Active participation is a lower standard of involvement than material participation and is more commonly used among individuals, such as landlords and rental property owners. You are an active participant in your rental real estate activity if you own at least 10% of the rental property and are substantially involved in management decisions. Management decisions include approving new tenants, deciding on rental terms, and approving expenditures.
This level of participation allows you to deduct up to $25,000 in passive losses from your rental real estate each year against non-passive income. The $25,000 special allowance typically decreases by 50% when adjusted gross income (AGI) exceeds $100,000 and completely disappears when AGI exceeds $150,000.
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How To Qualify for Active Participation
To qualify, you simply need to meet the following criteria:
- You must own at least 10% of the rental and have substantial involvement in managing the rental.
- You are not a limited partner
- The amount of loss eligible for the $25,000 allowance is determined by netting income and losses from all of the rental real estate activities in which you actively participate
Note that active participation is not the same as material participation. Active participation is a less stringent test that makes it possible for individuals who are not real estate professionals to deduct their passive losses from both passive and active income.
Phase out of the $25,000 Loss Allowance
The maximum amount of the special allowance that you can claim during the tax year is $25,000 ($12,500 if you’re married but file separate returns). 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 for MAGI above $100,000 and will completely phase out when your income reaches $150,000.
Your MAGI is determined by taking your AGI and “adding back” certain deductions.
You’ll begin with your AGI from Form 1040, Line 11, and then add back certain deductions and subtract certain income.
Here is a sample of deductions that could be added back to calculate MAGI.
Adjustment | IRS Form/Line number |
|---|---|
Subtract Social Security and Railroad Benefits | Form 1040-SR, Line 6b |
Add Back Deductible Individual Retirement Account (IRA) Contributions | Form 1040, Schedule 1 |
Add Back Deduction for Student Loan Interest | Form 1040, Schedule 1, Line 6 |
Add Back Deduction for One-half of Self-employment Tax | Form 1040, Schedule 1, line 15 |
Add Back Rental Losses Claimed by Real Estate Professionals | Form 1040 Schedule E or Schedule C |
Subtract Employer-paid Adoption Expense | Form1040, Line 1f |
Click here for two examples to see how the $25,000 allowance can save you taxes.
Mr. Y is a single taxpayer without any children. The following applied to Mr. Y during the tax year:
- Earned $80,000 in wages
- Had $20,000 in rental losses.
- Did not actively participate in 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, he cannot net his passive rental loss against his active income. His rental losses of $20,000 will be suspended for the current year and carried forward to 2024 to offset any potential rental income.
Mr. Y is a single filer who earns $80,000, so after deducting the $13,850 standard deduction from his income, he still has $66.150 in income. This puts him over $44,725, but not over the $95,375 tax bracket for 2023. His total tax due will be based on the following formula: $5,147 plus 22% of the excess over $44,725.
If taxable income is | The tax due is |
|---|---|
Not over $11,000 | 10% of taxable income |
Over $11,000 but not over $44,725 | $1,100 plus 12% of the excess over $11,000 |
Over $44,725 but not over $95,375 | $5,147 plus 22% of the excess over $44,725 |
Excerpt of 2023 tax brackets
Tax = $5,147 + [($80,000 – $13,850) – $44,725] x 22% = $9,860.50
Let’s consider the same facts as above, except that Mr. Y did actively participate 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 $13,850 is $46,150.
Let’s take a look at how this will work.
Tax = $5,147 + ($46,150 – $44,725) x 22% = $5,460
Although his taxes in the current year are lower, he also doesn’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 prefer to be an active participant. This might not be true if Mr. Y anticipates a higher tax rate in future years.
Frequently Asked Questions (FAQs)
In general, no, but an exception applies when you actively participate in a real property rental activity.
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 all of them up or until you dispose of the activity. Passive losses are “released” and deductible when an activity is disposed of.
Bottom Line
If you actively participate in rental real estate activities, do not forget to net your losses from your passive income against any other form of income you earn. Netting your losses will lower your taxable income, which will lead to a huge tax savings that you don’t want to miss out on.
