Chapter 4 Introduction

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Chapter 4 is a short chapter but how rental income is viewed by the IRS and when rental losses can (or can’t) be deducted. It opens with the IRS’s categorization of income into earned, portfolio, and passive—and quickly focuses in on how rentals are typically considered passive unless special rules apply (which might one of the reasons you are reading this). The chapter explains passive activity loss (PAL) limitations, which are anything but your pal, and the $25,000 exception available to many landlords, with phaseouts starting at $100,000 of modified AGI.

The coveted Real Estate Professional Status (REPS) is introduced (but expanded in a later chapter), which, if met, allows rental losses to be treated as non-passive and deductible against other sources of income including W-2 income. However, it also calls out California’s non-conformity with REPS under state tax law, meaning losses still face limitations even if you qualify federally. Yeah, sorry for the spoiler.

Other nuanced topics include vacation home rules, lots of them, and how states treat rental income and losses differently from the IRS, often complicating your filing requirements and increasing your tax burden. Not so good.