Active participation in rental property requires an individual to own at least 10% of the rental property and participate in management decisions regarding the property. By actively participating, the rental property owner receives a $25,000 rental loss allowance that permits the deduction of up to $25,000 in rental losses against nonpassive sources of income like wages and self-employment income. Otherwise, rental property losses are nondeductible unless they can be used to offset passive income, like rental income from other rental properties.
Key Takeaways:
- The $25,000 rental loss allowance requires “active participation” in a passive rental real estate activity, a more accessible standard than the “material participation” standard applied to avoid passive losses from a trade or business.
- When modified adjusted gross income (MAGI) exceeds $100,000, the $25,000 rental loss allowance is reduced by 50% of the excess and thus is completely eliminated when MAGI exceeds $150,000.
- Any losses in excess of the allowable amount are carried over for use in subsequent tax periods.
- Real estate professionals treat rental losses differently than other taxpayers.
For purposes of this special $25,000 allowance, the IRS only requires active participation, which is a lower standard than the material participation standard applied to determine if a non-rental trade or business is active or passive.
How to Qualify for Active Participation
To meet the active participation standard for the $25,000 special allowance, the following criteria must be met:
- You must own at least 10% of the rental and have substantial involvement in managing the rental.
- You must meet the 10% ownership requirement for the entire tax year
- You are not a limited partner? in the real estate endeavor
Management decisions to qualify as an active participant include approving new tenants, deciding on rental terms, and approving expenditures. To satisfy this requirement, solely being designated to make management decisions is not sufficient without the actual execution of managerial tasks.
How Active Participation in Rental Property Can Save Taxes
Here are two examples to see how the $25,000 allowance can help save taxes.
Example #1
Mr. Y is a single taxpayer without any children. The following applied to Mr. Y in 2024:
- Earned $80,000 in wage income
- Had $20,000 in rental losses
- Did not actively participate in his rental activity
Let’s look at the treatment of his income and losses for the tax year.
Since Mr. Y did not actively participate in real estate activities, his rental loss can only be used to offset passive income. He cannot net the $20,000 rental loss against his active wage income. His rental losses of $20,000 will be suspended for the current year and carried forward to 2024 to offset any future rental income.
Mr. Y’s 2024 tax is calculated as follows:
Wages | 80,000 |
Deductible Rental Loss | 0 |
Adjusted Gross Income | 80,000 |
Standard Deduction | (14,600) |
Taxable Income | 65,400 |
Income Tax (Rounded) | $9,441 |
The income tax is calculated using the 2024 income tax brackets for single filers as follows:
Tax = $5,426 [(65,400 − 47,151) × 22%] = $9,440.78
Example #2
Let’s consider the same facts as above, except that Mr. Y actively participated in real estate activity.
Since Mr. Y actively participated in real estate activities during the tax year, he can net his passive rental loss against his active income. Thus, he will subtract his rental losses from his income, and his adjusted gross income will be $60,000. His taxable income after subtracting the standard deduction of $14,600 is $45,400.
Let’s take a look at how this will work. Given Mr. Y’s active participation, his 2024 tax is calculated as follows:
Wages | 80,000 |
Deductible Rental Loss | (20,000) |
Adjusted Gross Income | 60,000 |
Standard Deduction | (14,600) |
Taxable Income | 45,400 |
Income Tax (Rounded) | $5,216 |
The income tax is calculated using the 2024 income tax brackets for single filers as follows:
Tax = $1,160 + [($45,400 − $11,600) × 12%] = $5,216
Although his taxes in the current year are lower, he won’t have any suspended losses to offset potential income in 2024 and later years. Generally, it’s best to deduct your losses as soon as possible, so Mr. Y will likely prefer to be an active participant. This might not be true if Mr. Y anticipates a higher tax rate in future years, in which case a deferred tax loss would be preferable.
Phase Out of the $25,000 Rental Loss Allowance
The maximum amount of the special allowance you can claim during the tax year is $25,000 ($12,500 if you’re married but file separate returns). The special allowance is reduced—or phased out in tax language—when modified AGI (MAGI) exceeds $100,000 ($50,000 if you’re married filing separately).
Modified Adjusted Gross Income
The amount of the $25,000 allowance that you are eligible to take depends on your modified adjusted gross income (MAGI). Your MAGI is determined by taking your adjusted gross income (AGI) and adjusting for certain deductions such as student loan interest, qualified education expenses, and adoption expenses.
Your AGI can be obtained from Form 1040, Line 11. To arrive at MAGI, you’ll need to add back certain deductions and then subtract certain income items. Here are the most common adjustments:
- Subtract taxable social security benefits
- Add back deductible IRA contributions
- Add back deductible student loan interest
- Add back a deduction for 50% of your self-employment tax
You can deduct up to $25,000 in passive losses against your ordinary income if your modified adjusted gross income (MAGI) is $100,000 or less. This deduction phases out by 50% of your MAGI above $100,000, and will completely phase out when your income reaches $150,000.
For example, if you have a MAGI of $130,000, your rental loss allowance is reduced by $15,000—from $25,000 to $10,000:
Phase-out = ($130,000 − $100,000) × 50% = $15,000
Rental loss allowance = $25,000 − $15,000 = $10,000
Carryforward of Excess Passive Losses
Rental losses that exceed your rental loss allowance (whether it’s the full $25,000 or a reduced amount) can be carried forward to future tax years and are referred to as suspended losses. Suspended losses can offset passive income in future years. If there is no passive income in the future year, suspended losses can be deducted using the rental loss allowance for that year remaining after the current year losses are deducted.
For example, assume that Mr. Y has suspended losses from 2024 of $10,000 and a current year loss in 2025 of $21,000. Further assuming Mr. Y’s rental loss allowance in 2025 is not phased out, he can deduct the $21,000 of 2025 loss and $4,000 of the suspended loss from 2024. The remaining suspended loss of $6,000 will be carried forward again to 2026.
Suspended losses can be carried forward indefinitely until the rental property is sold. Once sold, the suspended losses are “released” and can be deducted against any source of income. Suspended losses must be tracked separately for each rental activity so the proper amount can be released when the activity is sold.
Frequently Asked Questions (FAQs)
In general, no, but an exception applies when you actively participate in a real property rental activity, or when you materially participate in a rental activity and meet the IRS’ definition of a real estate professional.
No, generally, you don’t treat the work performed as an investor in an activity as participation unless the investor is directly involved in the day-to-day management or operations of the real estate activity.
You can carry your suspended passive losses forward indefinitely until you have used them to offset passive income or until you dispose of the activity. Passive losses are “released” and deductible when an activity is disposed of.
Active participation in rental property means that you take part in the management decisions required to operate the rental property. For purposes of the $25,000 allowance, you must have also owned a 10% interest in the property throughout the entire tax period.
Most rental activities are automatically passive, but exceptions exist for short-term rentals like motels and equipment rental.
Bottom Line
If you actively participate in rental real estate activities, you can net your losses from your passive income against other forms of income you earn. Netting your losses will lower your taxable income, and may lead to substantial tax savings.
