Many high earners buy rental property expecting depreciation and expenses to reduce their taxes. But under the IRS passive activity rules, rental losses do not automatically offset W-2 wages or other active income.
Why Rental Losses Are Usually Passive
Rentals are generally treated as passive, even if you help manage them. Passive losses can usually offset only passive income, not salary or active business income.
A special allowance lets active participants deduct up to $25,000 of rental losses, but it phases out between $100,000 and $150,000 of modified AGI, so most high earners cannot use it. Disallowed losses are not lost. They carry forward and can generally be used in full when the property is sold.
Real Estate Professional Status (REPS)
If you qualify for REPS and materially participate, rental losses may be treated as nonpassive. You must spend more than 750 hours a year in real estate trades or businesses, and more than half of your total working hours, including W-2 hours. This is very difficult with a full-time job.
On a joint return, one spouse can qualify even if the other has W-2 income, but spouses cannot combine hours for the REPS test.
Material Participation and Records
You must also materially participate in the rental, most commonly by spending more than 500 hours on it. Each property is generally a separate activity, so owners of several properties may need an election to treat all rentals as one activity.
Keep real-time logs of dates, hours, tasks, and properties, supported by calendars, emails, and invoices. Logs recreated after an IRS inquiry may receive more scrutiny.
Short-Term Rentals
If the average guest stay is 7 days or less, the property generally is not treated as a rental activity under the passive rules. If you materially participate, losses may offset active income without REPS. These rules are technical and heavily promoted online, so review them carefully first.
Plan Before Taking the Deduction
The real question is not whether your rental shows a loss, but whether that loss can legally offset active income. Review your income, participation, elections, and records before claiming it.
SKJ CPA helps individuals, families, and business owners review rental real estate strategies and related U.S. tax issues.