What are passive loss carryovers on rental properties and how do they work?
If you own rental property, you may be familiar with passive losses. Passive losses are only deductible against passive income, and once passive losses exceed income, they become suspended passive losses, or passive loss carryovers.
Passive loss carryovers are passive losses that could not be deducted in the current tax year, and therefore carryover indefinitely to future years, until you either us the carryover losses to offset net positive passive income, or you dispose of the rental property. Passive losses can also be used to offset additional passive items like other rental properties and limited partnership income.
There are instances when passive losses may be deducted in the current year, subject to the following exceptions:
- You meet IRS qualifications to be considered a real estate professional, which requires that more than ½ of services you performed in all trades/businesses during the year were performed in real estate in which you materially participated. You also must’ve performed > 750 hours of real estate related activities. And/or...
- You actively manage your rental property, and your income is < $150,000 (having a management company handle your rental generally eliminates this exception, as it then eliminates the material participation aspect). In this instance, you may deduct up to $25,000 in losses per year, with the amount allowable phasing out between $100,000 and $150,000 of modified adjusted gross income (completely phasing out at $150,000 where all losses then carryover).
You may also deduct passive loss carryovers from net gains when you sell your rental property, assuming you sell all of the rental activity. For instance, selling the only property you own would qualify. But if you own multiple rentals, things get more complicated. If your multiple rentals are reported separately on your tax return and you dispose of one without using a 1031 exchange, you may deduct the passive loss carryovers, assuming the sale was an arms-length transaction (essentially meaning you don’t sell to a friend or family member).
We hope this helps clarify the mystery of passive loss carryovers on rentals!
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