Limits on Rental Losses

Rental real estate activities are generally considered passive activities, and the amount of loss you can deduct is limited. Generally, you cannot deduct losses from rental real estate activities unless you have income from other passive activities. See Passive Activity Limits, later.

Losses from passive activities are first subject to the at-risk rules. At-risk rules limit the amount of deductible losses from holding most real property placed in service after 1986.

Exception. If your rental losses are less than $25,000 ($12,500 if married filing separately), the passive activity limits probably do not apply to you. See Losses From Rental Real Estate Activities, later.

Property used as a home. If you used the rental property as a home during the year, the passive activity rules do not apply to that home. Instead, you must follow the rules explained under Personal Use of Vacation Home or Dwelling Unit, earlier.

At-Risk Rules

The at-risk rules place a limit on the amount you can deduct as losses from activities often described as tax shelters. Losses from holding real property (other than mineral property) placed in service before 1987 are not subject to the at-risk rules.

Generally, any loss from an activity subject to the at-risk rules is allowed only to the extent of the total amount you have at risk in the activity at the end of the tax year. You are considered at risk in an activity to the extent of cash and the adjusted basis of other property you contributed to the activity and certain amounts borrowed for use in the activity. See Publication 925 for more information.

Passive Activity Limits

In general, all rental activities (except those meeting the exception for real estate professionals, below) are passive activities. For this purpose, a rental activity is an activity from which you receive income mainly for the use of tangible property, rather than for services.

Limits on passive activity deductions and credits. Deductions for losses from passive activities are limited. You generally cannot offset income, other than passive income, with losses from passive activities. Nor can you offset taxes on income, other than passive income, with credits resulting from passive activities. Any excess loss or credit is carried forward to the next tax year.

For a detailed discussion of these rules, see Publication 925.

You may have to complete Form 8582 to figure the amount of any passive activity loss for the current tax year for all activities and the amount of the passive activity loss allowed on your tax return. See Form 8582 not required under Losses From Rental Real Estate Activities, later, to determine whether you have to complete Form 8582.

Exception for Real Estate Professionals

Rental activities in which you materially participated during the year are not passive activities if for that year you were a real estate professional. Losses from these activities are not limited by the passive activity rules.

For this purpose, each interest you have in a rental real estate activity is a separate activity, unless you choose to treat all interests in rental real estate activities as one activity.

If you were a real estate professional for 2000, complete line 42 of Schedule E (Form 1040).

Real estate professional. You were a real estate professional if, during the year, the time you spent performing services in real property trades or businesses in which you materially participated was:

1. More than half of the time you spent performing personal services in all trades or businesses, and
2. More than 750 hours.

A real property trade or business is one that develops, redevelops, constructs, reconstructs, acquires, converts, rents, operates, manages, leases, or sells real property.

Services you performed as an employee are not treated as performed in a real property trade or business, unless you own more than 5% of the stock (or more than 5% of the capital or profits interest) in the employer.

If you file a joint return, one spouse must separately meet both of the above conditions, without taking into account services performed by the other spouse.

Material participation. Generally, you materially participated in an activity for the tax year if you were involved in its operations on a regular, continuous, and substantial basis during the year. For more information, see section 1.469-5T of the regulations.

Participating spouse. If you are married, determine whether you materially participated in an activity by also counting any participation in the activity by your spouse during the year. Do this even if your spouse owns no interest in the activity or files a separate return for the year.

Choice to treat all interests as one activity. If you were a real estate professional and had more than one rental real estate interest during the year, you can choose to treat all the interests as one activity. You can make this choice for any year that you qualify as a real estate professional. If you forgo making the choice for one year, you can still make it for a later year.

If you make the choice, it is binding for the tax year you make it and for any later year that you are a real estate professional. This is true even if you are not a real estate professional in any intervening year. (For that year, the exception for real estate professionals will not apply in determining whether your activity is subject to the passive activity rules.)

See the instructions for line 23 of Schedule E (Form 1040) for information about making this choice.

Losses From Rental Real Estate Activities

If you actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from nonpassive income. This special allowance cannot be more than $12,500 if you were married, file a separate return, and lived apart from your spouse at all times during the year. It is not available if you were married, file a separate return, and did not live apart from your spouse at all times during the year.

The maximum amount of the special allowance is reduced if your modified adjusted gross income is more than $100,000 ($50,000 if married filing separately).

Example. Jane is single and has $40,000 in wages, $2,000 of passive income from a limited partnership, and $3,500 of passive loss from a rental real estate activity in which she actively participated. $2,000 of Jane's $3,500 loss offsets her passive income. The remaining $1,500 loss can be deducted from her $40,000 wages.

Active participation. You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions in a significant and bona fide sense. Management decisions include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

Example. Mike is single and had the following income and losses during the tax year:

The rental loss resulted from the rental of a house Mike owned. Mike had advertised and rented the house to the current tenant himself. He also collected the rents, which usually came by mail. All repairs were either done or contracted out by Mike.

Even though the rental loss is a loss from a passive activity, because Mike actively participated in the rental property management, he can use the entire $4,000 loss to offset his other income.

Maximum special allowance. If your modified adjusted gross income is $100,000 or less ($50,000 or less if married filing separately), you can deduct your loss up to $25,000 ($12,500 if married filing separately). If your modified adjusted gross income is more than $100,000 (more than $50,000 if married filing separately), this special allowance is limited to 50% of the difference between $150,000 ($75,000 if married filing separately) and your modified adjusted gross income.

Generally, there is no relief from the passive activity loss limits if your modified adjusted gross income is $150,000 or more ($75,000 or more if married filing separately).

Modified adjusted gross income. This is your adjusted gross income from line 33, Form 1040, figured without taking into account:

1. Any passive income or loss or any loss allowable by reason of the exception for real estate professionals discussed earlier,
2. Taxable social security or equivalent tier 1 railroad retirement benefits,
3. Deductible contributions to an IRA or certain other qualified retirement plans,
4. The deduction for one-half of self-employment tax,
5. The exclusion allowed for employer-provided adoption benefits, and
6. The exclusion allowed for qualified U.S. savings bond interest used to pay higher educational expenses.

Form 8582 not required. Do not complete Form 8582 if you meet all of the following conditions.

1. Your only passive activities were rental real estate activities in which you actively participated.
2. Your overall net loss from these activities is $25,000 or less ($12,500 or less if married filing separately).
3. You do not have any prior year unallowed losses from any passive activities.
4. If married filing separately, you lived apart from your spouse all year.
5. You have no current or prior year unallowed credits from passive activities.
6. Your modified adjusted gross income is $100,000 or less ($50,000 or less if married filing separately).
7. You do not hold any interest in a rental real estate activity as a limited partner or as a beneficiary of an estate or a trust.

If you meet all of the conditions listed above, your rental real estate activities are not limited by the passive activity rules and you do not have to complete Form 8582. Enter each rental real estate loss from line 22 of Schedule E (Form 1040) on line 23 of Schedule E.

If you do not meet all of the conditions listed above, see the instructions for Form 8582 to find out if you must complete and attach that form to your tax return.

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