Rental property can be a very useful and simple way to earn income. In addition, the losses that it generates aren’t always bad; in fact, you can use the losses from your rental to offset the income earned from other activities like interest and dividends, certain pass-through businesses, and even in some cases, your W-2 wages.
Passive
Rental property is generally treated as a passive activity. Passive activities generate passive income or passive losses. The good news is that passive losses generated from a rental property can be used to offset other passive income like interest, dividends, passive business income or passive rental income, reducing your total taxable income. The bad news is that passive losses cannot offset wages, retirement income, nonpassive business losses, or capital gains; these are considered nonpassive activities. If you generate passive losses and have no passive income, these passive losses are carried forward. Over time, carryforward passive losses can add up and effectively become unused, causing taxpayers to miss out on opportunities for tax savings.
Nonpassive
Nonpassive income typically makes up the majority of a person’s taxable income, and only losses from nonpassive activities can offset that income. The question, then, is this: Can I make my rental property a nonpassive activity to reduce my nonpassive income? If this was the case, I could generate nonpassive losses to offset other nonpassive income. Fortunately for taxpayers, there are a few ways to have a rental business be considered nonpassive.
Short-Term Rentals
Requirements for a short-term rental activity:
- The average customer stay at your property is 7 days or less; and
- Material participation: Material participation means that you have spent 500 or more hours during the year on property management and more time than anyone else employed by you.
Examples:
- Air B&Bs
- Short-term vacation rentals
Where is this reported on a tax return?
- Schedule E, as nonpassive activities
The average customer stay is the deciding factor for these activities. Be careful, though; if you provide significant services to your tenants similar to a hotel (daily cleaning, provide meals, bed turn-down, activities, etc.), you will have to pay self-employment tax on that income.
Real Estate Professional Status
Requirements for Real Estate Professional status:
- Material participation (see above)
- You performed more than 750 hours of work in the activity
- You have spent more than half of your total labor on that activity: Essentially, you cannot spend 40 hours of labor each week on your W-2 job or personal non-rental business and only 10 hours each week on your rental property. You must have spent more time on the rental activity than anything else.
Where is this reported on a tax return?
- Schedule E, as nonpassive activities
Remember that Real Estate Professional status is not determined by whether you have a real estate license; instead, those three qualifications must be met.
$25,000 Special Allowance
Requirements for $25,000 Special Allowance:
- Active Participation: Active participation means that you are making management decisions in a significant and bona fide manner. If you approve new tenants, decide rental terms, approve expenditures, or other similar activities, you are actively participating.
Where is this reported on a tax return?
- Taxpayers calculate their special allowance deduction on Form 8582. The deduction is limited to $25,000.
In conclusion, we’ve covered three ways that rental property owners can treat their rental losses as nonpassive for the benefit of offsetting nonpassive income. Those are the short-term rental, real estate professional status, and the $25,000 special allowance. See which situation applies to your rental business so that you can effectively plan for tax success.
Consulting with a tax professional is recommended to help maximize your benefits while ensuring compliance with tax laws. If you're already a client, please reach out to your current contact as we will be happy to discuss this topic further with you. If you're not already a client, please call 724.934.4880 and we'll be happy to discuss your situation further to determine how we can best help.
