Like regular rental activities, loss generated by real estate rental activities is passive but with one difference. Under the rules passive income loss is not currently deductible from non-passive income but up to $25,000 of passive activity losses from rental real estate activities may be used to offset non-passive income. However, once the taxpayer’s adjusted gross income reaches the statutorily set threshold it begins to be phased out. In order to qualify for the special allowance certain conditions must be met. Principally, the taxpayer must actively participate in the rental real estate activity.
Active participation is a lower standard than material participation and thus easier to establish. Regular, continuous, and substantial involvement is not needed. The taxpayer need only genuinely contribute to the activity in a meaningful way. In this context, managerial decisions such as selecting new tenants, deciding rental terms, approving related expenditures, etc. will suffice. Conversely, active participation will not be imputed if, during the tax year, the taxpayer and his or her spouse own less than 10 percent of all interests in the activity or if he or she is a limited partner in the rental real estate activity of a partnership. Furthermore, based on the rules a taxpayer that rents under a net lease agreement will not be deemed as engaging in a rental real estate activity because under the terms the tenant is responsible for costs and maintenance decisions.
In its simplest terms the special deduction is equal to the excess of the net loss from rental real estate activities in which the taxpayer actively participated over any net passive income from other passive activities. If the eligible amount goes above $25,000 than the excess may be carried forward and deducted in subsequent years so long as the taxpayer has actively participated in the rental real estate activity in that tax year. Nonetheless, the $25,000 maximum deduction is reduced by 50 percent of the amount by which a taxpayer’s adjusted gross income (AGI) surpasses $100,000. As a result, the deduction is eliminated if a taxpayer’s AGI is $150,000 or more. For purposes of calculating the AGI no weight is given to: 1) deductions permitted by the special rules for real estate professionals, 2) amounts excludable as income from United States Savings Bonds used to pay higher education tuition and fees, 3) amounts excludable as employer-provided adoption assistance, 4) the deduction for contributions to IRAs, 5) the deduction for student loan interest, 6) the education for qualified higher education expenses, and 7) any social security benefits includible in income.
Exceptions exist that either raise the $100,000 threshold to $200,000 or eliminate the phase out scheme altogether for passive activity that relates to community preservation and/or revitalization projects.