If you own rental properties that generate a loss, those losses are typically classified as passive losses on your tax return. This means that they are only deductible against other passive income for that year, and you cannot take passive losses that exceed passive income. However, if your passive losses exceed your passive income, you can carry those losses forward to future years.
That said, there are a couple of exceptions to this rule. First, if you meet the IRS qualifications of a real estate professional for tax purposes, then you can deduct losses up to a certain amount:
1. More than half of the personal services performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated; and
2. The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which he or she materially participated (Sec. 469(c)(7)(B)).
Second, if your income is under $100,000, a special rule allows landlords to deduct up to $25,000 in losses per year. That loss limit is phased out between $100k and $150k of modified adjusted gross income. The qualifications for this special rule are less stringent, but many are limited by their income.
What Are Suspended Passive Losses?
Suspended passive losses are the passive losses you could not deduct in the current year. These suspended passive losses can be carried forward indefinitely until you either use them to offset passive income or dispose of your rental property.
Also, your passive losses can be used to offset other types of passive income, such as limited partnership income, income from other rentals, or other business income you did not materially participate in.
Taxpayers should use IRS form 8582 to figure the amount of any passive activity losses for the year and report the use of any prior year unallowed losses.
Can You Deduct Suspended Losses When You Sell Your Property?
Yes, you can deduct your suspended losses from total profit when you sell your rental property, as long as you meet certain IRS rules.
First, when selling your rental property, you must sell “substantially all” of the rental activity. For example, if you own a single rental property and sell it, you have disposed of your entire interest and can take the full deduction. However, if you have more than one rental property, deducting your suspended losses depends on how your properties are structured.
If you manage each property as a separate entity, separating the activities for tax purposes, then disposing of one rental property would still qualify you to deduct the suspended losses in that year. In contrast, if you’ve elected to combine multiple properties into a single activity for tax purposes, then you cannot deduct the suspended losses unless you dispose of all the combined properties.
Second, it must be an arms-length transaction to deduct suspended losses when disposing of your property. This means you cannot sell the property to someone you have a pre-existing personal relationship with—you must sell to an unrelated party. That means not selling the property to family such as brothers, sisters, parents, grandparents, children, or grandchildren. Also, you cannot sell the property to a corporation or partnership in which you have more than 50% ownership.
Third, the sale must be a taxable event, meaning that a Section 1031 exchange where you defer the gains and roll them into another property will not qualify.
What Happens if You Lose Your Rental Through Foreclosure?
Unfortunately, some landlords may lose their rental property through foreclosure, leaving them to wonder what happens to their previously suspended passive losses?
Fortunately, the IRS Office of Chief Counsel has ruled that the foreclosure of a rental property qualifies as a taxable disposition and allows landlords to deduct their suspended passive losses during that year.
In a case involving the foreclosure of a $1,000,000 mortgage with $100,000 in suspended losses, the IRS ruled that the foreclosure is a fully taxable event, and the landlord could re-classify the losses as “not” from a passive activity and deduct them against their active income for the year. Notably, the passive losses were not reduced by any cancellation of debt from the foreclosure, meaning the landlord could deduct the total amount of previously suspended passive losses.
We’re Here to Help at Idaho Medical Association Financial Services
If you’re interested in working with a fiduciary CFP® professional to help map a unique investment plan for your circumstances, complete with a custom investment portfolio that accounts for rental properties, then Idaho Medical Association Financial Services is here to help.
Idaho Medical Association Financial Services is among the top Wealth Management firms in Idaho, specializing in fee-only money management services and investment planning for doctors. At Idaho Medical Association Financial Services, we focus on helping our clients build long-term wealth while also assisting them in maximizing the enjoyment they receive from their assets. We do this by partnering all of our clients with a dedicated CFP® professional backed by a team of financial experts.
For Idaho Medical Association Financial Services, it’s not just about managing your assets. It’s about serving our clients and helping them achieve all that comes with financial freedom. To learn more and schedule your no-cost consultation, visit our website at Idaho Medical Association Financial Services or call (208)-504-1736.