Plan Your Passive Activity Losses for Tax-Deduction Relevance
Written by Coach Janelle CPA on March 8, 2023
In 1986, lawmakers drove a stake through the heart of your rental property tax deductions.
That stake, called the passive-loss rules, causes myriad complications that now, 37 years later, are still commonly misunderstood.
In 1986, lawmakers made you shovel your taxable activities into three basic tax buckets. Looking at the buckets from a business perspective, you find the following:
1. Portfolio bucket for your stocks and bonds
2. Active business bucket for your material participation business activities
3. Passive-loss bucket for your rentals plus other activities in which you do not materially participate
This letter explains three escapes from the passive-loss trap so that you can realize the tax benefits from your rental losses.
Escape 1: Get Out of Jail Free
Lawmakers allow taxpayers with a modified adjusted gross income of $100,000 or less to deduct up to $25,000 of rental property losses. Once your income goes above $100,000, the get-out-of-jail-free loss deduction drops by 50 cents on the dollar and disappears altogether at $150,000 of modified adjusted gross income.
Escape 2: Changes in Operations
If you, or you and your spouse, have modified adjusted gross income that exceeds the threshold, you need a different plan to obtain immediate benefit from your rental property tax losses. To begin, let’s review how the tax-benefit dollars get trapped in the first place. As you may remember, to benefit from your rental property tax loss, you must either
1. have passive income from other properties or another source, or
2. both qualify as a real estate professional and materially participate in the rental property.
Example. Say the taxable income on your Form 1040 is $200,000 and you have one rental property.
Say further that rental has produced a tax loss of $10,000 a year for the past six years, none of which you have been able to deduct because you have no other passive income and you do not qualify as a tax-law-defined real estate professional. So here you sit: $60,000 in tax deductions trapped in the passive-loss bucket—not available for deduction against the income from the other buckets.
Not Lost, Just Waiting
This is sad, no doubt, but there’s some good news even in this bucket as you now see it. The $60,000 is not going to drown, disappear, or lose its tax-deduction attributes in some other way. That $60,000 simply waits in the bucket for you to give it an escape route.
Here are four possibilities for the escape route:
1. Generate passive income.
2. Change the character of the rental to non-passive.
3. Change your status to that of a real estate professional, and pass the material participation test for this property.
4. Sell the property, as explained in Escape 3 below.
Escape 3: Total Release
The $60,000 that’s trapped in the passive-loss bucket is like money in the bank. You can tap the trap when you want to release the deductions. It’s really quite easy. Here we are talking about releasing the entire $60,000 at once (a major jailbreak). You might want to do this right now, or you can wait. You have many options, and the good news is that you are the one in charge of this total release of your passive losses. To release the losses, you need to make a complete disposition. For example, say you sell 100 percent of the property to a third party. Presto! You now deduct the entire $60,000 in trapped passive losses.
The one thing to know is that if you have rental property losses that are trapped by the passive-loss rules, you have some strategies available.
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