Generally, the passive activity loss for the tax year isn’t allowed. However, there is a special allowance under which some or all of your passive activity loss may be allowed. The IRS real estate professional rules allow for a special passive activity loss rule for real estate professionals. See Internal Revenue Code section 469.
Generally, your passive activity loss for the tax year is the excess of your passive activity deductions over your passive activity gross income. For a closely held corporation, the passive activity loss is the excess of passive activity deductions over the sum of passive activity gross income and net active income. Real estate rental activities are often reported on schedule E, and the IRS often audits schedule E losses.
Rental Activity Passive Activity Losses
A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional. Moreover, an activity is a rental activity if tangible property (real or personal) is used by customers or held for use by customers, and the gross income (or expected gross income) from the activity represents amounts paid (or to be paid) mainly for the use of the property. It doesn’t matter whether the use is under a lease, a service contract, or some other arrangement.
Special $25,000 Deduction
Special $25,000 allowance. If you or your spouse actively participated in a passive rental real estate activity, the amount of the passive activity loss that’s disallowed is decreased and you therefore can deduct up to $25,000 of loss
from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing the passive activity loss. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.
If you’re married, filing a separate return, and lived apart from your spouse for the entire tax year, your special allowance can’t be more than $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you can’t use the special allowance to reduce your nonpassive income or tax on nonpassive income.
The maximum special allowance is reduced if your modified adjusted gross income exceeds certain amounts.
Active participation. Active participation isn’t the same as material participation (defined later). 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.
Only individuals can actively participate in rental real estate activities. However, a decedent’s estate is treated as actively participating for its tax years ending less than 2 years after the decedent’s death, if the decedent would
have satisfied the active participation requirement for the activity for the tax year the decedent died.
IRS Real Estate Professional Passive Activity Loss Rules
Generally, rental activities are passive activities even if you materially participated in them. However, if you qualified as a real estate professional, rental real estate activities in which you materially participated aren’t passive activities. 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. See the Instructions for Schedule E (Form 1040), Supplemental Income and Loss, for information about making this choice.
If you qualified as a real estate professional for 2020, report income or losses from rental real estate activities in which you materially participated as nonpassive income or losses, and
You qualified as a real estate professional for the year if you met both of the following requirements.
• More than half of the personal services you
performed in all trades or businesses during the tax year were performed in real
property trades or businesses in which you
• You performed more than 750 hours of
services during the tax year in real property
trades or businesses in which you materially participated.
Don’t count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer. You were a 5% owner if you owned (or are considered to have owned) more than 5% of your employer’s outstanding stock, outstanding voting stock, or capital or profits interest.
If you file a joint return, don’t count your spouse’s personal services to determine whether you met the preceding requirements.
However, you can count your spouse’s participation in an activity in determining if you materially participated.
Real property trades or businesses. A real property trade or business is a trade or business that does any of the following with real property.
• Develops or redevelops it.
• Constructs or reconstructs it.
• Acquires it.
• Converts it.
• Rents or leases it.
• Operates or manages it.
• Brokers it.