to Disallowed Losses?
Losses that exceed your allowance are not permanently lost. They become suspended passive activity losses and carry forward indefinitely. Suspended losses are freed in two ways:
- Offset passive income: If the same or another passive activity generates income in a future year, suspended losses reduce that passive income.
- Full disposition: When you sell the property in a fully taxable transaction, all suspended losses from that activity are released and deductible in the year of sale, regardless of your AGI at that time.
This is why heavily depreciated rental properties often produce a large deductible loss in the sale year, sometimes offsetting a significant portion of the gain.
Real Estate Professional Status
If you qualify as a real estate professional under IRC Section 469(c)(7), rental activities are reclassified as non-passive and the $25,000 cap does not apply. You must spend more than half your personal service hours in real property trades or businesses and exceed 750 hours per year. See our real estate professional status guide for the full requirements.
Planning Takeaways
- Track hours carefully. Whether trying to meet material participation or real estate professional thresholds, contemporaneous records are essential. Reconstructed logs are a common audit target.
- Group rental activities. A properly made grouping election can treat multiple rentals as a single activity, potentially helping meet participation thresholds. The election is generally irrevocable, so seek professional advice first.
- Seek passive income. Passive losses can offset income from other passive activities, such as a limited partnership that distributes profits. Structuring your portfolio to generate passive income is a legitimate strategy to absorb losses each year.
Managing passive activity losses across a real estate portfolio requires careful tracking and long-term tax planning. Contact TS CPA for a free consultation. We respond within the same day.