Many property owners are puzzled when they discover that losses from their rental properties aren’t deductible. This can be especially frustrating for those who rely on these deductions to offset other taxable income.
Understanding the reasons behind this limitation is essential for effective financial planning and tax strategy. Let’s explore the key factors that influence whether you can deduct your rental property losses.
Passive Activity Status
The U.S. tax code generally treats any rental activity as passive unless an exception applies. 1Legal Information Institute. 26 U.S. Code § 469 – Passive Activity Losses and Credits Limited
Material participation requires meeting specific tests in the regulations, including participating for more than 500 hours during the year. 2Electronic Code of Federal Regulations. 26 CFR § 1.469-5T – Material Participation (Temporary)
The passive activity loss rules, introduced by the Tax Reform Act of 1986, were designed to limit tax shelters that allowed offsetting active income with passive losses. Court cases like Sidell v. Commissioner have clarified these rules, making it essential for property owners to understand how participation impacts their tax benefits.
Income Threshold
For the 2025 tax year, individuals with adjusted gross income (AGI) of $100,000 or less can deduct up to $25,000 of losses from rental real estate in which they actively participate; this allowance phases out between $100,000 and $150,000 of AGI and is fully eliminated above $150,000. 3Legal Information Institute. 26 U.S. Code § 469 – Passive Activity Losses and Credits Limited
For instance, a taxpayer with AGI of $120,000 would have a reduced deduction limit of $15,000, calculated by reducing the $25,000 limit by 50% of the amount exceeding $100,000. Taxpayers near these income limits can explore strategies like maximizing retirement contributions or deferring income to manage AGI and retain eligibility for deductions. Consulting a tax professional can help tailor these strategies to individual circumstances.
Personal Use vs. Rental
The IRS distinguishes between personal and rental use based on days used personally versus days rented. A property is treated as a residence if personal use exceeds the greater of 14 days or 10% of the days rented at fair rental, which limits rental loss deductions. 4Legal Information Institute. 26 U.S. Code § 280A – Disallowance of Certain Expenses in Connection with Business Use of Home, Rental of Vacation Homes, etc.
For example, if a property is rented for 200 days and used personally for 25 days, it exceeds the 10% threshold, classifying it as a personal residence. Only expenses attributable to the rental portion, such as mortgage interest and property taxes, can be deducted. Accurate records are necessary to substantiate the number of days a property is rented versus used personally.
This classification affects deductible expenses like repairs and depreciation, which may become non-deductible or partially deductible if the property is deemed a personal residence. Maintaining detailed records helps ensure compliance with IRS regulations and reduces the risk of audits.
At-Risk Amount
Your deductible loss is also limited to the amount you are “at risk,” generally including money and property you contributed and amounts you borrowed for which you are personally liable or secured with property. 5Legal Information Institute. 26 U.S. Code § 465 – Deductions Limited to Amount at Risk
For instance, if you invested $50,000 cash in a rental and took out a nonrecourse $200,000 loan, your at-risk amount is typically $50,000. Proper calculation and documentation of the at-risk amount are critical to ensuring compliance with IRS rules.
Real Estate Professional Status
Qualifying as a real estate professional removes the per se passive treatment of rental activities, allowing losses to be nonpassive if you materially participate. To qualify, you must perform more than 750 hours of services during the year in real property trades or businesses and those services must constitute more than half of your total personal services for the year. 6Legal Information Institute. 26 U.S. Code § 469 – Passive Activity Losses and Credits Limited
Taxpayers must also demonstrate material participation in each rental property unless they elect to treat all interests in rental real estate as a single activity under Treasury Regulation § 1.469-9(g). 7Legal Information Institute. 26 CFR § 1.469-9 – Rules for Certain Rental Real Estate Activities
Insufficient Documentation
Even when taxpayers meet the requirements for deducting rental property losses, insufficient documentation can prevent them from claiming these deductions. The IRS requires accurate and comprehensive records to substantiate claims, particularly for material participation, rental income, and expenses.
Documentation should include lease agreements, rent payment receipts, and invoices for deductible expenses like repairs and maintenance. Depreciation schedules must also be accurate and follow IRS guidelines under MACRS, as errors can lead to disallowed deductions or penalties.
Detailed logs are essential for proving material participation or real estate professional status. These logs should include hours spent on activities like tenant communication and property repairs. Estimates are insufficient and may be challenged during audits. Utilizing accounting software can streamline record-keeping and help ensure compliance with IRS standards. Thorough documentation safeguards deductions and minimizes audit risks.