What it means
Normally, losses from passive activities, such as rental property, can only be used against income from other passive activities. This stops people from using paper losses on rental property to reduce tax on their salaries.
The rental real estate loss allowance is a limited exception to that rule. To qualify, the taxpayer must generally take an active part in the rental, for example by approving tenants, setting rents and authorising repairs, and must own a meaningful share of the property.
If those conditions are met, the taxpayer can deduct rental losses up to a capped amount against wages, business income and other non-passive income. Losses beyond the cap are not lost but carried forward to future years.
The cap reduces as the taxpayer's adjusted income goes above a threshold, and it falls to zero at a higher level. The result is that relief is concentrated on small and moderate landlords and not on high earners.
The exact dollar limits and thresholds are set in tax legislation, so anyone relying on them should check the figures in force for the relevant year. Landlords often create rental losses without a real economic loss, because depreciation (the tax deduction for the wear of a building over time) and mortgage interest can exceed rent in the early years.
The allowance converts some of that on-paper loss into a current tax saving. Higher earners who cannot use the allowance still benefit eventually, as suspended losses can offset rental profits or be used when the property is sold.
Readers outside the United States should treat this as one example of a wider idea. Many countries limit how rental losses may be used against other income, and they differ in the thresholds, the types of landlord covered and the carry-forward rules.
A local adviser is the best source of current detail.
In practice
Real-world examples.
Example
A schoolteacher owns a rental flat and manages it herself, approving tenants and arranging repairs. The flat shows a $6,000 tax loss in its first year because of depreciation and interest. Her income is below the threshold, so she deducts the full loss against her salary and reduces her tax bill.
Example
A software director earns well above the phase-out range and owns two rental houses that make tax losses. He receives no allowance in the year, but his accountant tracks the suspended losses. He plans to use them against rental profits in later years or when he sells the properties.
Example
A couple with combined adjusted income just over the threshold own a small apartment building. Their allowance is reduced but not eliminated. Their adviser times a repair program and a bonus payment to keep income lower in the year the property makes its largest loss.
Formula
Calculation
Allowance = Maximum cap - (Reduction rate x (Adjusted income - Threshold)), not below zero
Deductible loss = Lower of (Rental loss, Allowance)
Suppose, for illustration, the cap is $25,000, the threshold is $100,000 and the reduction rate is 50%. A landlord has adjusted income of $120,000, so the allowance = 25,000 - 0.50 x (120,000 - 100,000) = 25,000 - 10,000 = $15,000. The rental loss for the year is $22,000, so the deductible loss is the lower of 22,000 and 15,000, which is $15,000. The remaining 22,000 - 15,000 = $7,000 is carried forward to later years. These figures are only a worked illustration and the actual limits should be checked in current tax law.Case study
Seen in the real world.
Maple Grove Investors is an illustrative, fictional pair of siblings who bought a duplex and ran it themselves. In the first year the property produced $18,000 of rent but $31,000 of costs, including mortgage interest, repairs and depreciation.
The siblings' tax adviser confirmed they had actively participated in the management and that their incomes were below the phase-out range. They deducted the $13,000 loss against their salaries, saving several thousand dollars in tax.
In the following year, one sibling earned a promotion and her income rose into the phase-out range, so the allowance fell. The adviser explained that the unused loss would carry forward, and the illustrative lesson was that the timing of income can matter as much as the size of the loss.
Watch out
Common mistakes.
- Assuming that any rental loss can be deducted against salary, when the allowance is capped and reduced as income increases.
- Failing to keep records showing active participation, such as approving tenants and authorising repairs.
- Treating disallowed losses as gone forever, when they can normally be carried forward to later years.
Questions
People also ask.
Who qualifies for the allowance?
Generally, taxpayers who own a significant share of the property and actively take part in managing it, and whose income is below the phase-out limit.
What happens to losses I cannot use now?
They are normally suspended and carried forward, to be used against future rental income or when the property is disposed of.
Are the dollar limits fixed?
They are set by law and may be changed by legislation, so always confirm the figures that apply to the tax year in question.
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