Rental property losses

Real Estate Owner Can’t Fit Under Tax Threshold


Clients who rent out property are allowed to claim certain deductions on their taxes, but, as a new Tax Court case shows, the federal government will bite back if they ask for too much. Ken Berry explains the details of the case and what you need to pass on to your clients.

Dec 8th 2020
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Taxpayers who own and rent out real estate may not be able to deduct losses due to the complex rules for passive activities. In a new case, Sharma, TC Memo 2020-147,10/29/20, the amount of the deductible loss was reduced due to a special tax law threshold.  

Background: Generally, expenses from passive activities can only offset income earned from other passive activities during the year. In other words, you can’t claim a loss. Any excess is suspended and carried over to the next year.

For these purposes, a passive activity is an undertaking involving the conduct of a trade or business in which you do not “materially partic­i­pate.” This requires participation in the business activity on a regular, continuous and substantial basis. The IRS has issued detailed regulations specifying the requirements. For example, you’re considered to be a material participant if you work more than 500 hours a year at the activity.

A rental real estate activity is automatically treated as a passive activity. But there are two key exceptions in the tax law.

1. Real estate professionals: If you are legitimately involved in a real estate business as a professional, the passive activity loss limit doesn’t apply. This includes taxpayers who spend more than 50% of their working hours and more than 750 hours a year on real estate activities.

2. Active participant rule: A taxpayer who is an “active participant” in rental real estate may use up to $25,000 of loss to offset non‑passive income. This exception is phased out for taxpayers with a modified adjusted gross income (MAGI) between $100,000 and $150,000 for the year. The tax benefit disappears completely once your MAGI exceeds $150,000.

Note that active participation must be significant. For instance, you may qualify if make management de­cisions, approve new tenants, arrange for repairs and so on. But simply listing yourself as a real estate manager or rental agent isn’t enough.

In the new case, the taxpayer claimed that he was entitled to deduct the entire $25,000 loss as an active participant.

Facts: The taxpayer conceded that he didn’t qualify for the exception as a real estate professional for 2014, the tax year in question. However, he claimed the maximum offset of non-passive income based on the exception for active participants in real estate.

The IRS determined, after adjustments, that the taxpayer had an MAGI of $138,071. The taxpayer did not dispute this calculation at trial. However, the taxpayer contended that the MAGI must be be reduced by $5,579 of IRA distributions and $100,625 of distributions from pensions and annuities he received in 2014. These additional adjustments would result in a MAGI of $31,867, so the phase-out would no longer apply.

Tax court outcome: This argument is a fundamental misunderstanding of the MAGI calculation. The instructions address only situations in which a taxpayer has contributed to a retirement plan during the tax year. The taxpayer did not claim that he made any payment to an IRA or other retirement plan in 2014. Instead, he reported distributions—not contributions—from an IRA and other retirement plans during that year.

Thus, the taxpayer is subject to the phase-out rule. Accordingly, he is entitled to a only a $5,964 loss deduction based on his MAGI.

Time is running out: Contributions to qualified plans and IRAs can effectively reduce MAGI for 2020. Factor this into year-end tax planning for clients.

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