Passive Activity Loss Limits

By Jason Watson, CPA
Posted Saturday, August 10 2024

A long-standing rule is passive activity losses that exceed the passive activity income are disallowed for the current year. You can carry forward disallowed passive losses to the next taxable year. This comes from IRC Section 469(d)(1) which reads-

Passive activity loss
The term “passive activity loss” means the amount (if any) by which-

(A) the aggregate losses from all passive activities for the taxable year, exceed
(B) the aggregate income from all passive activities for such year.

Neat. So, what is a passive activity? IRC Section 469(c)(1) lovingly reads-

Passive activity defined
For purposes of this section-

(1) In general
The term “passive activity” means any activity—

(A) which involves the conduct of any trade or business, and
(B) in which the taxpayer does not materially participate.

As such, rental property activities are typically considered passive, meaning that you are not directly earning the income as you would with a W-2 job or as a small business owner. Passive losses cannot be deducted from non-passive income such as wages, portfolio income and business income.

We will discuss material participation in a moment and we dig into real estate professional status (REPS) later as well. Here is a big takeaway from the tax code- A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional. Ok, now what? We’ll get to that in a minute.

There are exceptions where your activity is not considered a rental activity for the purposes of passive activity losses-

• The average period of customer use of the property is 7 days or less. You can rent anything, right? So, the IRS uses this cryptic language. In the context of rental properties, it means average guest stays of 7 days or less.

• The average period of customer use of the property is 30 days or less, and you provide significant personal services. This is akin to a bed and breakfast or a hunting lodge. These services are facts and circumstances based but usually include cleaning the rental property while occupied, concierge services, guest tours, transportation and other hotel-like services.

There are other exceptions, but those are the two most popular among rental property owners. If you cannot meet those exceptions, can you still deduct passive losses generated by rental activities? Maybe.

IRC Section 469(i) reads in part-

$25,000 offset for rental real estate activities
(1) In general
In the case of any natural person, subsection (a) shall not apply to that portion of the passive activity loss or the deduction equivalent (within the meaning of subsection (j)(5)) of the passive activity credit for any taxable year which is attributable to all rental real estate activities with respect to which such individual actively participated in such taxable year.

(2) Dollar limitation
The aggregate amount to which paragraph (1) applies for any taxable year shall not exceed $25,000.

Therefore, the tax code allows for up to $25,000 in passive losses generated from rental real estate activities to be deducted from non-passive income (wages, investment income, business income, etc.). Yay! However, there are limits. Boo! Specifically, the $25,000 passive loss deduction exception reduces $1 for every $2 over $100,000 modified adjusted gross income (MAGI) and by $150,000 (for married couples) the passive loss deduction is $0. Bummer.

For example, you make $120,000 at your regular job and have $30,000 in rental losses. Your passive loss deduction is $15,000 ($25,000 minus $10,000) and the remaining $15,000 is carried forward.

Not all is lost, however. If your rental property losses are capped or unallowed because of passive loss limits, the portion exceeding the passive loss limit is carried forward on Form 8582, aggregated for each year, and may be utilized when-

• You sell (dispose) the rental property,

• You sell other rental properties that result in a gain, or

• You eventually have rental income (profits) that would otherwise be taxable.

Passive loss limits for single filers or for married persons who live apart for the entire tax year is $12,500. If you live with your spouse for any part of the year yet file a married, filing separate tax return (MFS) the passive loss limit is $0 for each you. Not good.

What the heck is modified adjusted gross income (MAGI)? To calculate your modified adjusted gross income, take your AGI and add-back certain deductions. Many of these deductions can be rare, so it’s possible your adjusted gross income (AGI) and MAGI can be identical. Different credit and deductions can have differing add-backs for your MAGI calculation. According to the IRS’s obscure Coke formula including MAGI calculations, your MAGI is your AGI with these items possibly added back-

• Student loan interest

• One-half of self-employment tax

• Qualified tuition expenses

• Tuition and fees deduction

• Passive loss or passive income

• IRA contributions

• Non-taxable social security payments

• The exclusion for income from U.S. savings bonds

• Foreign earned income exclusion

• Foreign housing exclusion or deduction

• The exclusion under IRC Section 137 for adoption expenses

• Rental losses

• Any overall loss from a publicly traded partnership

The big takeaways are- these are potential add-backs depending on your unique circumstances. Rental losses are always added back which makes sense otherwise the passive loss limits would have a circular reference. Foreign earned income exclusions calculated on Form 2555 are also added back. Student loan interest is as well, but this doesn’t usually push the needle around too much.

To summarize-

• Passives activity losses can only be offset by passive activity income. Generally, material participation changes the color of money, and the activity is no longer passive (see definition above).

• However, rental activities remain passive even if you materially participate. You must materially participate as a real estate professional. There is an exception, a loophole if you will, for short-term rentals where your average guest stay is 7 days or less and you materially participate. It is a loophole since you do not need to materially participate as a real estate professional in your short-term rental. Yes, convoluted, and we demystify the short-term rental loophole in a later section. If you cannot leverage real estate professional status or the short-term rental loophole, there is an exception allowing $25,000 of passive losses created by rental losses to be deducted against other non-passive income. But you must actively participate.

• Active participation is a less stringent standard than material participation. For example, you may be treated as actively participating if you make management decisions in a significant and bona fide sense. Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

• Treasury Regulations Section 1.469-2 states that self-rentals, where you rent an office building to your business (as an example) is not considered a passive activity.