Rental Losses: Rentals generally are passive activities and are subject to the passive loss disallowance rules. See IRC § 469(c)(2). A loss from a passive activity is not currently deductible unless one of the following applies:
- Passive income exists (losses are allowed to the extent of passive income);
- The taxpayer actively participates in a rental real estate activity and qualifies for the $25,000 special allowance;
- There is a qualifying disposition under IRC § 469(g); or,
- The taxpayer meets the requirements of IRC § 469(c)(7) for real estate professionals.
The Law: A taxpayer may deduct up to $25,000 in rental real estate losses as long as the taxpayer actively participates and MAGI is less than $100,000. The $25,000 rental real estate allowance under IRC § 469(i)(8) allows individuals to offset losses from rental real estate without necessarily having passive income. A real estate professional is permitted treat a rental activity like any other business, but the taxpayer must materially participate to treat it as non-passive.
Active Participation: As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity. There is no specific hour requirement. However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager. Several categories of taxpayers do not meet the standard of active participation and therefore do not qualify for the $25,000 special allowance:
- A limited partner in an activity (IRC § 469(i)(6)(c)).
- A taxpayer who has less than 10 percent ownership (IRC § 469(I)(6)(A)).
- A trust or corporation. The $25,000 is available only to natural persons.
Modified Adjusted Gross Income: The full $25,000 allowance is available for taxpayers whose MAGI is less than $100,000. For every $2 a taxpayer’s MAGI exceeds $100,000, the allowance is reduced by $1. Once MAGI exceeds $150,000, the special allowance is no longer available.
Exceptions to Rental Definition
There are six exceptions to the definition of rental. Under Reg. § 1.469-1T(e)(3)(ii), six types of activities normally defined as rentals, are treated as non-rental activities, i.e. as businesses, in most cases. As a result, the active participation standard and the $25,000 allowance do not apply, it is passive or non-passive based on whether the taxpayer materially participates.
- The average period of customer use is 7 days or less. For example: condo rentals, short-term use of hotel/motel rooms, and businesses that rent videos/tuxedos/cars/tools, etc.
- The average period of customer use is 30 days or less and significant personal services are provided with the rental. Examples: hotels and motels.
- Extraordinary personal services are provided with the rental. Examples: hospitals, nursing homes and boarding schools.
- The rental is incidental to a non-rental activity.
- The taxpayer customarily makes the rental property available during defined business hours for nonexclusive use by various customers. Example: golf courses, health clubs and spas.
- The taxpayer provides the property for use in a non-rental activity of his own partnership, S Corporation, or joint venture. The key word here is “provides,” not “rents.” For example: a partner contributes property in exchange for an ownership interest. This non-leasing transaction with the partnership is not a rental. Reg. § 1.469-1T(e)(3)(vii) states: “Thus, if a partner contributes the use of property to a partnership, none of the partner’s distributive share of partnership income is income from a rental activity…”
Real Estate Professional: a real estate professional may treat rental real estate activities as non-passive if the taxpayer materially participates in the rental activities. The material participation requirement applies separately to each rental activity (unless the taxpayer made a timely election to group all his rentals as a single activity). These rules apply to individual taxpayers and closely held C Corporations. If the taxpayer does not materially participate, despite being a real estate professional, the rental is passive.
- To be a real estate professional, an individual must spend the majority of his or her time in real property businesses:
- Development or redevelopment
- Construction or reconstruction
- Acquisition or conversion
- Management or operation
- More than 50 percent of his/her time working in real property businesses; AND,
- More than 750 hours of service during the year. 
- The taxpayer must meet each of the following two time requirements:
Election to Group Rental Real Estate: A real estate professional may make an election to group all rental real estate activities as one single activity. In order to make a valid election, Treasury Regulation § 1.469-9(g) requires a taxpayer to file a written statement and attach it to an original return. This election cannot be made on an amended return or during an audit!
By curtis | Published: January 11, 2011